The Market Solution!

As a believer in market solutions/mechanisms, the last few weeks have been trying, to say the least." How, in the face of all that has happened, can you still trust markets?" is a question that I have been asked. I could give you all the facile answers - it is not the market's fault... imperfect regulatory frameworks are to blame... errant traders are the reason.. but my heart is not in any of these explanations.
I think that markets did fail, at least partially, in this cycle, just as they have in other cycles in the past. The costs are being borne by all of us. Notwithstanding the failure (and others like it), here is why I still remain a believer in markets. Markets exaggerate the best and worst aspects of human nature. At their best, human beings are creative, innovative and capable of bouncing back from the worst of adversity, and markets allow them to have maximum impact. From the Model-T Ford to the Google search engine, financial markets have allowed entrepreneurs to reach beyond their local markets, reach a broader marketplace and change the world in the process. At their worst, human beings are short term, greedy and not particularly rational, and markets feed into these emotions. When markets are good, we exalt them and when they are bad, we detest them.
So, here is the question. Would we be better off without financial markets? The good of markets, in my view, vastly outweighs the bad. While that may seem debatable at this point in time, consider two of the fastest growing economies in the world - India and China. For centuries, the people in the two most populous countries in the world stagnated under controlled economies (with colonial powers, royalty and central governments - socialist or communist- all promising a better future, but not delivering). In two decades, markets have done more to bring the the poor out of poverty in these countries than the rulers from prior generations. I may be an optimist but I do trust markets more than experts, when it comes to the big issues of the day!



Step away from the ledge!

Let's get the bad stuff out of the way first. It was an awful day for investors in every market. There was no safe haven today. I am sure that you are convinced that the end of the world is coming but let me offer you my take on the market.
First, the bad news. The credit crisis is spreading beyond mortgage backed securities. As banking failures in Europe illustrate, the problem is a much wider one. Banks lost their perspective on default risk and lent money at rates that were far too low to borrowers who did not meet the creditworthy test - individuals, corporations and businesses. As borrowers default, loan portfolios are being savaged around the world and the banks that were most aggressive about seeking out growth are facing the consequences.  Banks spread their pain around and there is no way that the global economy will not feel the pinch. At this stage, the question seems to be no longer whether we are in a recession but how deep and long the recession lasts. The failure of the bailout bill also illustrates the precarious state that markets are in: we are really in trouble when traders on the floor are watching  congressional vote tallies and reacting to the success and failure of legislation.
Second, the neutral news. So what do I think will happen next? There will be congressional action, though I am not sure whether the action will be necessarily in the long term best interests of either Wall Street or Main Street. The market will have its relief rally, just to show that it is playing along. 
So, what is the good news? Investors, consumers and economies are a lot more resilient than we give them credit for. While the great depression seems to increasingly be a theme in business news stories, I think that the modern global economy can weather the storm and come out of it intact. My suggestion to you is to think long term (if you can afford to) and invest in companies with healthy balance sheets and solid products. The Coca Colas, Apples and Nestles of the world will still provide long term value.



II. Why did it happen?

The blame is being spread around for the current crisis:  securitization, lax regulation and the housing bubble have all been fingered as culprits, but I think that these were contributing factors. I would attribute what has happened on financial markets to two phenomena, one of which is age-old and cannot be easily cured by regulation or laws and the other of which can be remedied.
1. Over optimism and hubris: Through history, we (as human beings) have always exhibited these traits. In good times, we become complacent and under estimate the likelihood of their ending, and we also tend, when successful, to attribute that success to our skills (rather than to luck or good fortune). It does not surprise me that there was a housing bubble and I do not believe for a moment that this is the last bubble that we will see in our lifetimes. There will be other bubbles in other markets, just as there always have been through history.
2. Risk taking and risk bearing: I know that risk is viewed as a bad word now. Rather than viewing excessive risk taking as the problem, we need to examine why it occurred in the first place. I believe that the separation between risk taking and risk bearing is at the heart of this crisis. Our risk takers (traders, bankers, mortgage brokers) sought out risks because they shared in the lucrative upside (with compensation tied to profits from activity), but the downside of risk was borne by others (the deposit insurers, taxpayers, other banks and investors). To fix this asymmetry we need to do two things: 
(a) Reform compensation systems to make them less tied to outcomes in short periods. A trader who receives a large bonus in the year in which he makes a large profit on his trading position is receiving encouragement to take the wrong types of risk. Compensation should not only be tied to more long term results but should also be linked to process (as opposed to outcome). In other words, a trader who makes money by taking the wrong types of risk should be punished and not rewarded. 
(b) Price risk correctly: A system that systematically subsidizes excessive risk taking by charging the same price for insuring all risk takers, no matter how much risk they take, is a system designed to fail in the long term. Charging all banks the same price for federal deposit   insurance, while allowing them to have very different loan/asset risks, will result in some banks gaming the system for profit. Prudent banks and taxpayers should not be providing subsidies for imprudent risk taking.
I am not suggesting that either of these actions will be easy to implement, but the task is laid out for us. It is time to get to work!



I. What happened?

This is the first of three posts that I hope to put up on my thoughts on what we see unfolding in financial markets. Here is my take on what happened:
1. The ultimate sources of this turmoil are the real estate market and the bond market. Between 2002 and 2007, housing prices increased at rates unseen in decades and well above the inflation rate. At the same time, default spreads on bond markets converged on historical lows.
2. As housing prices increased, funded by cheap mortgage financing, the mortgages themselves were bundled into mortgage backed securities, entitling buyers to different layers of the collective cash flows on the mortgages, with the first layers having the least risk and the last layers of the cash flows having the most risk.
3. The same optimism that pervaded the housing market (about future housing prices) and the bond market (about future default spreads) led to the mispricing of every layer of these mortgate backed securities, with the mispricing being greatest at the riskiest (or top) layers of the cashflows.
4. Financial services companies (banks, investment banks, insurance companies) were the primary investors in these mortgage backed securities, with the former using debt to fund much of their holdings. In some cases, investment banks were buying the riskiest layers of the mortgage backed debt, using short term financing.
Here is how it unraveled:
1. Housing prices started their decline at the end of 2006 and accelerated into 2007. The contemporaneous economic slow-down also started pushing up default spreads in bond markets.
2. The values of the mortgage backed securities on the books of buyers started dropping as the built in assumptions about increasing housing prices and low default risk came under assault.
3. A few financial service companies reacted quickly and sold some or most of their holdings by mid-2007, taking their losses. Most held on, hoping for a market turn-around. 
4. Accounting requirements on marking-to-market required banks to begin restating the values of their securities to reflect current value. As the values of mortgage backed securities dropped, the liquidity in these markets also dried up, leading to big write-offs in value, which in turn reduced the book equity at these firms. 
5. As the book capital dropped, these firms started showing up on regulatory warning screens as being under capitalized, based on book equity. (In late 2007, firms like Lehman and Bear Stearns could have made equity issues or raised fresh equity to provide a safety margin, but they believed they could ride out the storm).
6. As the liquidity problems in the mortgage backed security market worsened, the write downs continued. By the beginning of the summer of 2008, firms like Bear Stearns and Lehman had lost any buffer they might have had, and the equity options available at the end of the prior year had also dried up.
7. Bear Stearns is liquidated, with the Fed's help. If Lehman had one last chance to raise fresh equity, it would have been in the weeks after the Bear liquidation. 
8. The hits keep coming and Lehman falls. The question, given the absence of liquidity in the mortgage securities market, is who's next? That turns out to be AIG, but it is quite clear that there will be always someone else next in line who will be targeted to fall. 
9. The recognition that this is as much a liquidity problem as a valuation problem comes to the Treasury and the Fed. The Paulson bailout is a liquidity plan, where the illiquid securities will be taken off the books of financial service firms, and held by the Federal Government, the only institution that can create its own liquidity (nice to control those printing presses).
I am hoping that the next phase is a happier one but we are watching financial history get written as we speak!





GE's aborted buybacks...

In news that was overshadowed by the bailout debate, GE announced today that it was suspending its stock buyback program. While the suspension was precipitated by declining earnings and worries about GE Capital, there are some general comments that I want to make about the action that relate to stock buybacks in general
1. Flexibility: One of the biggest reasons for the shift among US companies from dividends to buybacks was that firms can respond much more quickly to adverse circumstances with the latter. GE's announcement on buybacks was greeted with sanguinity by markets today. If GE had cut dividends, the market reaction would have been much more negative than it was this announcement.
2. Announcement versus Action: Investor should take stock buyback programs announced by companies with a pinch of salt. Many company announce buyback programs with fanfare but do not carry through all the way.
3. Valuation: Last year, companies in the S&P 500 returned twice as much cash to stockholders in the form of stock buybacks than dividends, resulting in a total yield of 5.34% on the index (about 1.9% from dividends and the rest from buybacks). One measure of whether the equity market will be able to sustain the body blows it is receiving now will be in how well the buyback number holds up for the next year or so. A bunch of companies, including Microsoft ($40 billion), have announced buyback programs.



The Bailout

The news of the week has been the proposed Federal (or Paulson) Bailout, with $700 billion being the price tag associated with it. Let me state at the outset that there is a crisis looming over many financial service firms and drastic action is unavoidable. So, is this bailout the solution?
1. The price tag on the bailout is a little misleading. The $700 billion is what the government will pay to buy mortgage backed securities off banks, but the net cost will be lower. In fact, if everyone goes back to paying their mortgages on time, the Federal Government will make money on the deal. It is very unlikely that this optimistic scenario will unfold. What is far more likely is that there will be defaults, and how much this bailout will cost us will depend upon how quickly housing recovers.
2. There are two keys to making this not a "bailout". The first is to pay fair value (See below) for these mortgage backed securities, rather than an optimistic value or face value. This fair value may still be a bargain for banks that face the problems of having to mark these securities to market every period. To the extent that liquidity has dried up in this market, these securities may well have to written down below fair value. The second is for taxpayers to get something in return for taking these problem securities off the books. I would use the Buffett model (from his Goldman acquisition) and ask for warrants or equity to compensate for at least a portion of the difference between the fair value and the current value (which will reflect the illiquidity).
(What is fair value? It is the present value of the cumulative cashflows on these mortgage backed securities, discounted back at a rate that realistically reflects default risk. This will be well below face value, since these securities were misvalued using default risk estimates that we too low.)
3. I know that the zeal for punitive measures is strong and that people want to punish the bankers who have put us in this position. While I will not defend sloppy valuations and poor oversight, I also believe that there is plenty of blame to go around. In fact, anyone who bought a house in the last 5 years and traded up, using a cheap mortgage to fund the move, participated in the benefits of the boom. I am not eager to seek out these homeowners and punish them either.
4. Regulation is not the answer. After all, this problem was created by a patchwork of regulations that left loopholes to be exploited. What we need is a consistent regulatory environment that covers all types of risky assets, rather than different regulatory environments for real estate, mortgage backed securities,  corporate bonds and equities. In fact, I think trying to regulate trading and restrict risk taking in a global marketplace is akin to trying to stop unauthorized downloads of movies on the internet... A waste of time and money!
I think that the bailout will not end the troubles at banks, but it is a solution to the liquidity crisis that is haunting this market. 




The end of investment banking?

The big news of the morning is that Goldman Sachs and Morgan Stanley will reorganize themselves as bank holding companies, thus ending a decades-long experiment with stand-alone public investment banking. Before we buy into the hyperbole that this represents the end of of investment banking as we know it, it behooves to us to look both back in time and into the future and examine the implications.
Independent investment banks have been in existence for a long time, but for much of their existence, they were private partnerships that made the bulk of their profits from transactions and as advisors. They seldom put their own capital at risk, largely because they had so little to begin with and it was their own money (partners). Part of the impetus in their going public was the need to raise more capital, which in turn, freed them to indulge in more capital-intensive businesses including proprietary trading. That model worked well for much of the last two decades, but three things (in my view) destroyed it. The first was that it became easier to access low cost, short term debt (especially in the last few years) to fund the capital bets that these firms were making, whether in mortgage backed securities or in other investments. The second was that the compensation structure at investment banks encouraged bad risk-taking, since it rewarded risk-takers for upside gains (extraordinary bonuses tied to trading profits) and punished them inadequately for the downside (at worst, you lost your job but you were not required to disgorge bonuses in prior years... in many cases, finding another trading job on the Street or at a hedge fund was not difficult to do even for the most egregious violators). The third was a patchwork of government regulation that was often exploited by investors to make risky bets and to pass the risk on elsewhere, while pocketing the returns. The combination worked in deadly fashion these last two years to devastate the capital bases at these institutions. Lehman, Bear Stearns and Merrill have fallen...
So, what will change now that Goldman and Morgan Stanley have chosen the bank route? The plus is that it opens more sources of long term capital since they can now attract deposits from investors. Having never done this before, they start off at a disadvantage. The minus is that they will now be covered by banking regulation, where the equity capital they be required to have will be based upon the risk of their investments. This will effectively mean that they will need more equity capital, if they want to keep taking high risk investments, or that they will have to bring down the risk exposure on their investments. My guess is that they would have gone down one of these roads anyway. In pragmatic terms, it will also mean that their returns on equity at investment banks will drop to banking levels - more in the low teens than in the low twenties. I think the stock prices for both investment banks already reflects this expectation.
Ultimately, Goldman and Morgan Stanley have sent a signal to the market that they are willing to accept a more restrictive risk taking system. In today's market, that may be the best signal to send. There will be times in the future, where I am sure that they will regret the restrictions that come with this signal, but they had no choice.



Are you a contrarian?

In investing mythology, there is a special place reserved for the contrarian investor, i.e., the investor who goes against the crowd and makes money in the process. In fact, many investors, asked to describe themselves, describe their investment style as both contrarian and long term. But are you really a contrarian investor? Last Wednesday offered a simple test. At 3.45 pm, the S&P 500 was down to about 1150, the Dow had dropped 800 points in three days and the bottom was falling out of the market. If you were watching the screen at that time, which of the following impulses did you feel?
1. Denial: This is a bad dream... I am going to wake up from it any moment... It is not happening.
2. Panic: Sell everything. The world is coming to an end.
3. Cool Assessment: Buy now. Panic yields the best opportunities.
4. Wait and see: I think I should buy, but I am too nervous. Let me wait for things to settle down a little bit.
If you were truly a contrarian, you would have chosen (3) and done something about it: tapped out your cash reserved and invested in banking stocks, for instance..... For most of us, though, denial, panic and waiting would have been more natural impulses. At the risk of revealing more about my psyche than I should be, I did not pass the contrarian test. I chose to wait and see, which in the long terms turns out to be waiting and waiting for the right moment, which either never comes or comes too late. I think, though, that there are broader lessons to be learned from this test. 
a. It is easy in the abstract to be a rational, long-term investor. It is much more difficult in practice. The same can be said about being a contrarian.
b. The fact that information is so much more easily accessible and timely has actually made the task of being a long-term investor more difficult. Twenty years ago, most of us would have been working in blissful ignorance at our regular jobs, completely unaware (at least during the day) that Wall Street was collapsing... and that may have been healthier.
c. You cannot force yourself to adopt an investment style that does not fit your make-up as a human being. Many of us are not hard-wired to be patient, long term investors, and fewer still have the stomach to go against the crowd.



What is the risk free rate?

The risk free rate is the building block on which we erect risk premiums. When I was taking my first finance classes a long, long time ago, I was taught that the risk free rate for U.S. dollar based returns was the treasury rate - the T.Bill rate for short term and the T.Bond rate for long term. The implicit assumption, not often stated, was that the US Treasury was incapable of default. At worst, they would print more currency to pay off bonds coming due. This is a lesson I have passed on to students in my classes and put into print in my books.
This week, that conventional wisdom was challenged for the first time. After the Federal Government stepped in to provide a backstop to AIG, and then later in the week, for an even larger package of mortgage backed securities, there was a sense in markets that the rules of the game had changed. In the Credit Default Swap (CDS) market, where investor buy and sell insurance against default risk, the price for insuring against default risk in the treasury climbed to 0.25%, on an annual basis, on September 18, 2008. While it is possible that this was an over reaction to the tumult of the week, that number should give us pause. If true, the true long term riskfree rate in U.S. dollars on September 18 was not the 10-year treasury bond rate of 3.77% but the default risk adjusted rate of 3.52% (3.77% - 0.25%).
I will wait and see what the next few weeks bring. It may be time to rewrite finance textbooks to reflect the new realities.



The key number for stocks: The Equity Risk Premium (ERP)

If there is one number that captures what the market mood is right now and how investors feel about equities collectively, it is the equity risk premium (ERP), i.e. the additional return that investor are charging for buying equities instead of putting their money into treasuries. The equity risk premium reflects the tug-of-war between hope and fear that equity investors bring to the market, and will vary on a day-to-day basis. As investors become more risk averse, they will a higher equity risk premium, which should translate into lower stock prices.
Last week provided a laboratory to observe movements in both direction in the equity risk premium. We started Monday morning (9/15/2008) with the S&P 500 at 1250 and the equity risk premium at 4.54%, but here is what happened over the week:
9/15/2008 (End of day): S&P 500 = 1193 ; ERP = 4.75% ; Fear rules (Lehman down)
9/16/2008 (End of day): S&P 500 = 1214; ERP = 4.67% ; Recovery (Hope for AIG/)
9/17/2008 (End of day): S&P 500 = 1156 ; ERP = 4.90%; Sheer, unadulterated Panic... 
9/18/2008 (End of day): S&P 500 = 1207; ERP = 4.70%; The world did not end!!!!
9/19/2008 (End of day): S&P 500 = 1255; ERP = 4.52%: Euphoria!!!
Now, that was a week for the history books!!!!
If you are wondering how I came up with these numbers, I won't bore you with the details here but you can download a paper on the topic on my website at
Check under research/papers! I would love to have your comments!





Selling Short: The debate

One of the big news items competing for attention today was the SEC's decision to bar short selling temporarily on more than 700 financial service companies. While the SEC statement paid the usual lip service to the importance of allowing short selling in orderly markets, it also concluded that short selling was contributing to market instability and should not be allowed for the moment.
Implicit in the ban, and in the support that it is getting from many investors and portfolio managers, is the assumption that short sellers are bad people - speculators, naysayers and vultures who make money off long term investors. I think that short sellers, like long buyers (why not?), cannot be easily categorized. Some are motivated by good information, some are trading on rumor and some can be unscrupulous (floating false news stories to bolster their positions). While the ban may have helped markets today, here is why I think it is counter productive:
1. If we want market prices to reflect all news, good as well as bad, we have to allow people to trade on both types of news.
2. Investors who believe that the prices of Citi, Chase or Goldman are going to drop in the next few weeks can evade the ban by using options or other alternatives. In effect, banning short selling is either going to push it deeper underground or make the carnage worse on the financial service companies where other alternatives exist.
I do believe that investors who take positions in stock - long or short - should be held accountable when they try to manipulate the price afterwards. That is an enforcement issue that the SEC should be thinking about rather than short circuiting the process.



The most exciting flat week ever?

I think we have a candidate for the most exciting flat week ever. The S&P 500 started the week at 1250 and ended the week at 1255, with two huge up days (yesterday and today) offsetting two huge down days (Monday and Wednesdays). The financial world at the end of the week looked very different from the beginning, with the ranks of investment banks thinning and government suddenly becoming the biggest player in the game. I am not willing to make a prediction of whether next week will be up or down (I know - that is quite cowardly of me) but I am willing to bet it will be volatile.  Hang on for a wild ride!



Risk = Danger + Opportunity

I have always believed that the Chinese symbol for risk, which combines the symbols for danger and opportunity, is the best definition of risk. Danger and opportunity are connected at the hip, something worth remembering in both good times and bad. In good times, opportunities abound, and the salespeople for these opportunities (brokers, hedge funds) tell us that there is little or no danger: those 70% returns are touted as "low-risk". In scary times, all we see is danger and no investment looks good. In both cases, we would be well served stepping back and looking for the link. Lucrative opportunities always expose us to risk, even in the best of times. And dangerous times bring opportunities, if we keep our eyes open and our wits about us! 



Market Meltdown

This has been a horrendous week for markets. As markets collapse globally, and doomsday scenarios are envisioned, it is time to take a step back and assess where we are.
1. Equity indices are down about 8-9% for the week in the United States and more in some emerging markets. The S&P 500 is down almost 20% for the year, a bad year by most standards but not quite a catastrophe (yet). 
2. The damage to equities has been uneven. The most pain has been inflicted in financial service companies (banks and investment banks). The decline in the rest of the market is far more muted.
3. While fear and panic are in the air in financial markets, the real economy, other than housing, has held up fairly well so far.
I do not know what tomorrow will bring, but if you have bragged about being a "contrarian", now is the time to put your money where your mouth is....




First thoughts

I must confess that I have mixed feelings about blogs. I do read quite a few on a variety of topics, but I have held back on starting one of my own for two reasons - first, I am not sure that I have enough to say that is interesting on a continuous basis and second, everything I say will be online for better or worse. Anyway, now that I have made the leap, here is what I hope to put on this blog on a regular basis. 
1. I will try to put down my thoughts and reactions to the news of the day, with an emphasis on how the news fits into my big picture view of corporate finance and valuation.
2. I will t follow some central themes in finance - equity risk premiums, the measurement of risk - and provide regular updates on interesting research in the area and how my thinking is evolving on the topic.
3. Once in a while, I will highlight a company that I am valuing and ask for your thoughts on the valuation.
I hope you will enjoy my ranting. 



Another strange incident... in a market full of anomalies!

In markets such as this one, where investors are reacting to events and rationality takes a back seat, we should not be surprised when we see anomalies... And that is where I would put what happened to Volkswagen's stock price this week. For a brief period on Tuesday, Volkswagen's market cap jumped four-fold to briefly become the largest market cap company in the world (in excess of $ 350 billion). In the process, hedge funds who had shorted the stock lost almost $ 20 billion. It was a classic "short squeeze", sometimes seen with small, market cap companies that are lightly traded, but seldom in a company of this size.
So, what happened? First, more than 60% of the shares in Volkswagen were held by investors who were not interested in selling the shares - 40%+ by Porsche and 20% by the Government of Lower Saxony; the float in the shares was low. Second, Porsche triggered the first run-up in the price by revealing that it would push its ownership stake to a higher number (60% or more). Third, the jump in the overall equity market on Tuesday added fuel to the price increase fire. Finally, the short positions that the hedge funds had were public information. Consequently, investors with net plus positions in the stock knew that they had the hedge funds over a barrel and could bargain for a higher price.
Today, the recriminations are flying. The hedge funds are accusing Porsche of misleading them, by leading them to believe that it would not increase its existing holding in VW. I think that Porsche did take advantage of these hedge funds and made billions in profits; in fact, it made more money from call options it had on Volkwagen stock last year than it made on it's entire auto business put together. At the same time, I feel not one iota of sympathy for the complaining hedge funds, since I am sure that they would have had absolutely no qualms doing exactly what Porsche did, if their roles had been reversed. You live by the sword, you die by the sword...



What is the message the market is sending?

The interesting theme that emerged from last week's market mayhem is how the story driving market movements has suddenly shifted from banking problems to the overall economy. Until last week, every market move was traced back to banks or investment banks in trouble and the governments' attempts to bail them out. Last week, the collapse of the markets was almost entirely attributed to the recession that investors/economists see looming for next year.
While I am not dismissing the notion, it is worth looking at history to see how good or bad a predictor the market is, when it comes to the real economy. Someone far wiser than I once said that the market has predicted ten of the last seven recessions. I think that saying captures both the strength and the weakness of the market. Most economic slowdowns have been preceded by market declines but not every market decline has been followed by a slowdown. A drop of the magnitude that we are witnessing is signaling that economies will slow down, but we should be not so quick to jump to the conclusion about how steep that decline is going to be.
Note that embedded in every market slowdown are also the ingredients for the recovery of the economy in the future. While we should be worried about how quickly banks can return to what their real mission is - take deposits from savers and lend them at fair (reflecting default risk) interest rates to individuals and businesses - we should also take some solace in the fact that oil prices are down more than 50% from their highs, other commodities are also down steeply and interest rates globally are likely to stay muted. Many emerging markets have seen their currencies lose significant portions of value, making easier for their manufacturers to compete in a global market place. These factors will play a role in the recovery, when it comes.



The New World Order: How this crisis affects valuation

Given how much this market crisis has shaken our faith in systems and numbers, it is no surprise to me that the most common question that I have faced these last few weeks is about how this crisis has changed the way I do valuation.
Before I answer, let me specify what has not changed for me. The intrinsic value of a business is still a function of its capacity to generate cash flows in the future. In other words, I am not going to create new paradigms for valuation just because we are in turmoil. In terms of estimates, though, here is what I believe has changed in these last 6 weeks:
1. The risk premiums we demand for investing in equities as a class and in corporate bonds has increased significantly. On September 12, the equity risk premium in the US was 4.2%. On October 16, it was greater than 6%. The key question we face is whether this is an aberration, in which case equities are massively under valued or whether we are facing a structural break, where we face higher risk premiums from now on. I think the answer lies somewhere in the middle. This crisis has increased equity risk premiums and default spreads for the next couple of years, but I believe that risk premiums will revert back to lower values (4-4.5%) in the long term. (Equity risk premiums in emerging markets have to be scaled up accordingly)
2. It is beyond debate now that there will be consequences for economies globally. The slowdown will affect real economic growth (and consequently earnings growth) next year for companies around the world.
3. The long term consequences for individual companies is likely to be mixed. The shake out and more limited access to capital will put smaller companies at risk and drive many of them out of business. Larger companies will strong balance sheets and significant competitive advantages will emerge the winners from this turmoil. The higher excess returns that they will earn will give them higher values.
I just put together a presentation this morning on the crisis and its impact. If you are interested, you can download it by clicking on the link below.
http://www.stern.nyu.edu/~adamodar/pdfiles/country/crisis.pdf
Hope you find it useful!



What is going on with the inflation indexed treasuries?

Strange things are happening in markets, but one development that I have seen little comment on is what is happening in the US treasury market. The Treasury has been issuing traditional bonds (where the coupon is set at the time of the issue) and inflation-indexed bonds (where a real return of return is guaranteed at the time of the issue) for more than a decade now. On September 12, 2008, the nominal 10-year treasury bond rate was about 3.8% and the interest rate on the inflation-indexed treasury was about 1.7%. In fact, the difference can be viewed as a market expectation of inflation over the 10 years (about 2.1% a year). Those numbers had been stable for years before.
For the first 10 days of the crisis, the relationship held, with the 10-year nominal and real rates staying relatively unchanged. About 2 weeks ago, the ten-year real rate started rising even though the nominal rate remained unchanged. On Friday, the nominal 1o-year rate was 3.9% (about 0.1% higher than it was at the start of the crisis) but the real rate had rised to 3%. I have attempted the following explanations but none hold up:
1. The real interest rate has risen because savers are more worried about investing in any type of financial asset. (Counter: If this is the case, why has the nominal rate also not risen)
2. Expected inflation has decreased because the economy has slowed. (Counter: If this is the case, both the nominal and real rates should have come down. It is also hard for me to believe that all these obligations taken on by the Federal government will not translate into higher inflation, not lower.)
The only explanation that I can think off is that investors who traditionally hold the inflation-indexed treasuries are selling them for liquidity reasons. If that is the case, we should expect a bounce back in the real interest rate to more conventional levels (about 1.5-2%), which would make inflation-indexed treasuries a great investment. The next few weeks should tell.



Is preferred stock equity?

In the last few days, we have seen announcement by both the UK and US governments of their intent to invest hundreds of billions into their biggest banks. In both plans, the investment will be in preferred stock in the banks, and the announcements have described them as investments in equity. But is preferred stock equity? That is a question that is not new but acquires fresh urgency, with these infusions.
Preferred stock is a hybrid security, sharing some characteristics with equity and some with debt. Like equity, it has a perpetual life and the dividends can be skipped, if a firm is in financial trouble, without the risk of default. Unlike equity, the preferred dividend is usually fixed at the time o the issue (as a percent of the face value of the preferred stock) and is often cumulative; failure to pay dividends one year is compensated for by paying the dividends in the next year. In fact, investing in preferred stock is more akin to investing in a bond than stock, with almost all of the returns coming from the dividends. There is one final confounding factor. While interest payment on debt are tax deductible, preferred dividends are not. In my discounted cash flow valuations, I have always considered preferred stock to be more debt than equity, and very expensive debt at that, since it does not provide a tax deduction.
Among US companies, the biggest issuers of preferred stock are the financial service companies (banks, insurance companies) and there is a simple reason for it. While it may be more expensive than conventional debt, it is counted as equity by the regulatory authorities while computing capital ratios for banks. 
So what is the bottom line of these capital infusions by the governments for existing equity investors in the banks receiving the infusions? If I were an investor in a US bank receiving the infusion, I am concerned about the effect of the preferred dividends that the banks have to pay for the foreseeable future out of after-tax earnings, which will lower my earnings and returns on equity going forward on common stock. However, given that the bank will have to raise capital to cover it's mistakes from the last few years, and that the capital will not come easily in this market (Think of the problems Bank of America had last week when it tried to raise $ 10 billion), I will accept this bargain. If I were an investor in a UK bank receiving capital from the British government, I am not so sure that this works in my favor. The British government plan is much more punitive to common stockholders; the dividend rate is set much higher, the banks will not be allowed to pay common dividends until they pay off the preferred stock and the government looks like it will take a much more active role in the way the banks are run. In other words, the British preferred stock infusion seems to encroach more on common equity than the US preferred stock infusion. Not surprisingly, the British banks that are prime targets for the infusion (Lloyds, HBOS and Royal Bank of Scotland) have seen their stock prices drop since the plan was announced, whereas the US banks have seen marginal improvements in the stock price.



Black, blue and white swans: Comments on Taleb

I want to steer clear of critiquing the work of others but my comments on long odds seem to have evoked a torrent of emails about Nassim Taleb and his work on randomness and black swans. Let me start off by sketching the points on which we agree. I think that Taleb is absolutely right that we (in academic finance and model building) have become enamored with normal distributions when building models. The real world delivers far more jumps, surprises and asymmetric movements than can be justified by a normal distribution. I also believe that what Taleb is saying was said much better by Benoit Mandelbrot several decades ago, in his argument for power distributions (which allow for bigger jumps than the normal distribution). My book on strategic risk taking has an extended discussion of Mandelbrot's work.
Here is where I part ways with Taleb. While I agree that we are always susceptible to the unforeseen event (the black swan), I do not subscribe to his prescriptions. The first one (and I may be mistaken in this) is that planning, forecasting and valuation are useless since they will all be rendered to waste by the "black swan'' event. This is the equivalent of arguing that it is pointless planning and saving for retirement, since you may be hit by lightning tomorrow... logical, maybe, but not very sensible. The second one is that you can somehow make money off the fact that model builders have a normal distribution fixation.. Taleb argues that since models are built upon normal distributions, investors can make money by buying out of the money options and other investments that profit from big moves. I think that the mistake here is assuming that people who build models actually set market prices. If markets reflect reality rather than models, there should be no scope for profits. 
Here is what I think. We have to make our best estimates of the future and value assets accordingly. We have to assume that there will be shocks to the system that we cannot anticipate and build an appropriate risk premium to reflect these risks. We cannot plan for the unforeseeable... and live our lives expecting black swans to show up.. 



Markets for sports outcomes- The long odds bias!

Since it is Sunday, it is time for sports, at least in the United States, I thought it would be an appropriate time to talk about markets based upon sports outcomes. People have been betting on sports for as long as there have been sports - I am sure that the ancient Romans had side-bets going on the gladiators. Today, sports betting is a multi-billion dollar business, though a big chunk of it is underground. In addition, we have markets like Tradesports.com (an online betting market), where you can bet on just about anything in the world, As with other markets, the question is whether the odds/prices you see in these markets are good predictors of success or failure.
Studies that have looked at sporting markets have uncovered some interesting evidence that gamblers bet too little on favorites and too much on long odds. As they lose money, they seem to increase their betting on longer odds. This has been attributed to a number of factors including a general tendency among humans to under estimate large probabilities (such as the likelihood that you will get sick) and over estimate small ones (say the odds of dying in an airline accident) and the craving for the excitement that comes from betting on long odds. Extending this finding to financial markets, this would lead to us to believe that deep out-of-the-money options and stocks in deeply distressed companies are likely to be over valued, since the long shot bias will push up their prices. Conversely, companies that are in boring and predictable businesses will be under priced like favorites. 
Of course, all of the evidence from the sports betting market has to be taken with a grain of salt, since sports gamblers (at least the big ones) may be less risk averse than the rest of us. So, do what you will with that finding!! I am going back to watching my son play soccer (and no bets on that one)!!!




Gold, fine art and collectibles...

I have always been deeply skeptical of investments in non-cashflow generating assets (gold, fine art, collectibles), where value is almost entirely driven by perception.  However, a crisis like the current one illustrates why these types of assets continue to have a hold on investors. When investors lose faith in financial assets (and the authorities and entities that back up those financial assets), they look for physical and tangible investments to buy that they can hold on to. Real estate used to be the investment of choice, but as my last posting indicates, real estate is behaving more and more like other financial assets. There is always gold, the fall back in every financial crisis in history, but the net actually has to be cast wider. I would not be surprised to see other collectible assets, including Picassos and baseball cards, go up in value.
Having said that, I still believe that these are terrible long term investments on their own. After all, an investor who bought gold in the early 1970s and reveled as the price of gold rose to $ 1000 in the last 1970s would have made about 3% a year for the last 30 years on the investment. The best role that I can see for them is as ancillary investments in a larger portfolio, where you accept that the expected return on the investment will be low but you are willing to invest in it anyway as insurance - against inflation and crises. Do I wish I had gold in my portfolio now? Of course! Am I going to sell everything that I own and buy gold? Of course not!



Diversification: Why is it not working?

It is  a core belief in finance that investors should diversify. Whether they should diversify across all stocks or a few is what is debated, and what you think about the efficiency of markets or lack thereof determines which side of the debate you will come down on. If you are a believer in efficient markets, you would have spread your money across index funds investing globally. If you believe that markets systematically misprice classes of securities (and realize their mistakes later), you would still diversify across these securities (low PE stocks, beaten down stocks etc.)
This market has tested the core belief in diversification. Even the most diversified investor in the universe would have lost a big chunk of his or her portfolio over the last 3 weeks. Why has this happened and why is diversification not paying off like it was supposed to? The answer lies in the fact that we have sold investors too well on the "diversification" idea. Twenty years ago, when the sales pitch for adding international stocks and real estate to portfolios was made, the gains seemed obvious. Equity markets in different countries were not highly correlated; what happened in Turkey had little impact on what happened in Brazil. Having stocks in both markets therefore dampened risk in the portfolio. Real estate seemed to move in directions unrelated to equities, thus making a portfolio composed of the two asset classes less risky. As investors(individuals, private equity funds, hedge funds) diversified across markets and asset classes, there are two things that have happened:
1. The correlation across equity markets has risen dramatically. A crisis in one emerging market seems to spill over into other emerging markets. A crisis in a developed market spills over across the world. As market moves mirror each other, having your money spread out across markets has a much smaller diversification benefit than it used to.
2. Securitizing real estate and bringing it into portfolios has made risk in the real estate market more closely tied to the overall equity market. Diversifying across asset classes has a much smaller impact.
Don't get me wrong. I think that not diversifying is a deadly mistake for most investors, and I am still firm believer in diversification. However, we need to temper the sales pitch. Diversifying can create benefits for investors, but those benefits are much smaller in the global market place that we are now.



Is it time to make the move?

Yesterday was a momentous day in many ways. The market meltdown was global and there were moments during the day when the first 1000 point drop day seemed possible for the Dow. However, there was something about yesterday that seemed different (at least to me) from the market tumult over much of the last 3 weeks:
1. The drop in the market, at least in the US, was caused more by concerns about economic growth than by fear. Put another way, while much the volatility in the markets of the last 3 weeks could be attributed to shifting equity risk premiums, yesterday's drop was caused more by more conventional concerns about an economic recession.
2. The implied equity risk premium in US equities hit 5% for the first time since October 20, 1987. That is a full percentage point higher than the average implied equity risk premium over the last 50 years. We are seeing either a structural break in equity markets or markets are oversold.
I could tell you that my gut feeling tells me that we are close to the bottom, but I frankly don't trust my gut (or anyone else's, for that matter). However, I think that I will be doing some bottom-fishing today, focusing particularly on companies that have the following characteristics:
1. Products/services that are part of everyday consumption and not particularly discretionary. 
2. Low debt ratios (and I will check for lease and rental commitments) and large cash balances.
3. Solid earnings numbers over the last 12 months.
4. Low price earnings ratios (and low EV/ EBIT)
5. Double digit return on capital
6. Medium to large market cap
I am trying to recession proof (1) and pay a reasonable price (4) for a well-run company (3 & 5) that also faces little danger from the credit squeeze (2 & 6). I don't want to put myself in the position of touting individual stocks on this blog but I will be looking globally. You are welcome to join in!



Explaining the Market....

The last three weeks have been a boon for financial reporters. All of a sudden, they get the front page stories in their newspapers, a little akin to being the weather forecasters in the middle of a hurricane. At the end of each day, after another violent market move, they go to the experts (academics, practitioners) and ask them for reasons. They get the obligatory: "The market went up (down) because...." I have always been skeptical of this Monday-morning quarterbacking, and last week illustrates why.
On Monday, the market was down 778 points and the culprit was so obvious that experts were not even consulted. The bailout bill failed to pass in the House, and the market fall was attributed to this failure. The rest of the week was less explainable. On Tuesday, when there was little news about the bailout, the market bounced back up almost 500 points. On Wednesday, when things looked rosier for the bill's success, the market was down again. On Thursday, after the senate had passed the bill, the market did nothing. (Boring never felt so good.) On Friday, the bill finally passed around midday. Good news, right! The market promptly swooned. 
There are several reasons why the market is so difficult to decipher. First, all events have to be measured relative to expectations. There is no good news or bad news in absolute terms but only in relative terms. An earnings increase of 50% at Google may be bad news, if investors were expecting an increase of 75%. A drop in earnings of 30% at Ford may be good news, if investors were expecting a drop of 50%.  Second, there are so many events swirling around markets that it is difficult to pinpoint exactly what caused the market to move on any given day: Was it the weakening dollar? Higher interest rates? Unexpected inflation? Third, a great deal of what happens on any given day cannot be explained; putting a reason on a big move after the fact allows us to feel better about ourselves (as investors) and a little more in control of our destinies. 
Do I think that experts should stop trying to provide explanations for market moves? Not at all. In addition to their entertainment value, these explanations may help markets put the past behind and move on... 



The Buffett Gambit: Buying (Selling) Credibility

In the last two weeks, Warren Buffett has made news by taking multi-billion dollar positions at Goldman Sachs and GE, two companies that would have topped the list of most admired firms a couple of years ago (and perhaps still). The fact that he is getting a good deal from both companies has been well publicized. In effect, both companies have given him a discount on his investment, thus giving him the potential for higher returns in the future. While part of those higher returns can be attributed to the fact that he is providing liquidity in a market where it is in short supply, that alone cannot explain the nature of the deals. After all, Goldman and GE, notwithstanding current financial problems, have recourse to other equity funding. So, why did they choose to deal with Mr. Buffett?
I think the answer lies in the mythology. As investors lose faith in the institutions that they thought were the foundation of US financial markets, from the investment banks to the Fed, Warren Buffett remains one of the few icons with any credibility left in this market. In my view, both Goldman and GE are buying a share of that credibility with these investments. They are, in effect, telling the market to trust them because Buffett is now watching over them. I should also add that I do not begrudge Mr. Buffett trading on his credibility to generate higher returns for Berkshire Hathaway stockholders. He has invested a great deal in his reputation over the last few decades and he is the ultimate capitalist!



Mark to Market or Not to Mark to Market?

The latest issue that has emerged in the talks on the bailout is whether the practice of marking to market, required of financial service institutions under FASB rules, should be suspended or even ended. Financial service firms currently are required to revalue the securities they hold as assets on their books at market value each period. As the markets for many mortgage-backed securities have dried up, their values have plummeted, which in turn have put the limited capital that banks and investment banks at risk.
I have mixed feelings about the rule. I am a believer that investors should be provided with information that allows them to make better judgments on value. Thus, restating assets to reflect their current value seems like a good thing to do. I am not sure that accountants are in the best position to make this judgment or that balance sheets should be constantly restated to reflect the accounting estimates of value, and here is why: 
  1. Accountants already have plenty to do in terms of estimating earnings, debt outstanding and capital invested. Adding one more item to their to-do list can be a distraction. 
  2. By their very nature, accounting estimates of value have to be based on clearly defined rules and standards to prevent game playing. That works well for conventional accounting but not for valuation. For every rule in valuation, there are dozens of exceptions and it is impossible to write a FASB rule that captures the exception. 
  3. The very notion of fair value is a nebulous one, since the fair value of even the simplest assets can vary depending upon what parameters you put on it. For instance, the fair value of a company run by its existing managers can be very different from the fair value of a company run optimally. Similarly, the fair value of a private business for sale in a private transaction can be very different from the fair value of that business to a public buyer. 
  4. Illiquidity is a wild card in the entire process. Traditional valuation models capture the intrinsic value of an asset, but what someone is willing to pay for that asset will reflect the illiquidity in the market. The problem with pricing illiquidity is that it can not only vary across time but also across investors. A long term investor with a substantial cash cushion, will care less about illiquidity than a short term investors, and all investors care more about illiquidity during crisis.
  5. Marking to market is applied inconsistently across asset classes. For instance, marking to market seems to followed more religiously when it comes to security holdings than it is with loan portfolios. Thus, financial service firms that have securities on their balance sheets seem to be held to account but banks with bad loans get a pass. 
So, is there an intermediate solution? I think accountants should steer away from estimating the fair value of assets that are long term assets; let's dispense with this move towards balance sheets reflecting the values of brand name, customer lists and other such assets. Fair value accounting is an oxymoron: what you will end up with will be neither fair value nor accounting. With securities that are held for trading/sale, I agree that we should have a different standard but rather than reflect what firms would get for those securities today in the market (which is a liquidation value), I would suggest that firms  either provide estimates of intrinsic value (or the raw data that will allow investors to make that estimate themselves). For mortgage backed securities, as an investor, I would like to see what types of mortgage backed securities are on the books of these companies, what the promised cash flows on the mortgages are and the default risk that they face. 



Corporate Hedging: Answers to questions

A couple of posts ago, I presented six examples of risk hedging/ taking that I would like to take through my three bucket test - risk to pass through, risk to avoid/hedge and risk to exploit.
  1. Southwest has always hedged against oil price risk, using futures contracts. Is what they are doing make sense? Given that Southwest's core competence (see, I can speak like a corporate strategist) is running an airline (not forecasting fuel prices), that fuel prices are such a large portion of total costs, and Southwest has done this through high and low oil prices (and are thus not trying to time the oil market) , I think it makes sense.
  2. In the last two years, other airlines that had never hedged against oil price risk decided to start because oil prices had gone up so much. Is what they are doing make sense? I am much more suspicious of this activity. The very fact that they are hedging only after oil prices have run up, suggests to me that there is an element of market timing here. Not surprisiingly, firms that do this end up with the worst of both worlds. They hedge against oil prices after they have run up and stop doing it after oil prices have gone down.
  3. A publicly traded soccer team buys insurance against it's leading player getting injured. Does that make sense? I think this does, since investors in the firm would have a difficult time doing this on their own. The team also has information on the player's physical status that an investor would have no access to.
  4. As the Brazilian Real increased in value against the US dollar, Aracruz decided to make a bet of tens of millions on the continued strengthening of the Real. Good idea, bad idea? This is plain dumb. Aracruz is a paper and pulp company. As an investor in the company, the last thing I want them to try and do is time exchange rate movements (and I would have said the same thing even if they had made money)
  5. A trader at an investment bank decides to bet, with proprietary capital, that interest rates in the US will rise over the next year. Makes sense? I have always been skeptical about propreitary trading profits reported at investment banks, since I see little that they bring to the table as competitive advantages. They trade with each other, using the same information base and often the same traders (who move from bank to bank). I see no reason to believe that a trader at an investment bank (and the economists at the bank) have any special insight into the future direction of rates.
  6. Barrick Resources, a gold mining company, decides to sell futures contracts to lock in the price of golf for the next five years. What do you think? I invest in gold mining stocks because I am optimistic about gold prices going up. If Barrick goes out and hedges against gold price movements in the future, it is undercutting my rationale for investing.
The bottom line, though, is that we should not judge any of these firms by the outcomes of their actions, but by whether their actions make sense. (Aracruz could have made hundreds of millions on its currency bets and Southwest is probably losing money, now that oil prices are declining)



Happy Thanksgiving!

Time to take a break from pontificating and navel gazing. While there is much to worry about and anguish over, there is so much more to be thankful for. Have a wonderful Thanksgiving!



Corporate Hedging: The Down Side

There is a news story in the New York Times today about Asian airlines and the losses that they are facing because of put options that they had sold against oil prices, months ago, that are now coming due as large costs. They sold these puts to offset the costs of buying calls against oil, where were, in turn, designed to hedge against higher oil prices.

In these days of risk and uncertainty, I am sure that many companies will be on the lookout for ways to hedge against risk, and they will find plenty of entities willing to tell them how to do it or sell them products or services that provide protection. After all, every macro uncertainty from interest rates to inflation to commodity prices can be hedged using derivatives or insurance. But is this a good idea?

In my book on risk, titled "Strategic Risk Taking", I have argued that the essence of good risk managment is separating risk into three buckets:

a. Risk that should be passed through to investors, because they either want to be exposed to this risk or because they can protect themselves at a far lower cost. Included in the first group would be commodity risk to a commodity company: investors buy stock in oil companies because they want to make a bet on oil prices. An oil company that hedges against oil price risk is undercutting that bet. Included in the second group would be risk that cuts in different directions for different companies. I think it is generally a bad idea for companeis to hedge against exchange rate risk, simply because a stronger dollar helps some companies and hurts others. As an investor with stakes in both Coca Cola and Boeing, I think about exchange rate risk in my overall portfolio (which I can choose to hedge if I want to) rather than in individual companies.

b. Risk that should be avoided/ hedged: This would include risks that are not easily visible or difficult to hedge for investors in the firm, but are large enough to affect it's operations or survival. Included in here would be the risk of physical damage to property (against which you can buy insurance) and the costs of inputs into the production process. Thus, there is a rationale for an airline buying oil price futures to lock in the cost of fuel, Not that the action will not make the firm more profitable over time but may improve its operating efficiency; the airline can set ticket prices, knowing what their costs will be, and focus on improving efficiency in areas where it can make a difference.

c. Risk that should be sought out and exploited: Firms become successful by seeking out and exploiting risks and not be avoiding them. However, they have to find those risks on which they have a competitive advantage to do this. This is where corporate strategy meets corporate finance/ risk management. The edge could be technology, brand name or information...

Since this post has become way too long, I will leave you with questions about risk hedging/taking in general that you can try answering with this framework (if that is how you want to waste your day):
  1. Southwest has always hedged against oil price risk, using futures contracts. Is what they are doing make sense?
  2. In the last two years, other airlines that have never hedged against oil price risk decided to start because oil prices had gone up so much. Is what they are doing make sense?
  3. A publicly traded soccer team buys insurance against it's leading player getting injured. Does that make sense?
  4. As the Brazilian Real increased in value against the US dollar, Aracruz decided to make a bet of tens of millions on the continued strengthening of the Real. Good idea, bad idea?
  5. A trader at an investment bank decides to bet, with proprietary capital, that interest rates in the US will rise over the next year. Makes sense?
  6. Barrick Resources, a gold mining company, decides to sell futures contracts to lock in the price of golf for the next five years. What do you think?



Jekyll and Hyde revisited!

Yesterday's Financial Times had this headline: "Citi plans good bank, bad bank structure". In effect, Citi plan to separate all the toxic assets and put them in the bad bank and keep all the money making assets in the good bank. Well, I guess we should carry this to its logical extreme and let every company do this - break up into good and bad parts. Thus, Microsoft can consign Office and Windows to the good part and throw Xbox into the bad part.. The next step would be to have two listings for every company - with investors allowed to trade each part separately (we could call them MSFT-G and MSFT-B).

Here is the practical problem. Investors will undoubtedly mark up the prices for the good part, but how are we going to induce them to buy the bad part? After all, if the assets in this part are proven money losers, you would have to pay people to take parts of these assets. In the case of Citi, the plan is obvious. They want to keep the good part and spin off the toxic part to the government; in effect, tax payers will be left holding pieces of assets that will generate negative cash flows as far as the eye can see. If I were negotiating for the Treasury, I would demand a large chunk of the good part (in options or equity) in return for taking the bad part. Otherwise, it seems like a bad deal!



Dividend Yield and T.Bond rate

The last few weeks have seen their share of the strange and the unusual. Last Wednesday, another milestone was reached. The dividend yield on the S&P 500 exceeded the 10-year treasury bond rate for the first time since 1958; just to add, the dividend yield went up only because stock prices have dropped so much this year. So. what is the significance of this occurrence?

a. The Bargain Basement view
: If we assume that dividends are stable - and they have been remarkably predictable for the last few decades - investing long term in stocks seems like a no-brainer. The income you get from the dividends is greater than what you would make investing in treasuries, and when stocks eventually recover, you get the upside of price appreciation as well.

b. Dividends will drop: The counter to this viewpoint is that the recession and a desire for liquidity will cause companies to cut back on dividends. When they do, it is argued that this aberration will disappear.

I tend to agree more with the first viewpoint than the second. After all, companies in the US have not increased dividends much over the last 40 years and chosen instead to buy back stock. Last year, stock buybacks accounted for two thirds of the cash returned by corporations. I believe that companies that are facing hard times and desirous of liquidity are more likely to reduce stock buybacks than cut dividends.

However, I would fine tune the strategy. I would focus on companies paying high dividends - the list is long - and have little debt & large cash reserves. The collective dividend yield on these companies will be higher than what you can make on most safe investments currently...



Good companies in bad businesses

All this talk about a federal bailout of GM and Ford has started me thinking about something that has always bothered me. There are some businesses where even the best companies seem to barely make it and everyone else is under water. The automobile business is a good example. Take Toyota, a company that most analysts would consider to be the star of the sector. The company earned a return on capital that matched its cost of capital last year and that was a good year. If the best company in the sector breaks even in a good year, where is the upside in this business? The airline business, since deregulation, is another example of a business that has few profitable companies. I know.. I know.. There are Southwest and Ryanair, but even these paragons of corporate profitability earn returns on capital that trail their costs of capital. The rest of the business is a disaster.

I opened up my economics and corporate strategy books to see if I could find an answer. One possibility is that these businesses are filled with irrational companies that do stupid things over extended periods, but I find that hard to believe. The other is that these businesses have not found (or have lost) a structure that can generate profits on a sustained basis. In the airlines business, deregulation opened the business up to new entrants and the new firms that entered undercut the established competition with lower prices for the most profitable routes. In the automobile business, the problem seems to be legacy costs - c0sts that firms have piled up over time, usually in return for short term labor peace. Note that the older automobile firms are in the most trouble... those pension obligations that they committed to decades ago have come back to haunt them.

Eventually, these businesses will have to find a stable structure, where the companies at least on average earn their cost of capital. When will this happen? I don't know, but we, as consumers, will continue to buy cars and travel on airlines... It is in our best interests that the companies that provide these products/services make a reasonable profit in the process.



Some thoughts on Las Vegas!

I was in Las Vegas yesterday, staying at the Bellagio. As I walked through the casino floor to get to the convention center, where I was delivering a presentation on valuation, there were three things that struck me about the setting:
1. The first is that there is no better example of the ruthless power of the law of large numbers and probabilities than a casino. Think about it. You have hundreds of slot machines programmed to deliver about 90 cents on the dollar, on an expected value basis. No surprise, then, that they do.... The house always wins (at least on the slot machines).
2. The second is that there is no worse setting for talking about risk, risk aversion and risk premiums than a casino. After all, any individual who would spend his money in a casino has accepted an investment with an expected return of about -10% and some risk, not exactly compatible with a risk averse, rational individual. I know, I know.. Gambling is not an investment but done for entertainment. I did not see much joy in the faces of the slot machine players as I walked by.. If they were being entertained, they did a good job hiding it.
3. The final point, though, came from a movie that I saw a few months ago called "21", about six MIT students who figured out a way to beat the odds at Vegas by counting cards. Even the most secure systems (and Vegas is as close as you can get to a slam dunk as you can get..) have their weaknesses.
The bottom line... If you play a game where the odds are against you, you are likely to lose and the longer you play, the greater the chance that the odds will catch up with you.



Blackstone's Woes: Some thoughts on Private Equity

About a year and a half ago, at the height of private equity's success, I put together a presentation on LBOs that examined what makes an LBO work and, conversely, why many of them were destined to fail. The LBO I looked at was the Harman deal, backed by two big names - Goldman and KKR. Based on my analysis then, I concluded that Harman fit none of the requirements for a good target - it did not have significant debt capacity (nullifying the leverage benefit), it was well managed (eliminating the restructuring need) and did not suffer any serious separation between management and ownership (countering the going private argument). If you are interested, I have a paper describing the deal that can be downloaded by going to: 
My purpose in the paper was not to pick on Goldman and KKR but to make the following points:
1. Even smart people (and there are quite a few at both Goldman and KKR) sometimes do stupid things.  No one is immune from the "herd" mentality. Goldman and KKR were caught up in the mood of the moment - debt  would remain cheap and the economy would keep growing forever - and the deal was reflective of these views.
2. First principles in finance are like first principles in physics. If you violate them, they will catch up with you, no matter who you are. What are these first principles? Here is one. If you are a business that does not generate high cash flows right now, even though you may have great growth potential, you should not borrow money (even if there are people out there willing to lend you this money).
All of this pontificating brings me to Blackstone's earnings announcement due today. My guess is that "marking to market" all of their deals will have a devastating impact on their earnings. No one should be surprised and Blackstone is not alone in feeling the pain, but the lesson we should take away is that private equity and hedge fund investors make the same mistakes that other investors make - the only difference is that they do it on a bigger scale.




The Crisis of 2008: Lessons learned, unlearned and reinforced

The one thing I can say about 2008 was this it was not boring. I know that there will be a flood of books coming out over the next few months telling us what happened, why it happened and most important of all, who to blame. I don't think that they will tell us much that we don't know already.  I have a different book in mind and this is what I want to do. I want to look inward and ask myself what I have learned from these last few weeks that I can incorporate into my "view of the world" looking forward. I The market collapse and investor reaction has been a humbling experience and has revealed how much I do not know or fully understand about finance.  Here is my initial list:

Things that I know now that I did not know on September 12....
  1. Nominal interest rates can become negative.
  2. There is no riskfree asset.
  3. Equity risk premiums can change dramatically even in mature markets.

Things that I thought I knew on September 12, that I am not so sure about now...
  1. Large companies in developed markets can always raise new capital.
  2. Bank runs are things of the past, with the regulatory oversight, accounting rules (mark to market) and risk management tools that we have today.
  3. Value investing (investing in low PE , high dividend yield and low PBV stocks) is less risky than growth investing.
  4. Dividends are sticky.
  5. Diversification across asset classes provides protection.
Things that I kind of knew on September 12 that have been reinforced since....
  1. Debt is a double edged sword. (The costs and likelihood of distress can be much higher than I thought...)
  2. A large cash balance is not just a wasting asset but protection against danger.
  3. The line between hedging and speculation is a very fine one... and easy to cross...
  4. Main Street and Wall Street are co-dependent. One cannot be healthy, if the other is not.
  5. We are in a global economy.
  6. Ignore illiquidity at your own peril.... Its cost can vary across time and across markets
  7. Risk is not just a number.
  8. Stocks don't always win in the long term.
  9. Smart money is not that smart!!! 
  10. Even great investors make mistakes! 
In fact, I have been collecting ammunition for each of these points, by scouring news stories from the the last three months. Sometime over the next year, I will sit down and start putting it down on paper. All I need is a good title!




Sticky dividends!

When we look at how companies have set dividends in most markets, the word that comes to mind is "sticky". Put another way, most companies set absolute dividends and stick with those dividends through good times and bad. A few even have a policy of consistently raising dividends and continue to do so, even in the worst of times. This has been true for decades in the United States, but I was curious about whether the last three months of market turmoil have made significant inroads into changing the policy. The answer seems to be yes, but with caveats...

1. S & P keeps track of how many companies in the S&P 500 index increase, decrease and suspend dividends, by month. In the last quarter of 2008, 32 firms increased dividends, 17 firms cut dividends and 10 suspended dividends. No firm initiated dividends during the period. If you are surprised that more firms increased dividends than cut or suspended dividends, here are the statistics for the previous three quarters.
  • First quarter, 2008: 93 increases, 7 decreases, 4 suspensions
  • Second quarter, 2008: 65 increases, 9 decreases, no suspensions
  • Third quarter, 2008: 45 increases, 6 decreases, 8 suspensions
  • Just as a further contrast, in all of 2007, there were 299 dividend increases, 7 decreases and 3 suspensions.
2. Some companies did deviate from long-standing dividend behavior in these last three months. To provide an illustration, Pfizer did not increase its dividends in 2008, for the first time in 42 years, evoking an article in the Wall Street journal wondering why they decided to do so...

I think 2009 will lead to even more conservative behavior, at least when it comes to dividend policy. After all, one reason that companies felt comfortable maintaining dividend payments, even in the face of declining earnings or losses, was the belief that they could raise funds from capital markets, if they needed them. If the last quarter of 2008 has taught them a lesson, it is that capital markets can shut down even for the largest companies in the most developed markets. There is a new found respect for large cash balances at companies, though I am not sure how long it will last.



Hard wired to deceive?

As the Madoff story runs its course and investors express surprise and shock that they were taken to the cleaners, it may be worth noting that research in the social sciences suggests that this may be par for the course, given our genetic make-up. Here is the evidence:

1. Brain size and potential for deceit are correlated: Studies of primates have uncovered an interesting finding. The larger the brain of a primate, the more likely it is that it will indulge in deceitful behavior. The great apes, for instance, are masterful deceivers but as the primates with the largest brains (arguably), human beings are at the top of this deceitful heap... And smart human beings are much better at deceiving others than dumb human beings!!
Bottom line for investing: You are at greatest risk of being lied to, when you invest with the smartest portfolio managers (hedge funds?)...

2. We lie and we do so habitually: A study that tracked students (by inviting them to keep track of their lies in a journal) uncovered the fact that they typically lied about two times a day.
Bottom line for investing: The standard investment sales pitch contains more than its share of half truths.

3. We do feel guilty when we lie, but that does not stop us from lying again: The same study that uncovered the fact that students lie two times a day, on average, also found that while they felt guilt at doing it, the fact that they were able to get away with it reinforced the behavior. Put another way, if you get away with lying once, you will will try it again...
Bottom line for investing: All the ethics classes in the world and forcing everyone to attend religious services every week won't stop the next big fraud or even reduce its likelihood.

4. We often want to be lied to: Here was the most interesting conclusion. The researchers who have looked at this phenomenon and noted that it has been going on for as long as we have been on earth have determined that, deep down, we want to be lied to. In some cases, this is because the truth will hurt too much (That dress does really make you look fat) and in other cases, because the lie makes us feel better (You are brilliant!!!)..
Bottom line for investing: Every fraud has two players - the fraudster and the victim. While we tend to think of the former as the villain and the latter as the victim, they need each other for it to work.

So, take the
talk that you hear about this being the fraud to end all frauds with a grain of salt. This has happened before and will happen again... why? .. because we are human!!



To zero..and beyond...

Day before yesterday, the Fed announced that is was cutting the Fed Funds rate close to zero. In the weeks preceding, the three-month US treasury bill rate has flirted with negative yields... Both phenomena raise a question: Can nominal interest rates become negative?

Let us start off by accepting the fact that real interest rates can become negative and have, for extended periods in the past. Real interest rates can happen when expected inflation is high but central banks decide to flood the market with enough funds to keep nominal interest rates below the expected inflation rate. However, a negative nominal interest rate is not only unusual but difficult to grapple with. As my sixteen-year old put it, why would someone put their money into an investment to get less in three months than they invest today? Why not stick the money in a checking account or even under the mattress for that period?

For small amounts of money, nominal interest rates should never fall below zero, because either the checking account option and the mattress option is viable. But what if you are a portfolio manager or a corporation with $ 3 billion in cash? Holding the cash balance as currency in your corporate headquarters is an invitation for the heist of the century (Think Oceans 11, 12 or 13..) Putting the cash into a bank account is not completely secure, because the FDIC protection works only up to $250,000.... If the bank goes under, your principal is at risk. In normal times, we would not consider this a likely scenario but we are not in normal times.

Both the Fed move to cut the Fed funds rate close to zero and the short term treasury bill rate dropping below zero are indications of how much investors have lost faith in the banking system. Large investors are in effect saying that they would rather accept an -0.5% nominal interest rate than risk leaving large amounts of cash in a bank. That is not only astounding but scary.



To Madoff or not to Madoff?

By now, everyone has heard the story of Bernhard Madoff, the New York city based investment advisor, who was just arrested for perpetrating a fraud estimated in the billions ($55 billions?) As we look at list of prominent people who have been snared in this web of deceit, including Mortimer Zuckerman and Elie Wiesel, we have another opportunity to examine the consequences of greed, hubris and eventual downfall.

The facts of the story seem fairly clear. Madoff made his initial reputation as a broker/dealer, and he built a business based upon computerization and quick trades for his customers. Somewhere along the way, he also became an investment advisor, though he did not file to officially become one until 2006. He moved in the highest circles of society, and wealthy investors clamored to be his clients. He made himself even more desirable to these investors by turning away several. His allure was not that he delivered super high returns but that he delivered stable and solid returns year in and year out. In effect, he seemed to have found a way to take little or no risk and deliver about 5-8% more than the treasury bond rate. Last week,. he gave away his secret. He had been operating a Ponzi scheme, i.e, using money raised from new investors to deliver returns to old ones. Like all Ponzi schemes, it was dependent on new money coming in. The market collapse of the last few months essentially cut off that inflow, leaving Madoff exposed.

Rather than make this a treatise about bad investment advisors and unquestioning investors, I would like to make a general point about investing in general and professional investors in particular. There are two questions that we can ask about these investors:
a. How much money (returns) did a particular investor make over a period or periods?
b. Why did they make the returns that they did?
As individuals, we are drawn to the first question and there are services that report these numbers in mind-numbing detail. Morningstar, for instance, has returns on every mutual fund in the US, going back in time. Others then build on these numbers: the funds themselves advertise with evidence of superior returns and ranking and reputations are built on past returns. The second question, however, is viewed as intellectual and in some cases, as academic, and seldom gets answered seriously. If we want to entrust our money to a professional, though, we need both questions answered well. In other words, I not only need to know how much you (as a professional money manager) have made over time but also why you made this return: was it superior information, your analytical ability or your trading skills? Using the language of corporate strategy, I would like to know what your competitive edge is and how you plan to maintain it.

 Any investor asking the second question about Madoff would have uncovered red flags. The man was not (and never claimed) to be a sophisticated number cruncher and he clearly did not enunciate an innovative investment strategy. The only potential advantage that he might have had came from his access to the trading data of investors (through his broker/dealer firm) and front running (trading ahead of) his brokerage clients. That, of course, is illegal and would eventually be uncovered. In other words, there was no basis for his solid, stable returns. He was either lucky (but that is tough to pull off over 30 years) or committing fraud. Last week we found out the answer.



Enterprise value is negative... Is that possible?

There are three measures that can be used to capture the market value in a business. We can measure the market value of equity, i.e., the market capitalization of the equity in the firm. We can add the market value of equity to the market value of debt to get the total market value of the entire firm: think of this as the market value of all of the assets of the firm. We can add the market value of equity to the market value of debt and subtract out cash and marketable securities to get to the enterprise value: this, in effect, is the market value of the operating assets of the firm.
We see the first number in equity multiples; the PE ratio and the Price to book equity are computed using the market value of equity. We see the last number in multiples of EBITDA and revenues; the rationale for netting out cash is that the income from cash is not part of either EBITDA or revenues.
All of this leads me to a curious phenomenon that has occurred at some large firms, where the enterprise value has become negative. Here, for instance, is a Bloomberg article on the topic:
http://www.bloomberg.com/apps/news?pid=20601087&sid=ahiVT6vmGNEA&refer=home
In other words, the cash and marketable securities exceed the cumulated market values of debt and equity. In theory, at least, this seems to be an easy arbitrage opportunity, where you can buy all of the debt and equity in a firm and use its cash balance to cover your investment costs and keep the difference. Here are some reasons why you should be cautious:
1. The computed enterprise value may not have captured all of the debt outstanding in the firm. With a retail firm, for instance, enterprise value should include the present value of lease commitments as debt. What you see reported as enterprise values for WalMart, Target and Best Buy is understated because of this failure. In the Bloomberg list, for instance, there are a preponderance of banks and financial service firms. I have always had a tough time defining debt and enterprise value at these firms and am dubious about most of these firms.
2,. The cash that is netted out to get to enterprise value is usually from the most recent financial statement (rather than the current date used for market cap). Given how quickly firms burn through cash, what you see on the balance sheet may not reflect what the firm currently has as a cash balance.
3. Some services are sloppy about their definition of market value and seem to mix up market value of equity with market value of the firm.
The core of the article, though, is that stocks are cheap on a historical basis but history also tells us that there are no slam dunk investment profits. There is a many a slip between the cup and the lip when it comes to arbitrage profits.



Bias in Valuation

I kicked off the valuation class with a discourse (actually, more of a rant) about the bias in the valuation process and how it skews numbers. I firmly believe that bias is, by far, the biggest enemy of good valuations and that it is pervasive. By bias, I am referring not only to the preconceptions we bring into the valuation of a company but also to the payoff to doing the valuation. He who pays the prices sets the bias in motion, and the valuation reflects it. Thus, if I were an investment banker hired to value a target company in an acquisition, I am going to bias my value upwards, since I make money if the deal goes through but not if it does not. I am sure that Pfizer has an investment banking valuation of Wyeth, right now, that backs up their bid.  In class today, I set up 12 different valuation scenarios and asked for guesses on the direction of the bias. Here is the link to the list:
Make your best guesses... Visit my web site for the answers.

So, what is the cure for bias? I am afraid that there isn't one. However, we can reduce bias by changing the process by which we pay for valuations. 
1. No deal maker should ever be asked to analyze whether the deal makes sense. This is what we ask of investment bankers in acquisitions. The process will create bad valuations. I think that acquirers should pay a third party (one that makes money only for doing appraisals) for the valuation.
2. In legal processes, we should have less adversarial valuation, where the expert for one side comes in with a high number and the other side with the low number and the court splits the difference.
3. Trust, but verify. Even the biggest names in the business - Goldman, McKinsey - are susceptible to bias. 

As someone who looks at other peoples' valuations all the time, what experience has taught me is that the most critical questions to ask in assessing  a valuation are: Who paid the appraiser to do the valuation? What are the potential sources of bias? That tells me a great deal more than perusing the numbers.



Rebirths and Fresh starts!

As many of you know already, I view myself as a teacher first and everything else - academic, researcher, professor - second. There are many reasons why I love teaching but as I get ready for the first class of the Spring semester, here is one. I get to start with a completely fresh slate, with a new class and a new subject. Everything I have done before is irrelevant and any mistakes or accomplishments from the past are erased. That kind of new beginning is tough to find in any other profession. The closest you can get to it is when you get a new job at a company where you know no one.... But you cannot keep doing that every six months... as I get to...

My blogs over the next few months will reflect what I am talking about in my corporate finance and valuation classes. Obviously, I will not bore you with the details, but if you are so inclined, you should be able to peek in on the class, since the lectures are webcast. So, I am off to class! Even after 25 years of doing this, I am excited and I hope the excitement rubs off on those in the class.



Data update for January 2009

As those of you who are on my mailing list (now about 15000 long)  know, I just completed by annual update of data about a week ago. If you are unfamiliar with my data updates, you can get the data on my website:
I have been reporting industry averages for corporate finance and valuation variables (returns, betas, costs of capital multiples)  for a while now: this is my 15th annual update for US companies, and my seventh for European, Japanese and Emerging Market companies. In most years, the changes over the previous year have been marginal, especially for developed market companies. But the 2009 update was very different. Here are some of the highlights:

1. Risk premiums: Both the equity risk premium and default spreads on debt jumped dramatically over the year. The equity risk premium started 2008 at 4,37% and ended the year at 6.43%, its highest value since 1978. The default spreads more than doubled, and in some cases tripled, over the year for every single ratings class; for instance, the spread on a Baa1 rated bond increased from 1.75% to 5.25%. This will have profound effects on valuation. The same company, with earnings, beta and rating unchanged, but with default spreads updated is worth about 40% less today (in intrinsic value terms) than it was a year ago. (One aside. The risk premiums for debt increased more than the risk premiums for equity, which has implications for the mix of financing used by firms).

2. Emerging Market risk: In a crisis, risky asset classes get hit the worst and the country risk premiums for emerging markets have increased for two reasons. One is that the base mature market premium is now higher. The second is that the premium you demand for an emerging market is now higher. For example, the equity risk premium for India has increased from 7% to 11%. The drop in the Sensex should be no surprise.

3. On a multiple basis, everything looks cheap: The sector averages for every multiple - revenue multiples, PE ratios and EV/EBITDA - seem to suggest that we are surrounded by bargains. Before you jump in, a note of caution. The prices are as of January 2009 but accounting numbers lag. The most recent fiscal year for most companies in January 2009 is the 2007 fiscal year. Even trailing 12-month data ends in September. We are scaling post-crisis prices to pre-crisis accounting numbers. Hence, the low multiples. I will do an update in May 2009 and those numbers should contain some of the crisis impact. I am afraid the mismatch will not disappear until the 2010 update.

One final note. I have been asked why I do these data updates and put them on my site. I would love to claim that I am the "Mother Theresa" of finance but I do it for purely selfish reasons. Curiosity drives me to look at the data, and since the tools to convert raw data to accessible data are easily accessible, I bear no cost in sharing what I find with the rest of the world. I hope you find the data useful. 



Corporate Finance - post crisis

I just finished teaching my first corporate finance class in the post-crisis period (to an executive MBA class). Having taught this class for close to 25 years now, I was wondering how I would bring in the events of the last few months into the sessions and be able to draw out the implications for businesses. I must confess that it was a lot less trying than I thought it would be.

In broad terms, these are the corporate finance implications that I see for the near future and the long term:
a. In investment analysis: I see a shift away from expected value and base case valuations that have dominated financial analysis for the last few decades to more probabilistic approaches. Since both the data and the tools (Crystal Ball, @Risk etc.) are accessible and available now to most of us, I think this shift is long overdue.

b. In risk and hurdle rates: For the near term, I see a move towards higher risk premiums for both equity and debt, reflecting recent history and changes in risk aversion. In the long term, I think that we have to become more dynamic in our assesments of risk parameters and premiums, since the assumption that these numbers don't change much has clearly been shaken. Put another way, we have to accept the fact that risk premiums can change quickly even in developed markets and even more so in emerging markets.

c. In capital strucure: If debt represents a trade off between tax benefits on one side and expected bankruptcy costs on the other, the last few months have clearly tilted the scales away from the use of debt. The probability of distress and the cost of distress have both increased, particularly so for large companies where the notion that capital markets would provide needed funds is no longer universally accepted. I expect to see debt ratios decrease as companies retool and a less cavalier use of short term financing to fund long term assets.

d. In dividend policy: In the short term, companies will value liquidity and cash balances will go up. In the long term, the events of the last few months will make companies even more wary about instituting and increasing dividends (because of the instability and unpredictability of earnings) and I would not be surprised to see even more of a shift towards flexible cash return policies (stock buybacks).

I feel more confortable now, going into the new semester. I don't have all of the answers but I feel that I have a framework for approaching the questions. The 450 students in my class will put me to the test and I am looking forward to it. You will have a ring side seat.



Accounting Fraud

The news of the day is the resignation of the CEO of Satyam Computer, Ramalinga Raju, after admitting to fraud on a grand scale. Revenues and earnings were overstated massively over the last couple of years, and the company admitted that the cash that had been reported on the last balance sheet did not exist.

I would claim to be surprised and shocked by this news but I am not, becuase it is one in a long series of similar events - Enron, Parmalat, Worldcom etc. Rather than focus on Satyam and the sins of its managers, I would like to make some general points about accounting fraud and its consequences:

1. Self interest ultimately rules the day: The modern corporation is rife with conflicts of interests - between stockholders and bondholders, stockholders and managers, different classes of stockholders and different lenders. When decision makers are faced with a conflict of interest, self interest ultimately will win out. Note that Satyam's deception came to the surface when the company tried to buy stakes in two proprety companies owned by the Raju brothers.

2. Corporate governance matters: While we cannot do much about human beings acting in their self interest, we can put up roadblocks that prevent them from ripping off the rest of us. Having a board of directors tha asks tough questions and holds management accountable is critical to keeping managers/ founders in check. In this case, I have serious problems with the board of directors at Satyam and their oversight of the managers. I know at least 3 people on this board and believe that they are smart, honest people, but they were clearly led down the garden path. I have always had problems with the structuring of family companies in Asia, where families often control dozens of firms using a variety of devices including cross holdings and pyramid structures. When confronted, the families contend that they are "honorable and noble" and that they have the best interests of stockholders at heart. I don't think so!!!!

3. New Accounting and disclosure rules won't prevent fraud: The Indian government and accounting standards board will start writing new rules that they will claim will prevent this type of fraud. I seriously doubt it. Firms will always be one step ahead of the accounting rule makers when it comes to pulling off these heists.

What are the lessons for us as investors? When things look too good to be true, they are usually false. I am not familiar with Satyam's financials, but it may be worth looking at past statements to see if the clues were there that we chose to ignore. There is a strong need for forensic accounting... Just a warning! Fraud and malfeasance come to the surface when times are bad and I will expect to see a flood of Satyam-like cases all over India and China especially. Growth has masked the weaknesses of corporations in both countries and its absence will separate the wheat from the chaff.



Fama-French and the Proxy Wars

A turning point in the debate on risk and return occurred in the early 1990s, when Gene Fama and Ken French wrote one of the most-quoted and influential papers on the topic. In it, they began with a simple premise. If our objective in risk and return models is to come up with expected returns on investments, should we not judge the quality of these models by looking at how well they explained actual returns over very long time periods? They began by looking at the CAPM: in it, all return differences across investments should be explained by differences in betas. Looking at actual stock returns from 1962 to 1990, Fama and French found that betas cannot explain a very large portion of the differences in returns across stocks.

This finding was not knew and reflected what other researchers had concluded in earlier papers. Fama and French, however, decided to turn the problem on its head. Rather than build an alternative risk and return model, which is what others had tried to do with the arbitrage pricing and multi factor models, with all their baggage, they decided to start with the data on returns and work backwards. In other words, they went looking for other company characteristics that would do a better job of explaining differences in returns across stocks, than betas did. Their search led them to two variables - the market capitalization of the company and it's price to book ratio- that together explained a large portion of the differences in returns. Small market cap companies and low price to book value companies consistently earned higher returns than large market cap companies and high price to book value companies. Rather than view this as an inefficiency (which other papers had in the past), Fama and French considered these variables as proxies (stand ins) for risk. In effect, they concluded that small companies must be riskier than large companies and low price to book companies must be riskier than high price to book companies.

While the logic of the Fama-French approach is impeccable, it has one significant weakness. Since it is data driven, any proxy, no matter how outlandish, that explains differences in returns could be used in the model. At the risk of pushing this argument to absurd limits, if companies with fatter CEOs have higher returns than companies with thinner CEOs, the weight of the CEO should be used as a risk proxy. Not surprisingly, as the data we look at gets richer and deeper, other variables have been added to the list of good risk proxies - return momentum, earnings revisions, insider buying etc.

Models that test the CAPM against proxy models by looking at how much of past returns are explained by each are almost certainly going to find the CAPM wanting. After all, the proxies were not picked at random but because they had been correlated with returns in the past.

I think that the question of whether to stick with the CAPM or go with a proxy model depends in large part on what you are using the model for. If your job is performance evaluation, say of mutual funds, I think that proxy models make sense, because you are looking at the past and examining whether individual mutual funds beat the market. If you are trying to forecast expected returns in the future, which is what you are doing when estimating cost of equity in corporate finance or valuation, I prefer to stick with the CAPM, with bottom up betas and adjustments for financial and operating leverage.



Can betas be negative? (and other well used interview questions)

Here is a favorite question among corporate finance interviewers: " Can betas be negative? And if so, what exactly do they tell us?" The reason negative betas pose a conundrum to many finance students is that they seem to go against intuition. After all, if a beta of one is average risk and a beta of zero is riskless, how can an investment have negative risk?

Here is the answer. Yes, betas can be negative. To see how and why, consider what betas measure: the risk added by an investment to a well diversified portfoli0. By that definition, any investment that when added to a portfolio, makes the overall risk of the portfolio go down, has a negative beta. A more intuitive way of thinking about this is that a negative beta investment represents insurance against some macro economic risk that affects the rest of your portfolio adversely. A standard example that is offered for a negative beta investment is gold, which acts as a hedge against higher inflation (which devastates financial investments such as stocks and bonds). It is also true that puts on stocks and selling forward contracts against indices will have negative betas.

What are the consequences of a negative beta? The expected return on that investment will be less than the riskfree rate; the nominal returns on gold over the last 40 years have been 2% less,on average annually, than the riskfree rate. However, that makes complete sense if you think of it as buying insurance. You are paying for the insurance by settling for a very low or even negative return.

Are there actual investments out there that have negative betas? I know that there are stocks with negative regression betas, but those are the mostly the result of something strange happening during the period of the regression - an extended lawsuit or acquisition battle throwing off the correlation with the market- rather the true betas. In fact, in my fifteen years of updating betas by sector, I have still not found a sector with a negative beta. Furthermore, even assets that, in theory, could have negative betas (gold, for instance) seem to have positive betas when securitized (gold shares, gold ETF). There seems to be something about the securitization process that makes real assets behave more like financial assets.



Alternatives to Regression Betas

In my prior post, I explain why I am averse to regression betas - the high standard errors of the estimates, the backward-looking nature of the estimates and the loss of intuitive feel for risk. In this post, I would like to look at alternatives that are offered to regression betas, with an eye towards making better estimates:

1. Relative standard deviations: The beta is a function of the standard deviation of the stock, the standard deviation of the market and the correlation of the stock with the market:
Beta = (Correlation between stock and market) (Std dev of stock)/Std dev of mkt
The primary culprit behind the high standard error of betas is the shifting correlation number. Hence, there are some who suggest using an alternative measure of relative risk:
Relative Std dev = (Std dev of stock)/Average std dev across all stocks
Note that the denominator has to the average standard deviation across all stocks, not the standard deviation for the market, since you want the relative risk number to average out to one across all stocks (and it will not if you use the standard deviation of the market).
Pros: This number, like beta, should average out to one across stocks and should have lower standard error; even in a period like the last quarter, the standard deviations rose across the board and the relative standard deviation was fairly stable.
Cons: You are looking at total risk (not just market risk), which may not be appropriate for a diversified investor. You are also still backward looking and dependent on stock prices.

2. Option based approaches: A few years ago, there was a hue an a cry, arising from a paper published in the Harvard Business Review, which claimed to have come up with a forward looking estimate for risk. In the approach, the implied standard deviation of stocks is backed out of traded options issued by the company and compared to the standard deviation of bonds issued by the same company.
Cost of equity = Cost of debt *(Imp std dev of equity/ Std dev of bonds)
Pros: Forward looking, becauase you use option prices to back out standard deviation.
Cons: Works only for companies that have traded options and bonds... and it mixes up total risk and market risk. Does not strike me as a general approach that will work with most companies.

3. Accounting betas: Rather than regressing stock returns against market returns, we could regress changes in accounting earnings at a company against changes in accounting earnings for the entire market, and the slope would be the accounting beta.
Pros: Not dependent upon stock prices and can be estimated even for private businesses. For those who do not trust markets, accounting earnings offer a more stable alternative (assuming that you trust accountants).
Cons: Accounting earnings are often smoothed out and lag true earnings. Furthermore, the number of observations in your regression is restricted. With quarterly statements, you will have 20 observations over 5 years and the resulting standard error will be huge.

4. Bottom-up Betas: In this approach, we start with the businesses that a firm operates in, estimate the betas of these businesses (by looking at the average regression betas of publicly traded firms in each of the businesses) and clean up for differences in financial leverage.
Pros: The average across many regression betas will be more precise than any individual company's regression beta. It can be computed based upon the current or even a future business mix of a company and for private businesses.
Cons: You do need to find publicly traded companies that operate predominantly or only in each individual business and you the average regression beta does reflect the past. For instance, the average beta across all banks over the last 5 years may understate the true beta for banks for the future.

I am a firm believer in the last approach. Since there are lots of mechanical details that can trip you up, I do have a link on my site where I examine these:
http://www.stern.nyu.edu/~adamodar/New_Home_Page/TenQs/TenQsBottomupBetas.htm
More in my next post!



The problem with regression betas

I must confess that I find the practices used to estimate betas to be both sloppy and counter intuitive. The standard approach, offered in every finance text book, is to regress returns on the stock against returns on a market index, with the slope yielding the beta. I have five problems with this approach:

1. Statistically, the slope coefficient in a simple regression comes with a standard error. The beta estimate for a typical US company has a standard error that is about 0.20. One way to read this number, is when you are told that the beta for a company (from a regression) is 1.10, the true beta could be anywhere from 0.70 to 1.50 (plus or minus two standard errors).

2. Outside the US, regression betas often look much more precise but only because the indices used tend to be narrow local indices (DAX, Bovespa, Sensex). As anyone who has toyed with the parameters of the beta regression (2 vs 5 years, daily vs weekly, different market indices) knows, you can arrive at very different betas for the same company, based on your choices. None of them is the right beta, and they may all be coming from the same distribution, but it is a wide one.

3. By definition, a regression beta has to be backward looking, since you need past returns. To the extent that companies change their business mixes  (by expanding, divesting and acquiring businesses) or their financial leverage (debt ratios) over time, the regression beta may not be a good measure of the beta for the future.

4. If the only way you can estimate betas is with a regression, you will be stymied right from the start, if you are analyzing the division of a company, a private business or a company that went public recently.

5. By making beta a statistical number, we are missing the fundamentals that drive beta. Every company has an intrinsic or true beta that comes from choices it has made and understanding how these choices can cause your beta to change is central to a better beta estimate.

So, I would take any beta reported for a company by a service or an analyst with a grain of salt. It probably came from a regression and should not define your thinking about the firm's risk. In my next two posts, I will offer my analysis of the determinants of betas and an alternative to regression betas.



What betas can... and cannot do...

There is no concept that is more abused, and more misinterpreted, than beta in corporate finance. I have heard betas blamed for everything from global warming to the market collapse. "Warren Buffet does not use beta", the refrain goes, "so why should I?"

I think the biggest mistake that people make is to wrap betas up with the assumptions of the capital asset pricing model (CAPM). Does the CAPM make unrealistic assumptions about no transactions costs and no private information to get to its final conclusion (that all exposure to market risk can be captured in a beta, which should then be the sole determinant of the differences in expected returns)? Absolutely. However, just because you don't like the CAPM's rigidity does not mean that you throw the baby out with the bathwater and abandon beta as a measure of risk, or worse, use no measure of risk at all.

I think of betas as measures of relative risk, with the risk defined as exposure to macro economic variables (interest rates, overall economic growth, inflation). Thus, a stock with a beta of 1.2 is 1.2 times more exposed to macro economic risk than the average stock in the market. That proposition stands, whether one buys into the CAPM or not. Seen from that perspective, here are the things betas cannot do:
1. Explain changes in returns for the entire market. The betas for all stocks cannot go up at the same time, since they have to average out to one. (This is in response to those who have argued that the recent drop in equity prices can be explained by an increase in betas across the board.)
2. Capture emerging market risk. If we regress the returns on emerging market stock against emerging market indices, which is the standard practice for most estimation services, the average beta for Indonesian stocks will be one, as will the average beta of Swiss stocks. If we run regressions against a global index, the results are often unpredictable, with betas for emerging market companies often dropping simply because they are such as a small part of the index.
3. Capture firm specific risk: Betas cannot incorporate risks that affect only a firm or a few firms, even if these risks are huge. Thus, a tobacco company's beta cannot reflect litigation risk and a biotech firm's beta will not capture the uncertainty inherent in the FDA approval process.

Here is what betas can do. They can capture shifts in risk across the market. If a sector gets riskier, its beta should go up, but there has be another sector whose risk has to go down to compensate. Thus, banks will have higher betas today than they did a year ago but technology firms may have seen their betas decline, as they have held up fairly well in this downturn. They provide simple, intuitive and surprisingly effective snapshots of how risky an investment is, relative to the rest of the market, especially if you are an investor with multiple investments in your portfolio.

I do have to mention in closing that running a regression of stock returns against a market index is both a terrible way of estimating betas and of thinking about betas. However, this post is already way too long for me to suggest alternatives to regression betas. That will come in the next post.



Executive Compensation Caps

The news of the day is the decision by the Obama administration to put caps on executive pay, at least at the companies that have lined up to received funds from the government. Not surprisingly, there are people with strong views lining up on both sides of the issue. So, I guess I will stick my toe into the water and hope not to get burned (since there is an obvious political component to this debate).

As a general rule, I don't think governments should have any role to play in setting compensation limits. The heavy hand of government intervention will not only create quirks in the labor market but have unintended consequences. For instance, the US government (in its last populist phase in the early 1990s) decided that executives were getting too much and decided to restrict the compensation that firms could deduct for tax purposes to $ 1 million (per executive)... Since compensation was defined in the legislation as pay and bonuses, and did not include options, it played a role in triggering the huge option packages that executives have received in the last two decades.

But here is why I am torn. The proposed executive pay cap is toothless for most companies and will have an impact only at those firms that have used the federal government as a piggy bank (Citi and BofA ). If we accept the proposition that there is no free lunch, these firms asked taxpayers for capital, were provided this capital and are in no position to deny taxpayers a say in how they make decisions or compensate employees. (As taxpayers, we are singularly unfortunate that we are represented in this process by legislators who have the attention spans of infants and the time horizons of riverboat gamblers...) Faustian bargains have a way of coming back to haunt you.... You lie down with dogs, you wake up with fleas!! (No more analogies, I promise!!!!)

I must close by noting that I think executive compensation is way out of hand at many companies but I think that just as voters in a democracy get the government that they deserve, stockholders are getting the treatment that they too deserve. If we want compensation to be reasonable, and by reasonable, I am not ruling out very large compensation for managers who truly deserve it (Steve Jobs at Apple should be given a few hundred million), we should not be looking to the government for solutions but to ourselves. Investors, and especially institutional investors, need to work to put in place rules that give them more say in compensation. I also like the British notion of putting top management compensation agreements up for stockholder approval routinely.



Low riskfree rates...

One of the many perils of valuing a company in the US or Europe right now is that the riskfree rates in US dollars and Euros are at unprecedented lows - about 2.3% in US $ and about 2.8% in Euros. Analysts, confronted with these riskfree rates, are faced with a quandary. If they use the low riskfree rates, they end up with low discount rates which then result in high valuations. To get around this problem, many are asking the question: Are riskfree rates too low and should we replace them with higher normalized rates (perhaps average rates over time)? Good question, but the wrong place to ask it...

Let me take a step back. It is true that riskfree rates are low but they are not the only numbers at unusual levels. Equity risk premiums and default spreads are at historical highs and the worry about global economic growth is deeper than at time in recent history. When we use low riskfree rates in valuation, we have to accompany them with much higher risk premiums than we would have used a few months ago, lower real growth and lower expected inflation. The net effect is that intrinsic values are lower now than they were a few months ago. 

What gets analysts into trouble is inconsistency. If we use today's riskfree rates and stick with risk premiums that we used to use in the past and growth rates and inflation rates that are also from the past, we will over value companies. The culprit is not the low riskfree rates but internal inconsistency. 

My advice is that you stay with today's riskfree rates but update the other numbers you use in valuation to reflect the environment we face right now. If you insist on replacing today's riskfree rate with your normalized number, you should then adjust all your other numbers to be consistent - not easy to do, in my view. 

Finally, I have a paper on riskfree rates that you may find useful (or not). You can find it by clicking on this link.
I hope you find it useful.





Who uses preferred stock?

In my last post, I made the argument that preferred stock is very expensive debt. To give you a sense of the differences in costs between the different types of financing, consider a company like GE that has common stock, preferred stock and conventional debt outstanding. In March 2009, the cost of equity was close to 12%, the preferred dividend yield was about 9-10% and the pre-tax cost of debt was about 6-7%. On an after-tax basis, the pre-tax cost of debt was closer to 4%.

To understand why firms use preferred stock, given its high cost, we have to look at the two groups of firms that are its biggest users - financial service firms and young, growth companies.

1. With financial service firms, the allure comes from the way regulatory authorities define equity capital for capital ratios. They generally include preferred stock in equity. Thus, preferred stock may be considered expensive debt that gets treated as regulatory equity - a big bonus for firms that get judged based upon their capital ratios. (To add to the problem, ratings agencies also seem to treat preferred dividends as quasi-equity... giving higher ratings to these firms than they truly deserve, given their cash flow obligations).

2. With young, growth companies and some distressed companies, there is a different reason. Since these firms are often losing money, debt does not provide a tax advantage anyway. From, the firm's perspective the difference in costs between debt and preferred stock narrows, as a consequence. From the investors' perspective, the allure of preferred stock is that it is generally cumulative (dividends not paid have to be made up for in future years) and convertible to common stock. Thus, the investors, while running the risk of not receiving preferred dividends during the bad years, get priority in claims to cash flows (if the company starts making money) and can use the conversion option, if the firm's market value also climbs.

If nothing else, the existence of preferred stock is a testimonial to the effects that regulatory and tax laws have on financing choices. Bad laws (and regulatory definitions) will create bad financing choices. We may be seeing this play out in the current crisis. In my view, banks, insurance companies and investment banks that faced capital constraints would have been better off raising common equity early in this crisis rather than go for preferred stock from unconventional sources. Even those banks that thought they were getting a good deals on preferred stock (from the government) are discovering that there are implicit costs in these deals.



Preferred Stock: Fish or Fowl?

In my last post, I talked about hybrids but I stuck with the conventional example of convertible debt. In this one, I would like to draw attention to another source of financing - preferred stock - which I find much more difficult to work with.

Before I begin, though, let me also draw a distinction between preferred stock in the United States and preferred stock in some other parts of the world (such as Brazil). In the United States, preferred stock commands a fixed dollar dividend that is set at the time of the issuance. If you buy preferred stock, your returns come primarily from the dividends - any price appreciation (or depreciation) is a side story. In much of Latin America, preferred stock is really common stock with preferential claims on dividends and limited voting rights. The dividends are usually specified as a percentage of earnings (rather than as an absolute number) and will go up, if the company is doing well, and go down, if not. Returns therefore mirror returns on common stock, with dividends and price appreciation.

Where should we put preferred stock in the cost of capital computation?
1. With the "common stock" variety preferred, the answer is easy. Treat it as equity, even though it may be called preferred stock.
2. With the "fixed dividend" preferred stock, our task becomes more difficult. It is clearly not equity, notwithstanding what it is called, since your claim is on a fixed dividend. (If you have preferred stock that is entitled to more cash flows, such as a share of the remaining profits, I would consider it equity). Including this item in debt creates a problem, since preferred dividends are not tax deductible (and attaching an after-tax cost of debt to the overall debt will understate the cost of preferred).

Here is my compromise solution. If the value of preferred stock is less than 5% of overall firm value (market), act like it does not exist for cost of capital purposes and subtract the preferred dividend out from earnings and cash flows. (It will make little difference to your cost of capital, if you do include it, and more headaches than it is worth) If it is more than 5%, we have no choice but to create a third source of capital and give it it's own cost. The cost of preferred stock should be the preferred dividend yield (which will be lower than the cost of equity but higher than the pre-tax cost of debt).
Preferred dividend yield = Preferred dividend per share/ Preferred stock price

The puzzle then becomes the following. Preferred stock is essentially very expensive debt (because you do not get the tax advantage). So, why would any sensible firm even use it to raise capital? More on that in my next post.



My thoughts on the AIG fiasco

As I watch the AIG circus unfold, I don't whether to laugh or cry. First, the people running these banks must be tone-deaf not to recognize that once you appeal for government bailouts (and get them), the rules have changed. If something appears unseemly, it is so. And when there people are scared - about losing their jobs and seeing their savings meltdown - the notion that AIG paid bonuses in the millions strikes many as unfair.

There do seem to be two separate components to the AIG actions. One relates to the billions that AIG supposedly funneled out to investment and commercial banks. I noticed Goldman Sachs at the top of the list. I really have no idea what these payments were for but if these institutions were counter parties on positions that AIG had taken, I see nothing wrong with this. After all, was this not what the bailout money was supposed to be for? To ensure that AIG did not default on its obligations and bring other institutions down with it!

The second story (and the one getting press) comes from the retention bonuses that AIG paid out, after it received the bailout money. While the payments may fail the political and populist tests, they too may have been merited. Why should you reward those who created the problems with bonuses, you ask? Remember that the vast majority of the employees at AIG did their jobs and added value to the organization. They had no role in creating this mess. A handful or risk takers brought the firm down. In the aftermath of the crisis, the firm had to do everything it could to keep the good employees from fleeing. After all, what would be the point of saving the institution, if its biggest asset (human capital) departs? I don't know enough to pass judgment, but methinks that the legislators protest too much.



Dealing with Hybrids

One of my favorite devices to introduce concepts in valuation and corporate finance is a financial balance sheet. Unlike an accounting balance sheet, a financial balance sheet is a forward looking instrument. On the asset side of this balance sheet, there are only two categories for assets: assets in place, i.e., the value of investments that have already been made by the firm and growth assets, i.e., the value added by investments that I expect the firm to make in the future. On the liability side of the balance sheet, there are only two items as well: Borrowed money (debt) or owners' funds (equity).

While I hold fast to the belief that all financing has to come from debt or equity, and that the cost of capital is a weighted average of the costs of these two funding sources, hybrid securities pose both a conceptual and a practical challenge. Hybrids, of course, are financing choices that are part debt and part equity. A classic is convertible debt, where the lender (bondholder) has the option to convert to equity at a fixed price. Convertible debt has a debt component (the traditional bond or loan, with a finite maturity and interest payments) and an equity component (the conversion option).

While I see companies and analysts treating convertible debt as a source of funding, separated from debt and equity, it is a bad idea for two reasons. First, it makes any attempt to optimize capital structure much more difficult - it is easier to find the optimal mix when you have two elements to work with, rather than three. Second, and this is my real problem with this approach, is that it can lead firms to make bad choices and here is why. Analysts who treat convertible debt as a financing choice often use the coupon rate on the convertible debt as the cost of convertible debt. This coupon rate will be low, because of the presence of the conversion option. A corporate treasurer who compares the cost of convertible debt to straight debt will then jump to the unsurprising conclusion that convertible debt is cheaper than straight debt and will lower the cost of capital... And analysts feed the illusion!

So, what should we do with hybrids? I would attempt to break the hybrid security down into its debt and equity components. With convertible debt, this is simple to do. Ignore the conversion option and value the convertible debt as if it were straight debt, i.e, take the present value of coupon payments and the face value using the pre-tax cost of debt for the firm's straight debt. With its low coupon rate, you will arrive at an estimate of value that is well below both face value and market value. That is the debt portion. Subtracting this from the market value of the convertible bond will yield the conversion option value: this is the equity portion. If the convertible debt is not traded, the conversion option will have to be valued using an option pricing model. Add the debt portion to the rest of the debt, the conversion option value to equity and presto: there is no hybrid left.

Almost debt hybrids can be dealt with using this technique. The one exception is preferred stock, a hybrid that is tough to categorize. More about what to do with that source of financing in my next post.



The Yankee infield and debt...

I have been a sports fan all my life, following (and playing) cricket, tennis and now baseball (especially since my sons are all big baseball fans). Since I have lived in New York now for almost 25 years, I have become a New York Yankee fan.. As some of you may know that Yankees have built a new billion dollar stadium (actually the city did...) and opening day is April 17. I was able to get on EBay and buy three tickets for the game.

I am really looking forward to that day but as the Yankees run on to the field, my thoughts will turn to debt and leverage and here is why. The Yankees have the most expensive infield in baseball history (and perhaps the highest payroll of any team in any sport):
At first base: Mark Teixeira: $22.5 million every year for the next 8 years
At second base: Robinson Cano, $7.5 million every year for the next 4 years
At short stop: Derek Jeter, $19 million every year for the next 2 years
At third base: Alex Rodriguez (injury healed and steroid free), $27.5 million a year for the next 9 years
Behind the plate: Jorge Posada, $13.5 million every year for the next 3 years
On the mound: CC Sabathia, $ 23 million every year for next 7 years

These contracts represent commmitments that have be met, no matter how well or badly the Yankees do as a team, and independently of how these stars play. In other words, they are debt commitments. Taking the present value of these commitments, using a pre-tax cost of debt of 6%, we arrive at an astounding sum of $561 million. Here are the implications:

1. Looking at the Yankee balance sheet will give us a misleading measure of how much they owe as a business Their conventional debt is a small number but adding the present value of commitments gives us a debt ratio that is much higher. (General lesson: Firms with significant fixed commitments, such as retailers and restaurants are much more highly levered than they look, based upon conventiional measures.)

2. Last year's Forbes estimate of the values of different sporting franchises put the Yankees on top of the list, with an estimated value of about $1.5 to $ 2 billion, with Manchester United just behind them. If you are wealthy enough to buy the Yankees for $ 1.5 billion, you really are paying close to $ 2.1 billion (since you are assuming the player contracts when you buy the team) (General lesson: When we use ratios like EV/EBITDA to value firms, and define EV = Debt + Equity - Cash, we should be including the present value of commitments in debt in computing enterprise value.)

3. From a corporate finance standpoint, firms that already have substantial fixed commitments for extended periods should be cautious about adding to these commitments. In other words, if the Yankees had decide to pay for their own stadium, I would have cautioned them against borrowing; I would have suggested selling a portion of the equity. (General lesson: A typical airline makes huge lease commitments to buy its planes. To add to these commitments by borrowing conventional debt seems to be asking for trouble. Yet, the typical airline still does it.. Any wonder that the sector is full of distressed companies?)

I am sure that I will be able to put all these thoughts out of my mind before the first pitch is thrown, but it adds to my contention that life is full of corporate finance lessons.



What is debt?

Figuring out how much debt a company has outstanding is not only critical to assessing its default risk but is a central input into much of what we do in corporate finance (cost of capital, cost of equity and valuing equity). It is a topic we have been examining in both the corporate finance and valuation classes this week. 

I use three criteria to classify an item as debt. 
1. It gives rise to contractual (fixed) payments that have be made in both good times and bad.
2. These payments are tax deductible.
3. Failure to make these payments results in loss of control

Using these criteria, it is quite clear that all interest bearing debt (whether short term or long term, bank loans or corporate bonds) should be considered debt. Here are the more controversial items:

a. Accounts payable and supplier credit:  Generally, I would not include these items as debt and here is why. The interest expenses on accounts payable and supplier are not explicitly broken out. Consider how supplier credit works. You buy items from a supplier, and he lets you pay in 10 days or 50 days. If you pay in 10 days, you get a 2% discount, which you lose if you take the entire 50 days. When you use supplier credit to increase your cash flows, you give up the discount, which effectively is the interest you are paying on the credit. However, when you account for the expense, you record the total cost you pay as part of cost of goods sold and do not break out the discount lost as an interest payment. So, here is the trade off. If you want to count accounts payable as debt, you will have to go into your cost of good sold and break out the portion of that cost that is the foregone discount and show it as interest expense. That can be tough to do.

b. Lease commitments: By the same token, lease commitments should be treated as debt because they are (a) contactual commitments (b) tax deductible and (c) failing to pay them can expose you to legal consequences. We can debate whether they are closer to unsecured debt than secured debt, but not whether they are debt. For any retail or restaurant company, the bulk of the debt is in the form of  lease commitments and we should be considering the present value of these commitments as debt. For firms like the Gap, Walmart and Starbucks, 80-90% of the debt takes the form of lease commitments.

c. Under funded pension and health care obligations: We are trained in accounting classes to be conservative when it comes to debt and to count everything we can as debt. That advice serves us badly in valuation. If we start including under funded pension and health care obligations as debt, we will inflate debt ratios and reduce cost of capital. That does not strike me as conservative. I would ignore these as debt for cost of capital purposes, but will consider them as debt, later in the valuation, when I am intent on getting from firm value to equity value.

More posts on this as we go on, but that is it for now.






My favorite novels on financial markets

After that last rant, I am ready to get back to matters that are more pleasant. I love reading crime fiction and I consume everything I can get my hands on. Since I love reading about markets as well, a few of my favorite novels combine the best of both genres.

One of my favorite authors is David Liss. For those who have never had the pleasure of reading his novels, I would recommend his first novel, titled "The Conspiracy of Paper". Set in London at the time of the South Sea Bubble, the book is a fascinating period piece, describing the social setting of the city then. What makes it fun to read, though, is its description of the financial markets of the time and how swindlers took advantage of investors. In fact, as you read about the starting of rumors in pubs that then circulated among stock traders, you see the primitive versions of the financial press today. In fact, there are so many parallels that you can draw between then and now, that you realize that the more things change, the more they stay the same.

Almost as good is his third book called "The Coffee Trader", about the very first derivatives markets in coffee and commodities. Again, the close linkage between the development of market and commerce come alive as you read about the antics of traders in Amsterdam. Short squeezes and momentum investing have been around as long as markets have existed.

I must confess that I did not like his most recent book, "The Whiskey Rebels' as much. While it is built around the Whiskey Rebellion of 1794, it weaves in the story of Alexander Hamilton, the first Secretary of the Treasury of the United States, and his attempt to create a central bank... While it is about finance, I think that Liss is much better at describing the chaos of markets than he is in high finance.



Why I cannot stand George Soros!

Let me start with a confession. There are some people I will pay not to listen to, and one of them is George Soros. First, let's dispense with the myth that this guy is a great investor. I don't know Buffett, but if I did, I would tell you that Soros is no Buffett. George Soros is a speculator who got lucky at two levels. The first was timing.. betting against the British pound in the early 1990s was perfect. The second was that he has made his big score betting against central banks that refused to face the facts.

There are many investors who mistake luck for skill and I would not blame Soros for doing the same, if it were his only fault. There are two things about the man that I find distasteful:
1. Moral high ground: I find it hard to listen to lectures on morality and ethics from Mr. Soros, A speculator who made his money on a few big bets should not be telling the rest of the world what constitutes good or moral behavior and why hard work should be rewarded.
2. False expertise: The Financial Times has been publishing a series of articles by Soros on how banking can be fixed in developed markets. A few years ago, Soros also told us what was wrong with the derivatives markets and why options and futures should be restricted, regulated or banned because they could be misused. Unfortunately, the man knows little about either. But, he made a lot of money on derivatives, you say... True! But we don't consider a guy who hits the jackpot on a slot machine in a casino to be an expert on probabilities, do we?

My point is a larger one. We assume that people who have been successful in investing know a great deal more about investing than we do. We buy their books, we listen to them on television and radio and worst of all, we entrust our savings to them at substantial cost. While this may be true in a few cases, it is not true in most. Most successful investors and traders are successful because they are lucky and not because of their intellectual prowess or investing smarts... it is better to be lucky than smart. A few of these investors (like Soros) let success get to their heads and start believing their own hype. They should be ignored!



Buffett: Man or Myth

Warren Buffett is now more myth than man. The investors who claim to follow Buffetology, read the Berkshire Hathaway annual report and actually make the trip to Omaha (the value investing Woodstock) numbers in the tens of thousands, if not millions. I think that we do a disservice to Buffett, when we put him on a pedestal and treat every word he says as gospel. At the risk of sounding like a curmudgeon, here is my take on Mr. Buffett.

Let's start with the obvious. Warren Buffett has been an incredibly successful investor and his string of successess cannot be explained by luck. He has been able to make money with diverse investment strategies, but with a core philosophy that has remained unchanged over the last four decades. That core philosophy: you buy a business, not a stock. Hence, his competitive advantage has been assessing the value of an underlying business, especially in chaotic times, and buying stock in that business, when the price is down.

Buffett has never been an activist investor, i.e., he has seldom taken positions in poorly managed companies and tried to change the management. In fact, one of his criteria for investing in a company is that he admires the management. He has also never been comfortable straying from his niche, which is mature businesses: I cannot think of a single, big investment that he has made in a technology or young company.

I like to read Buffett's comments on the markets. Unlike many market strategists at investment banks, who cloak their recommendations in buzz words and hedge them until they are meaningless, Buffett is to the point and says what he means. His emphasis on corporate governance puts most institutional investors to shame.

My only real issue with Buffett is that he sometimes lets his "Aw, shucks! I am just a regular investor" persona cover up two things that he does that contribute to his success. One is his careful focus on cash flows; he might not use the terminology of valuation but Buffett has been using free cash flows to measure investments for as long as he has been investing. The second is that he is now an insider in many of the companies that he invests in; he has an advantage over you or I, when taking the same investments.

One final point about Buffett. The mythology is that Buffett does not adjust for risk, when he invests. I have even heard people say that he settles for the riskfree rate. Right? Buffett may not use betas or risk-adjusted discount rates but he certainly factors risk into the analysis by making conservative estimates of the cash flows. In effect, he reduces the expected cash flows of riskier businesses, i.e., uses certainty equivalents.

Be like Buffett, if that is what you want to do. But don't view this as a license to ignore risk and to just buy companies with good management (no matter what the price). You are almost certainly not going to make money that way.



The future of the MBA

As someone who has a vintage MBA (from 1981) and has taught MBAs for almost thirty years, I have been spending the last few months wondering about the implications of the market crisis for MBA programs globally. After decades of almost uninterrupted growth in business schools, we are starting to look at not just a mature phase but potentially a phase of decline. Using the same principles that we so blithely recommend that companies facing similar challenges should follow, it is time for action. Knowing how slowly academia moves, I am not hopeful. Here are two of the reasons why I think we should be in crisis mode:

1. The growth in the demand for MBAs has been inextricably linked with the growth in the financial services sector. Many of our incoming MBA student have left good jobs as engineers, salespeople or analysts to come back to business school, in order to make the transition to the richer pastures of investment banking. Those pastures are not only looking smaller and less attractive now than they used to be but are likely to stay that way for an extended period.

2. As teachers at business schools, it looks like we failed the test. After all, some of our best students were at the helm of the institutions that drove us off the cliff. While the rationalization that is offered by many of my colleagues is that these individuals were ignoring what they were taught in business schools, there are other influential voices that are arguing that it is what they were taught at schools that caused the collapse.

Here is what I think we need to do:
1. Prepare for much less demand for MBAs looking forward. This has implications for people who are thinking of or are in Phd programs right now, who will be going into a smaller market.
2. We need to incorporate what this crisis has taught us into how we approach whatever we teach. We do not need to over react and throw first principles out, but this is not the time for defensiveness.
3. As individual faculty , we have to think far more seriously about what competitive advantages we have over the hundreds of others who teach the same subject. If all we are doing is delivering a standard product from a pre-set template, why should someone pay tens of thousands of dollars for that product?



Are accountants learning?

While I have many areas of disagreement with accounting, there are three accounting practices that I have taken particular issue with over time.

1. Not treating employee options as expenses when granted: There should really be no debate about this. Employee options are compensation, and like all other compensation expenses should be recorded at fair value, when granted. The fair value is the option value and not the exercise value.

2. Treating leases (or at least a significant portion of them) as operating expenses: Both FASB and IASB have used the ownership of the asset as the determinant of whether a lease should be treated as an operating or capital lease. As an earlier blog post noted, this allows retailers, restaurants and other big lessees to move most of their debt off the balance sheet.

3. Treating R&D expenses as operating, rather than capital expenses: Using the tenuous argument that the benefits of R&D are too uncertain, accountants have insisted on expensing R&D. In the process, =they misstate earnings at technology and pharmaceutical firms and keep the most valuable assets of these firms off the books.

As recently as three years ago, all three practices were still entrenched in accounting statements and standards. But the times are changing. A couple of years ago, accounting finally came around to the point of view that employee options should be valued and expensed when granted (FASB 123). Now, there is chatter that accounting rules will be changed to force all leases to be treated as debt.
http://www.globest.com/news/1380_1380/insider/177832-1.html

I know that companies will be up in arms over this rule and that analysts will issue scary reports about how making this change will be devastating for compaies. I don't think so, and have written what I hope is a comprehensive paper on what treating leases right (which to me is to treat them as debt) will do to all the numbers that we use in corporate finance and valuation. Since I have been treating all lease commitments as debt, in both my corporate finance and valuation classes, it will not change how I look at companies but it will surely make it easier for me to do so:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1390280

All that is left now is for the accounting rule makers to take a look at R&D and exploration costs and the logical fixes to make their treatment consistent with capital expenditures at other firms. I have mixed feelings about this happening. On the one hand, it will be a vindication of much of what I have been arguing for, over the last decade. On the other hand, what will I have left to argue about with my accounting colleagues?



Losing, sustaining and building on brand names

In my last two posts, I argued that a brand name can add significant value to a firm and that we can sometimes estimate that value. A news item last week about Domino's started me thinking about the fragility of brand name value and whether, and how long, it can be sustained: Two employees at a Domino's filmed themselves making sandwiches for delivery, adding ingredients (too disgusting to mention) to the meals. Even worse, they put the film up on YouTube.
http://www.youtube.com/watch?v=r4ftKIMLCl0
In the next few days, this video was watched by millions of people, who thought worse of Domino's after watching the clip. A service that measures brand name perceptions in real time (though I cannot attest for the precision of their measures) concluded that the perception of Domino's among the general public went from a strong net positive to net negative as a consequence.

Events like these indicate that even strong brand names can sometimes come under assault, sometimes from events outside of their own control. Johnson and Johnson, for instance, was confronted with incidents of someone poisoning Tylenol capsules in the mid-1980s. The firm responded by pulling all Tylenol off the shelves nationally and going public with the danger, a reaction that some thought was overwrought, but is now considered a case study of what companies should do when faced with such crises. If 60, 70 or 80% of your value comes from brand name, you should do whatever needs to be done to preserve it.

While dangers to brand name can come unexpectedly from the outside, the bigger dangers comes from within the firm. Here are some examples:
a. Misunderstanding where the value comes from: In perhaps the classic marketing blunder, Coca Cola in the late 1980s made the mistake of thinking that their brand name came from taste, and started experimenting with new flavors (New Coke, anyone?). In the process, they put the entire company at risk and had to back track. Apple and Disney have had near death experiences, where they have done something similar.
b. Neglect: Since brand name values come from perception, the value of a brand name will not pass on from one generation to the next. As a company's customers age, it has to actively work to ensure that the brand name value passes on to younger customers. Companies like Quaker Oats, the Gap and Xerox have all seen their brand name values dissipate over time.
c. Spreading the brand name too thin: Finally, there is a danger to trying to extend brand names beyond their product base. I am not sure that I would pay a premium for a T-shirt with a Coca Cola logo on them or eggs with Disney character pictures imprinted on them (I am not kidding.. Check your local grocery store).

A final thought. In spite of all of the dangers that I have listed, it still remains true that brand names represent some of the longest-lasting competitive advantages to businesses. A study in a marketing journal, for instance, found that three of the top five brand names in 1925 were still on the list in 2000. I cannot think of too many other competitive strengths that would have survived this long.



Valuing brand names

If we accept the proposition that a brand name can have significant value, it seems logical to follow up by trying to estimate that value. The best way to think about how much of the value in a company comes from its brand name is to ask the hypothetical question: What will happen to this firm's value, if it lost its brand name tomorrow?

That question is not always easy to answer since the effects of brand name are everywhere in the firm and are not easily separable. They can affect the company's sales, its pricing policies and its financing costs. Getting a clean estimate of brand name value can range from difficult, to close to impossible, depending upon the company. As a general proposition, brand name value is easiest to value when:
a. There are no quality differences between a company's products and those of its competitors (other than brand name) in the sector.
b. There is at least one company in the sector that is truly "generic".

One reason I use Coca Cola in my brand name valuations is that I really cannot think of any reason why one soda should sell for a higher price than another, based on taste and quality. I know.. I know.. there is the secret formula, but making a cola or an orange soda does not strike me as incredibly difficult to do. Thus, I feel that any differences in margins between Coca Cola and a generic soda manufacturer have to be because of the brand name that Coke has built up over the last century. That is the ploy that I used to estimate that 80% of Coca Cola's value came from its brand name (in the paper that I linked to on the last blog post).

In contrast, think about trying to value Sony's or Apple's brand name. While both companies may have higher margins than their competitors, there are reasons other than brand name that we can attribute these differences to: quality in the case of Sony and a superior operating system and styling for Apple. Thus, what we assign as a value for brand name for these firms may in fact be a composite of many different competitive advantages.

Does this bother me? To me, valuing brand name, for the most part, seems to be a cosmetic exercise. It is not as if Coca Cola would ever be able to sell its brand name and stay a viable company. Thus, what I really want to be able to do is value Coca Cola as a company. The fact that I cannot then break this value down into parts seems to me a secondary problem.



The power of a brand name

I am sorry about the long hiatus from posting but I was at Disneyworld last week with two of my children. As we wandered from one line to another, frantically collecting fast passes along the way, I perused the merchandise that I passed by and pondered the power of a brand name. Every conceivable item that can be fashioned into Mickey Ears has been, from T-shirts to mugs to waffles. And once the Mickey logo is put on a product, the price takes a quantum leap upwards.

To me, this captures the power of a brand name. Stripped to basics, it allows you to charge a higher price for exactly the same product. Very few companies have this type of power, and if they do, it clearly pays off big time in pricing power.

What are the implications for valuation? A brand name company will have a higher value than an otherwise similar company (same products, same total revenues) without the brand name. Note, though, that I am not suggesting that we attach brand name premiums to intrinsic valuations as I have seen some people do. If you do your discounted cash flow valuation right, the brand name should already be embedded in that value. It is in every input in the valuation from base year profits, to margins to returns on capital to value. Adding a premium to a discounted cash flow valuation usually results in a double counting of the brand name value.

I have watched with some trepidation the attempts by accountants to try to put brand name value on the balance sheet, In fact, I have a paper on valuing brand name and other intangibles that you may find interesting:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1374562

I value Coca Cola's brand name value in this paper and develop general frameworks that can be used to value several categories of intangible assets. More on brand name and the consequences for corporate finance and valuation on the next few posts.



MBAs and Ethics

Yesterday's New York Times had an article on the graduating Harvard MBA class. About 20% of the class have signed off on an ethics oath, which you can find here:
http://mbaoath.org/
If you follow the lead, you will find the list of what these students have promised to do:
  • I will act with utmost integrity and pursue my work in an ethical manner.
  • I will safeguard the interests of my shareholders, co-workers, customers, and the society in which we operate.
  • I will manage my enterprise in good faith, guarding against decisions and behavior that advance my own narrow ambitions but harm the enterprise and the societies it serves.
  • I will understand and uphold, both in letter and in spirit, the laws and contracts governing my own conduct and that of my enterprise.
  • I will take responsibility for my actions, and I will represent the performance and risks of my enterprise accurately and honestly.
  • I will develop both myself and other managers under my supervision so that the profession continues to grow and contribute to the well-being of society.
  • I will strive to create sustainable economic, social, and environmental prosperity worldwide.
  • I will be accountable to my peers and they will be accountable to me for living by this oath.
It sounds awfully good and I should probably rejoice at this rebirth of ethics in business, but I am not particularly moved for the following reasons:

1. Life is about making choices: From the sounds of this oath, these students plan to keep everyone happy for the rest of their lives. I wish them well, but the real questions will come up when the interests of stakeholders clash (stockholders versus co-workers, stockholders versus society). They will have to make hard choices and someone will be unhappy, oath or no oath. This sounds about as good as stakeholder wealth maximization and about as useless.

2. Self interest is not a bad thing: Embedded in this oath is the view that self interest is a bad thing and that we should be serving broader interests, but whose interests are those? Ultimately, the most productive societies have been built around individuals acting in their own self interest. I think the bigger challenge is to set up processes where what we do in our own self interest works to further the collective interest. It suggests to me that we need to expand reading lists in MBA programs to include a little more Adam Smith and Milton Friedman... and a little less of whatever is on the list right now.

3. Watch out for those who are holier than thou: I don't know the people who signed this oath and I am sure that many of them are well intentioned, good people but I do remain suspicious of people who sign oaths like these. My experience is that the people who indulge in breast beating about honor, ethics and honesty are often the least dependable in the face of an ethical challenge.

Finally,the article finds the obligatory ethics professor to quote. Not surprisingly, she proclaims the beginning of a new age of ethics in business. That's baloney. After every crisis, this type of talk abounds, in conjunction with business schools flaunting their newest ethics offerings. Notice how frequently they have to make these classes required courses rather than electives. Tells you something about how much of it is window dressing... Human beings are human beings, and by the time we get them in MBA programs, their ethics are already well formed. It takes incredible conceit to think that we can put grown ups through an ethics class and change their definitions of good and bad...



Stockholder democracy...

Today's New York Times carries an article on shareholder democracy that illustrates why there are shades of gray even with proposals that seem absolutely cut and dry at the outset. This one has to do with the proposal from the SEC, allowing institutional investors to propose board members who would then be listed in the proxies that companies send out to stockholders. (Only investors who are not interested in doing an acquisition and have held the stock for more than a year can propose new directors, and even then, only 25% of the directors can be challenged) The idea seems unexceptional. Until now, shareholders have had to vote for those directors proposed by the company or write in their own alternates; only in a proxy fight do shareholders get choices. This rule change would presumably give them more choices even in the absence of a proxy fight.

The fear voiced in this article is that some shareholders may have other interests in the company that overwhelm their interests in seeing stock prices improve. The example given is of a shareholder who has taken a large position on the credit default swap market, betting that the company will fail. Such a shareholder may gain more from seeing the company default than continue as a going concern; consequently he or she may nominate directors who will drive the company into the ground.

I think that the article has a point, though I think it is also a little over the top in terms of hysteria. There are two phenomena muddying the waters of shareholder democracy. The first is investors who own hybrids - convertible bonds, debt with equity options etc., who do have multiple and sometimes conflicting interests in the firm. This is not new but it is a much bigger factor now than two decades ago. The second is that increasing presence of investors who bet not on the direction of the stock price but on its volatility. Many option based strategies are directionless - investors don't care whether the stock goes up or down - but make or lose money depending upon how volatile the stock is. The SEC's implicit assumption that all stockholders have a shared interest in the stock price going up is coming into conflict with the consequences of a more diverse set of interests in stockholders: some want the stock price to increase but some do not.

I do not have an easy solution. We could try restricting shareholder voting only to those investors who have no conflicting interests, but I don't think that proposal can be easily policed and it would not be fair. A bondholder who has an equity position is just as much an equity investor as one who does not, even though the former's interests may diverge from the remaining stockholders. I am also not comfortable with any rule that tries to define "good" shareholders and "bad" shareholders. Good and bad are in the eyes of the beholder... Ultimately, as in any democracy, we have to trust the voters to make the right judgments, even though they may bring in very different interests into the voting booth.



Keep it simple!!

While I took issue with a great deal of what Mr. Buffett said in the last post, there is one point on which I completely agree. Keep it simple! In my valuation classes, I begin my class by promoting the principle of parsimony. In the physical sciences, this principle (also known as Occam's razor) specifies that when trying to explain any phenomenon, you start with the simplest possible explanation before moving on to more complicated theories.

In valuation, the principle of parsimony calls on us to use the simplest possible model to value any asset. However, there is a catch. The definiton of simplest will vary, depending upon the asset you are valuing. When valuing cash, for instance, you can just count the cash on hand; you don't need a model or elaborate assumption. When valuing a mature company, with stable and predictable, profits, knowing what the firm generated in cash flows last year may be sufficient to value the firm. When valuing a young, growth company, the simplest model may require you to forecast earnings and cash flows for an extended period. You may not like to do it (I don't think anyone does) but there is no real choice..

So, here is the bottom line. I oppose detail for the sake of detail and complexity designed to show the world how smart and sophisticated an analyst is. I think you risk mangling the valuations of simple assets by doing so. However, I think to argue that detail is always bad and that forecasting is dangerous works only if you decide that your investment space is going to be populated only by mature companies. If you, as an investor, are interested in buying growth companies (and there is no law that says you have to be) or valuing them, you have to face up to the truth. There is no way to value these companies without peeking into the future and making forecasts, and then adjusting your value for the uncertainty you feel about these forecasts.



Buffett and Munger... Shock value!

Berkshire Hathaway is having its annual meeting and the financial press is falling all over itself reporting what the sage from Omaha has to say about investing. Let me say at the outset that I have expressed my admiration for what Warren Buffet does well - the fact that he has a core philosophy that he does not deviate from and his instinct for going against the grain. Over time, he and Charlie Munger, who has operated at his right hand for decades, also say things for shock value to indicate how separated they are from both academics and other portfolio managers. Here is a listing of quotes and my responses to them.

Mr. Buffett: “There is so much that’s false and nutty in modern investing practice and modern investment banking, that if you just reduced the nonsense, that’s a goal you should reasonably hope for.”

I agree entirely. There is much that is done in portfolio management and corporate finance that does not pass the common sense test. Layering complexity on stupid ideas - that leverage always increases value, that securitization can make you a more valuable company - do not make them any less stupid.

Mr. Buffett said he was once asked by a student from the University of Chicago, a hub of modern portfolio theory, “What are we learning that’s most wrong?” To which Charlie Munger quipped, “How do you handle that in one session?”

My question to Mr. Buffett would be a simple one: What exactly is your understanding of Modern Portfolio Theory? I would wager that he would come back with Markowtiz portfolios and the CAPM. If you define modern as circa 1964, he would be right. If not, he has a lot of catching up to do.

Mr. Buffett on the efficient market hypothesis, the idea that all information is instantly priced into the market: “There’s this holy writ, the efficient market theory. How do you teach your students everything is priced properly? What do you do for the rest of the hour?”

Mr. Buffett probably does not realize this but the efficient market hypothesis is really a warning to those portfolio managers who try to trade on information - earnings announcements and acquisitions, for isntance - and day traders. To be honest, 99% of investors would be saved a lot of money, if they followed the suggestions of efficient market theorists. Let's face reality. If you define an efficient market as one where investors cannot easily take advantage of market imperfections, markets are efficient to most investors on most assets most of the time... One reason that Mr. Buffett continues to generate excess returns is that he is able to strike inside deals with managers... Do you think you or I would have been able to get the deal he got from Goldman?

Mr. Buffett on complex calculations used to value purchases: “If you need to use a computer or a calculator to make the calculation, you shouldn’t buy it.”

Spoken like a Luddite... How about an abacus, Mr. Buffett? Maybe a slide rule?

Mr. Buffett on the use of higher-order math in finance: “The more symbols they could work into their writing the more they were revered.”

Actually, I do share Mr. Buffett's concern that common sense is sometimes overwhelmed by mathematics. However, the people who are most revered in finance - Harry Markowtiz, Merton Miller and Gene Fama- are surprisingly down to earth in explaining their ideas.

Mr. Munger on the same theme: “Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you but it doesn’t. They teach that in business schools because, well, they’ve got to do something. ”

What would Mr. Munger do instead? Look backwards and discount forward? What part of forecasting does he think is pointless? And does he not agree with the proposition that a dollar today is worth than a dollar in year? If not, he should be sentenced to spend a year in a high inflation economy (say Zimbabwe)...

Mr. Buffett adds: “If you stand up in front of a business class and say a bird in the hand is worth two in the bush, you won’t get tenure…. Higher mathematics my be dangerous and lead you down pathways that are better left untrod.”

Depends upon your chances of getting the birds in the bush, right? If you feel that you have a 60% chance of getting the birds in the bush, is it not worth the trade off? No wait. Talking about probabilities probably is higher mathematics and I should not do it... My bad...

Mr. Buffett on the persistence of bad ideas in finance: “The famous physicist Max Planck was talking about the resistance of the human mind, even the bright human mind, to new ideas…. And he said science advances one funeral at a time, and I think there’s a lot of truth to that and it’s certainly been true in finance.”

It is true. In any discipline, for every three ideas you come up with, only one will move forward. But the solution to this is not to stop having new ideas but to churn out more...




Valuing declining and distressed companies

In my last post, I noted the difficulties that we face when valuing young companies. In particular, I noted both the difficulties we face in estimating cash flows for these firms and factoring in the possibility of failure. In many ways, we face the same problems at the other end of the life cycle, when valuing firms at the other end of the life cycle. In particular, declining and distressed firms share five characteristics:

1. Stagnant or declining revenues: Perhaps the most telling sign of a company in decline is the inability to increase revenues over extended periods, even when times are good. Flat revenues or revenues that grow at less than the inflation rate is an indicator of operating weakness. It is even more telling if these patterns in revenues apply not only to the company being analyzed but to the overall sector, thus eliminating the explanation that the revenue weakness is due to poor management (and can thus be fixed by bringing in a new management team).

2. Shrinking or negative margins: The stagnant revenues at declining firms are often accompanied by shrinking operating margins, partly because firms are losing pricing power and partly because they are dropping prices to keep revenues from falling further. This combination results in deteriorating or negative operating income at these firms, with occasional spurts in profits generated by asset sales or one time profits.

3. Asset divestitures: If one of the features of a declining firm is that existing assets are sometimes worth more to others, who intend to put them to different and better uses, it stands to reason that asset divestitures will be more frequent at declining firms than at firms earlier in the life cycle. If the declining firm has substantial debt obligations, the need to divest will become stronger, driven by the desire to avoid default or to pay down debt.

4. Big payouts – dividends and stock buybacks: Declining firms have few or any growth investments that generate value, existing assets that may be generating positive cashflows and asset divestitures that result in cash inflows. If the firm does not have enough debt for distress to be a concern, it stands to reason that declining firms not only pay out large dividends, sometimes exceeding their earnings, but also buy back stock.

5. Financial leverage – the downside: If debt is a double-edged sword, declining firms often are exposed to the wrong edge. With stagnant and declining earnings from existing assets and little potential for earnings growth, it is not surprising that many declining firms face debt burdens that are overwhelming. Note that much of this debt was probably acquired when the firm was in a healthier phase of the life cycle and at terms that cannot be matched today. In addition to difficulties these firms face in meeting the obligations that they have committed to meet, they will face additional trouble in refinancing the debt, since lenders will demand more stringent terms.

From a valuation perspective, using conventional discounted cash flow models can lead us to over value declining and distressed firms, where the possibility of distress is high. I think that we need to adjust the values that we obtain from DCF valuations for the likelihood that these firms will not make it. While there is no simple way to estimate the probability of failure, there are clues in the market that we can use to make reasonable estimates. I have a paper on the topic that you can download (if you are interested)

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1428022

Your comments are always appreciated.




Valuing Young Companies

One of the biggest challenges in valuation is valuing a young company, early in its life cycle, especially when that company has not established products. There are six reasons why valuation is difficult under these conditions:
1. No history: At the risk of stating the obvious, young companies have very limited histories. Many of them have only one or two years of data available on operations and financing and some have financials for only a portion of a year, for instance.
2. Small or no revenues, operating losses: The limited history that is available for young companies is rendered even less useful by the fact that there is little operating detail in them. Revenues are small or non-existent for idea companies and the expenses often are associated with getting the business established, rather than generating revenues. In combination, they result in significant operating losses.
3. Dependent on private equity: While there are a few exceptions, young businesses are dependent upon equity from private sources, rather than public markets. At the earlier stages, the equity is provided almost entirely by the founder (and friends and family). As the promise of future success increases, and with it the need for more capital, venture capitalists become a source of equity capital, in return for a share of the ownership in the firm.
4. Many don’t survive: Most young companies don’t survive the test of commercial success and fail. There are several studies that back up this statement, though they vary in the failure rates that they find. A study of 5196 start-ups in Australia found that the annual failure rate was in excess of 9% and that 64% of the businesses failed in a 10-year period. Knaup and Piazza (2005,2008) used data from the Bureau of Labor Statistics Quarterly Census of Employment and Wages (QCEW) to compute survival statistics across firms. This census contains information on more than 8.9 million U.S. businesses in both the public and private sector. Using a seven-year database from 1998 to 2005, the authors concluded that only 44% of all businesses that were founded in 1998 survived at least 4 years and only 31% made it through all seven years.
5. Multiple claims on equity: The repeated forays made by young companies to raise equity does expose equity investors, who invested earlier in the process, to the possibility that their value can be reduced by deals offered to subsequent equity investors. To protect their interests, equity investors in young companies often demand and get protection against this eventuality in the form of first claims on cash flows from operations and in liquidation and with control or veto rights, allowing them to have a say in the firm’s actions. As a result, different equity claims in a young company can vary on many dimensions that can affect their value.
6. Investments are illiquid: Since equity investments in young firms tend to be privately held and in non-standardized units, they are also much more illiquid than investments in their publicly traded counterparts.
In the new edition of my book titled "The Dark Side of Valuation", I have a chapter dedicated to young companies. I have excerpted the section of the book on young companies in this paper:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1418687
I hope you find it useful.



Macro and Market Timers

I am sure that you have sensed a bias that I bring to the table about market and macro timers but I think I should make it explicit. I believe that there are ways in which you can beat the market in the long term, but very few of those ways involve market timing or calls about the macro economy. I know that there are stories in every market about great market timers, i.e., investors who made exactly the right call at exactly the right time about a market: Japan in 1989, dot-com stocks in 2000, housing in 2007 and financial assets in late 2008. Here is why I remain a skeptic:

a. Small sample
: Unlike stock pickers who have to put out recommendations on hundreds of firms, the nature of market timing and macro calls (about exchange rates or the economy) is such that even the most long-standing forecasters have made only about 15-20 calls in their entire lifetime. As a result, rejecting the null hypothesis that successful calls are due to luck becomes much more difficult. For instance, a stock picker who gets 60 out of 100 calls right, is statistically beating randomness but we cannot reject the hypotheis that a market timer who is right 10 times out of 15 is just lucky.

b. Fuzzy recommendations
: One aspect of market timing and macro forecasting that is frustrating and makes testing difficult is the fact that market timers often do not make specific recommendations. Again, the contrast with a stock picker is stark: when a stock picker tells you a stock is cheap, you can buy the stock and test out the recommendation. Market timers and macro forecasters often make recommendations that are not just difficult to convert into action but also impossible to put to the test.

c. Timing is everything: Anyone who makes a market call and sticks with it for a long period will eventually be right. However, the call itself becomes a bad one for investors who followed it, since they often would have lost far more money in the period where the call was wrong than they made back at the time the call turns out to be right. Thus, calling the dot-com bubble in 1997, the housing crisis in 2004 and the Japanese stock market bubble in 1986 should all be classified as mistakes rather than the right calls.

Historically, there have been far more investors who have been successful, over long periods, picking stocks than timing markets, but the allure of market timing remains strong. Here are three tests that I would suggest you put any market timer or strategy to:

1. Has the market timer been right often enough to reject the hypothesis that his or her success is entirely random?
t statistic for success = Proportion of calls that are right/ (0.5/ Square root of the number of calls)
Thus, a market timer who has been right 15 times out of 25, will have the following t statistic:
t = (15/25)/ (.5/5) = 1.00
Statistically, this does not beat randomness?

2. Is the market timer right at the right time or is he or she a Cassandra?
Market timers who are consistently bullish or bearish are dangerous. There is more of a personal psychological component to their recommendation than an analytical component.

3. Does the market timer provide fuzzy stories or make specific recommendations?
I have more respect for market timers who are categorical about what investors should do - buy or sell short a specific market - than those who tell meandering stories (that may actually read well) but leave investors confused at the end.

Finally, ask the question that needs to be asked of any successful investor or strategy? Why does the investor or strategy succeed? Every successful strategy needs an edge. Since that edge cannot be better information with market timing (whereas it can for individual companies), what is it?



Culprit found for market crisis!!!!

You can now sleep better at night. Jeremy Grantham, market strategist for GMO, an institutional asset management firm, has found the culprit for the market crisis. According to Grantham, the efficient market hypothesis is to blame for the financial crisis. Quoting Mr. Grantham, "The incredibly inaccurate efficient market theory was believed in totality by our financial leaders.... It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight". Clearly Mr. Grantham has a gift for hyperbole but is he speaking the truth? Let's take apart his claims:

1. "Incredibly inaccurate efficient market theory": Perhaps, but my understanding of efficient markets is different from Mr. Grantham. My understanding is that very few investors can beat the market in an efficient market, and there is a catch in almost any strategy that claims to make money easily. I am not sure what part of this statement is inaccurate and I would love to be enlightened. It does take a lot of gumption for someone with Mr. Grantham's track record to talk about inaccuracy, but you are welcome to check out his history:
http://www.cxoadvisory.com/gurus/Grantham/

2. "Believed in totality by our financial leaders": Interesting. I did not know that we had financial leaders, but I guess Mr. Grantham is talking about the academia and investment banks. If it is academia, he is wrong, because almost every problem with market efficiency has been uncovered by academia, and academics (such as Robert Shiller) were among the first to draw attention to the dot-com and housing bubbles. It could not be investment bankers that he is referring to, because almost everything they do is premised on markets being inefficient. After all, what would the point of securitization be, if every one paid a fair price and there were no easy profits? Or of acquisitions, when all target companies trade at the right price?

3. "Lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments": Market efficiency is to blame for all of these? Really? So, let's see.
- The efficient market hypothesis is about 40 years old. There must have been no asset bubbles before then. I wonder how those investors in South Sea stock (London in 1711) and tulip bulbs (Amsterdam in 1637) got their hands on the efficient market hypothesis.
- Lax controls? The financial services sector, the most controlled and regulated sector in the economy, was the one that precipitated this crisis.
- Pernicious incentives? I don't disagree, but how can you blame the efficient market hypothesis for compensation contracts that tied traders' pay to how much profit they made in a yer.
- And wickedly complicated instruments? Sure, but there would be no point to these instruments in an efficient market, since everything would be fairly priced. It was people who believed that markets were inefficient who created these instruments with the intent of exploiting inefficiencies.

I guess I must be a dreamer to even think that efficient markets have a shot in the face of Grantham's well thought out arguments. After all, in an efficient market, active portfolio managers will, on average, under perform the market, returns will decrease with trading activity, equity research analysts will provide little value added to investors and market strategists will be useless appendages at investment houses, making meaningless forecasts about future market movements. Never mind! I think I have made my case.



Behavioral Corporate Finance 1: The Objective in Decision Making:

Every business needs a central objective that drives decision making. In traditional corporate finance, that objective is to maximize the value of the firm. For publicly traded firms, this objective often is modified to maximizing stock prices. In effect, any decision that increases stock prices is viewed as a good decision and any decision that reduces stock prices is a bad one. Implicitly, we are assuming that investors are (for the most part) rational and that markets are efficient, that stock prices reflect the long term value of equity and that bond holders are fully protected from expropriation.

A central theme of behavioral finance is that markets are not efficient and investors often behave in irrational ways. Consequently, stock prices can not only deviate from long term equity value but managers can exploit investor irrationalities for their own purposes. Asking managers to maximize stock prices in this environment can lead to decisions that hurt the long term value of the firm and in some cases put the firm's survival at risk. Behavioral finance theorists therefore argue that decision making should not be tied to stock prices, though they do not seem to have reached a consensus on what should drive business choices instead.

Here is where I come down in this debate. I agree with behavioral finance theorists that managers should not tailor decisions to keep investors (or analysts) happy in the short term. Too many firms have followed this path to destruction, by buying back stock or borrowing money, just because that is the flavor of the moment. Managers should focus on increasing long term value, but I think it is a mistake to ignore the messages that they get from market reactions to their decisions. When stock prices go up or down on the announcement of an action, there is some aspect of that action that is pleasing or troubling to investors. All too often, markets turn out to be right and managers to be wrong in the long term. In fact, managers who are convinced that their decisions will increase firm value are often operating under some of the same behavioral quirks that affect investors - they are over confident and systematically over estimate their abilities.

I think that the objective in decision making in a publicly traded firm should be value maximization with a market feedback loop.

In effect, managers should make decisions that maximize firm value but should use the stock price reaction to both frame those decisions in ways that appeal to investors, and modify the decisions themselves. Here is a simple illustration of how this process will work. Let us assume that you, as managers of a publicly traded firm, believe that the firm are over levered and that issuing new equity and retiring debt is the action you need to take to maximize long term firm value. Your initial announcement is greeted badly by investors, with your stock price going down. At one level, this reflects the fear (some may say irrational) of any action that increases shares outstanding - the dilution bogeyman. At another, it reflects skepticism about managerial claims that the firm is over levered. Here is how you could modify your decision to meet investor concerns/ beliefs. Rather than issue shares, you may raise equity using warrants (which do not seem to evoke the same fear of dilution) and provide more information to investors about why you believe that you are over levered. I know that there is no guarantee that this will work but I think it is worth a try.



Behavioral finance and corporate finance

I wrote my first corporate finance book in the 1990s and Corporate Finance remains my favorite subject to teach, since it forces me to think about how businesses should be run and not just about investing in these businesses. It is a constant reminder that it is great business people who create strong economies and not great investors. As a linear thinker who likes my ducks in a row, my vision of corporate finance has always been built around maximizing the value of a business (rather than stock prices) and how investing, financing and dividend policy should be set by a firm (private or public), with this objective in mind.

Over the last two decades, behavioral finance has become the fastest growing area in finance. Much of the early work was directed at how investors behave: studies indicated that investors suffering from over confidence, and with skewed estimates of their own ability and likelihood of success, tend to drive stock prices away from "rational" levels. In the last decade, behavioral finance has started making inroads into corporate finance, looking at how managers in publicly traded firms behave and finding, to no surprise, that they exhibit the same frailties that we see with the investing public. Over confident managers over estimate cash flows on projects, use too much debt and tend to feel that their stocks are under valued (thus explaining the reluctance to use new stock issues).

I must confess that I have been a skeptic about behavioral finance and there is almost no mention of it in any of my corporate finance books. I have tried to at least partially remedy that defect in the third edition of my Applied Corporate Finance book that will get to the book stores later this year. Why this capitulation and why now? Though it is easy to attribute everything to the market crisis of 2008, this has been building up for a longer period and these are some of my reasons:

a. Some of the initial work in behavioral finance was designed more for shock appeal and clearly aimed at shaking up establishment thinking (which needed shaking up). The early papers in the area took great glee in pointing out the failures of traditional finance but offered little in terms of how to do things better. In recent years, there have been two signs that the area is maturing. The first is that disagreements are popping up between behavioral finance researchers on key issues in behavioral finance. The second is that more of the literature in recent years has started looking beyond the descriptive component to prescriptions. In other words, rather than just tell us that managers fail to ignore sunk costs in decision making, we are seeing more discussion of how best to design systems that may minimize the costs from this tendency.

b. Traditional finance, by ignoring management (and human) proclivities, has given both theorists and practitioners an easy pass. It allows academics (who have never had to run a business) to lecture managers about how "irrational" they are in their decision making, and it allows managers to ignore basic principles on investing and financing, by pointing to the ivory towers that academics live in and the unrealistic assumptions they make to get to their conclusions.

As I tried to incorporate what I know about behavioral finance into my corporate finance big picture, I was struck by the tension between describing things as they are and describing things as they should be. It is true that managers often behave in ways that are inconsistent with traditional basic financial principles and it is also true that we can trace the way managers behave to quirks in human behavior. I understand why managers over invest, borrow too much or too little, are reluctant to issue new equity and buy back too much stock. I also believe that I cannot abandon talking about what managers should be doing and why their actions cost stockholders money. I tried my best to walk that fine line in my new edition and I will talk about my conclusions in pieces in the next few posts.



Losers and Winners: The inevitable consequence of risk taking...

I am still astounded by the incapacity of some in the financial media to see the obvious. As an example, consider this article from the Wall Street Journal today:
http://online.wsj.com/article/SB10001424052970204005504574233831651104814.html
If you cannot read the whole article, you are not missing a whole lot since I can summarize the basic theme as follows. A lot of the funds that were in the bottom 10% of last year's performers are in the top 25% of performers this year. As my 10-year old would say "Duh". Why is this a surprise? A risk taking fund will move back and forth between the best and worst performing funds on a period to period basis, based upon how the market does. A fund that is exposed to a great deal of market risk (high beta funds) will be among the best performers when markets do well and badly when markets do badly.

My problem with this article is that it tries to look for deeper meaning when there is really is none. The only good thing I can say about funds that did well this year is that they did not decide to become conservative at exactly the wrong time, but the ultimate test is whether you make money in the long term. There is little in the history of any of the funds mentioned in this article that fills me with confidence that they know what they are doing and that the returns that they are making in good years will cover what they will lose in the bad years.



Commodity companies and commodity dependent markets

My trip to Peru started me thinking about commodity based companies and markets and how best to value them. It is fairly obvious that the value of a commodity company will be a function of the price of the commodity. As oil prices go up and down, the prices of oil companies will vary. Embedded in this obvious relationship, though, are several interesting valuation issues:

a. What is the best way to forecast future commodity prices?
There are two basic approaches. One is to trust price cycles and look at average prices across time. Implicitly, we assume that commodity price cycles are pre-determined and that they will go through the same up and down cycles that they have historically (perhaps adjusted for inflation). The second is to look at the demand and supply of the commodity: arguing that higher demand from the growing Indian and Chinese economies will push up the price of oil is an example. I think there is some value in both approaches and perhaps a melding of the two will yield the most reasonable forecasts.

b. Should you bring commodity price views into the valuation of commodity companies?
Even if you have a view on commodity prices for the future, should you bring those views into the valuation of commodity companies? Put another way, if you believe that oil prices will double over the next 3 years, should you use those predicted prices in valuing oil companies. In my view, you should not. By bringing in macro views into micro valuations, you create composite estimates of value that reflect not only your views of the company being valued but also of the underlying commodity. (If you believe that oil prices will double over the next 2 years, almost every oil company you value will look cheap) As the user of your valuations, I would prefer that you be commodity price neutral when you value companies and offer your commodity views separately. That way I can decide which aspect of your forecasting - the macro or micro part - I think is of higher quality and worth following. What exactly does being price neutral mean? You do not have to assume that oil or gold prices will remain at today's level forever. You can use forward market rates but you cannot super impose your views on top of these.

c. How do you differentiate between commodity companies that hedge against commodity prices from companies that do not?
Some commodity companies hedge against commodity price volatility, and in the process, under cut investors who buy their shares to make a bet on the commodity. In general, I do not favor this type of hedging, with two caveats. If a commodity company is either highly levered or feels that is competitive advantages are at the operating level (finding the right place to explore for a resource... mining efficiencies), it may want to reduce it risk of default and increase the focus on its competitive advantages by hedging against commodity price risk.


In my latest edition of the Dark Side of Valuation, I have a chapter on valuing commodity and cyclical companies. I have modified the chapter to make it a down-loadable paper. If you are interested, you can get the paper by clicking on this link.
Paper on commodity and cyclical companies

Hope you find it useful!




Peru and Brazil

I just got back from my trip to Peru and Brazil. My first stop was Lima, and I had a blast. The people are friendly and hospitable, the weather is balmy and the food is extraordinary. While I have explored only a small sliver of the country, my impression of the Peruvian market is that it is commodity driven. As the price of copper and silver goes, so goes Peru's stock market. As a result, the market resembles a roller coaster. Peru has been among the best performing markets in recent years, as commodity prices have been on an up cycle. While I am not a pessimist by nature, it is inevitable that commodity prices will come down, and when they do, the market will reflect that fall. I hope that the Peruvian economy (and market) can use the surplus from the commodity boom to jump start other businesses - consumer products, technology or food (why not?).

I am more familiar with Brazil, this being my 15th trip to the country, and am always glad to see Rio (Sao Paulo, less so... the traffic drives me bonkers). I talked about the lessons that I have learned from the crisis for corporate finance and valuation. The presentation I used is available online on my website at:
http://www.stern.nyu.edu/~adamodar/pdfiles/country/crisislessonsUpdated.pdf
Since this will be the genesis of my next book, your comments will be appreciated.



Emerging Markets... and maturity....

Sorry about the long hiatus between posts but I took family time off to go to California. I am three weeks away from a new semester starting but I am on my way to Peru and Brazil over the next few days to talk about valuation. I have never been to Peru before and am looking forward to seeing Lima for the first time. I have been to Brazil once or twice each year since 1998 and I am looking forward to this trip just as much.

While I will never know as much about Brazil as I would like to, I have had the opportunity to watch the market change over the last decade. While each emerging market is different, I think that some of the changes I have observed in Brazil are common across emerging markets, as they mature:

1. From Macro to Micro: When I did my first valuation seminar in Brazil for the first time in 1998, almost every question that I got during the seminar related to macro variables, with little or no attention paid to individual companies. If fact, we spent more time discussing inflation than we did discount rates, cash flows or terminal value. Coming off the hyperinflation of the previous decade, this focus was understandable and reflected the belief that if you were right about the macro variables, company-specific information mattered little. In recent years, attention has shifted more towards company characteristics, including managerial competence and the quality of investing and financing choices , a healthy development, in my view

2. Foreign to Local Currency: In the late 1990s, spilling over into the first half of the decade, almost every valuation I saw of a Brazilian company and much of the capital budgeting was done in US dollars. Not only was there a profound distrust of the local currency (Brazilian Reais) among analysts, but the Brazilian government and large Brazilian corporations seemed to share that distrust by issuing long term debt only in US dollars. Estimating a risk free rate in Brazilian Reais was an impossible exercise. It is only in the last few years that the resistance has broken down, with the Brazilian government issuing long term Reai bonds and valuations in local currencies.

3. Foreign to Domestic Investors: When I did my first few sessions in Brazil, appealing to foreign investors (especially US institutional investors) seemed to be the key priority for corporate treasurers and Brazilian investment banks. One measure of maturity has been the increasing focus on domestic investors in recent years, with foreign investors being viewed as icing on the cake.

Like any emerging market, there have been political and economic shocks along the way, but the sessions that I do in Brazil in a couple of days will resemble closely the sessions I do in New York or Frankfurt. To me, that is a healthy development. The value of an asset is a function of its cash flows, growth and risk and that lesson should not vary across markets. I will let you know how this Latin American jaunt goes...




The dangers of relative valuation

In my last post on Twitter, I hypothesized that the valuation of Twitter was based upon what investors had assigned as a value for Facebook a few months earlier. I want to make clear that I am not suggesting that this is a good way to value businesses but that it is the status quo.

With relative valuation, the dangers of a bad initial valuation cascading into subsequent valuations is high and they get worse when the initial valuation is of a large company (Facebook is large, by the standards of networking sites) and done by what is viewed as a reputable source (private equity investors have an ill deserved reputation for valuation expertise and a big investment banking name helps..) In fact, this may be one reason for pricing bubbles in sectors.

I can carry the relative valuation lessons here to an absurd limit. I have 15,000 + members on the mailing list for my website (damodaran.com). I would argue that this is a fairly valuable potential list for anyone with an investment or valuation product. Applying the $32.5/member to each member (a bargain, given the selection bias), my site should be worth half a million. Any takers? Better still, why not just your add your name to my mailing list and increase my value $32.5 by doing so? (The incentives for sites to seek out new members, even if they are idle and do nothing, is extremely high...)

I am kidding here, since I have no intent of making my site commercial. I have always argued that relative valuation, at least as it is practiced, is a sign of laziness because analysts are not only sloppy but throw out much of the data that they have access to. Relative valuation, done right, where you use not just the averages, but also look at the differences in valuations across companies to draw lessons about how the market values assets, can be a very useful tool in valuation.



What is Twitter worth?

Yesterday's big news story, at least in valuation circles, is that private equity investors have invested $ 100 million in Twitter for a roughly 10% stake, suggesting a billion-dollar valuation for the nascent company.
http://blogs.wsj.com/deals/2009/09/24/breaking-news-twitter-to-raise-100-million-from-insight-t-rowe-price-other-investors/
Twitter, for those who may be living in the middle ages, has about 30 million members who post short messages (less than 140 characters) that other members can read (if they choose to follow your tweeting). Every celebrity (sports, politics, media) seems to be tweeting now. There are three questions that came up after the story:

1. How did the equity investors in Twitter come up with the $ 1 billion value?
We assume degrees of sophistication to private equity investors and venture capitalists that they usually do not possess. In my experience, venture capital valuations often represent back-of the-envelope computations with hefty discount rates (target rates if 30-60%) taking care of the uncertainty. I was not privy to the valuation of Twitter but I can read the tea leaves and guess how they valued the company. A few months ago, Facebook (a company that Twitter aspires to be at least in the new term) raised equity from a group of Russian investors, who attached a value of $ 6.5 billion to the company. At the time. Facebook had approximately 200 million members, which works out to about $32.5/ member. As of last week, Twitter had about 30 million members. Applying the $32.5/member to this estimate, I get $975 million (suspiciously close to $ 1 billion). This may be pure coincidence but given the pull towards relative valuation on the Street, I think it may explain the valuation.

2. Could Twitter be worth $ 1 billion?
"Could" is a very weak word. Of course! What Twitter has going for it is the numbers. With 30 million members, all I need to be able to do is to generate a small cash flow from each one and the valuation will be justified. A billion dollar value for a firm requires that the firm be able to generate about $ 100 million in operating income in steady state. (I am applying a 10% cost of capital, typical of mature firms, and assuming zero growth). With 30 million members, that works out to $3.33/year from each member. If you are a Twitterer, the question I would have for you is this: Would you be willing to pay an annual membership fee of $ 5 or $ 10 to follow your favorite celebrities thoughts? If the answer is yes, the billion dollars is paid for... If not, I will keep looking...

3. Is Twitter worth $ 1 billion?
Interesting question. As an ongoing business, I don't think so and here is why:
a. You don't buy a business that does not have a business model yet. Twitter has a lot of members but it really does not know how to make money of these members (yet). Advertising alone will not do it. Any blatantly obvious way to earn money (such as charging per tweet) will very quickly decimate the membership. So, where will the additional profits come from?
b. You are buying a business that may be a fad, at the peak of its faddishness: Twitter is hot right now, because it is in the news. However, most of the tweets that I read are inane: it is tough to be profound 24 hours a day and to express that profundity (is that even a word?) in 140 characters.

However, I think that you can justify a $ 1 billion value for Twitter at least to some investors and that is to think of it as an option. What you are buying then, when you buy this firm, is access to 30 million potential customers, who may not know each other but are tied to one another. There are at least two types of investors who may find this investment appealing:
a. A firm with deep pockets and products/services that may be appealing to the membership of Twitter. The 30 million members of Twitter tend to be techno-savvy, older than Facebook members (on average) and well off. They also tend ot think well of themselves or at least their opinions. To illustrate, Microsoft did take a position in Facebook a few months ago and I can see other companies with products (especially in entertainment) do the same with Twitter.
b. Risk money: While no investor in his right mind should be investing the bulk of his portfolio in Twitter, it may be a good investment for risk money, i.e., money you want to invest in high risk, high reward investments and are willing to lose. Spreading your bets across multiple investments like Twitter may create a portfolio that has a good risk/return trade off, especially if you can bring some selection acumen to the process.

P.S: Facing the scorn of my teenage daughter, I created an account on Twitter about 6 months ago. I have never tweeted but I have 228 followers. Scary!!!!



Buybacks and Stock Prices..

Floyd Norris has an article in the New York Times on stock buybacks:
http://www.nytimes.com/2009/09/19/business/19charts.html?scp=1&sq=buybacks&st=Search
He notes that buybacks are high when stock prices are high and that they fall off when stock prices are low. His conclusion is that this is irrational because companies should be buying back more stock when the price is low and less when the stock is high. While there is a point to his argument, there are two points he is missing:

1. Buybacks are more about returning cash to stockholders and changing financial leverage than making judgments about stock price: There are two very good reasons, other than the perception that the stock is cheap, for buybacks. The first is that it is an alternative mechanism for returning cash to stockholders, instead of dividends. In addition to providing some tax advantages to investors over dividends, it also allows firms to be more flexible in returning cash over time. (Increasing dividends can be viewed as a long term commitment, whereas buybacks are not.) The second is that it can allow firms that are under levered, i.e., have too little debt in their capitalization, to increase their debt ratio. Buying back stock reduces the market value of equity and increases the debt ratio; if the buyback is funded with debt, the impact is doubled. Thus, one way to explain why companies bought back stock over 2006 and 2007 is that they felt cash rich and a combination of high equity prices and low bond default spreads led them to believe that they were under levered. The crisis may have led them to rethink both assumptions.

2. Even if it is about the price, is not the price per se that matters but the price relative to value: Even if we accept the premise that buybacks are driven by a desire to take advantage of under valued stock, that decision will be driven not by what the price is but what it is relative to perceived value. In other words, a company may buy back stock, when the price is $ 40, if it perceives the value to be $ 50. It will choose not to buy back the same stock, six months later, at $ 20, if the perceived value is only $ 10. The problem with correlating buybacks with stock prices, which is what Norris does, is that it misses the key component of value.

I do think that some US companies, especially in the financial sector, bought back too much in stock in the two years prior to the crisis. I attribute this to the "me too-ism" that is all too prevalent in corporate finance, where firms do, not what's best for them (and their stockholders), but what other firms are doing. Thus, many firms bought back stock because others were doing so, and in a sense, the trend fed on itself.



A Risk Argument: Democracies versus Dictatorships

A few days ago, Tom Friedman, the columnist for the New York Times, and best-selling author of books on globalization, evoked controversy when he opined that "one party autocracy" is not too bad if it is led by a "reasonably enlightened group of people, as China today". To be honest, I have never found Friedman's work to be particularly thought provoking, nor do I much care for his characterizations of globalization: flat earth, fat earth, round earth, whatever.... . However, his article did start me thinking about whether businesses face less risk or more risk in a democracy than in a dictatorship.

As a generalization, there is more day-to-day uncertainty when dealing with a democracy than with a dicatorship. A democratically elected government can offer policies that are favorable to business, but may either not be able to deliver them legislatively or have to modify them to meet public consent. A dictatorship operates under no such constraints and can deliver on its promises, albeit at substantial cost to some segments of its population. Furthemore, the nature of democracy is that governments change and policies change with them. The flip side is that dictatorships do not last forever, and a benign dictator today can become malignant one in the future. Policies can then be turned on their head and today's favored businesses may fall out of favor tomorrow.

The choice between democracies and dictatorships, in my view, boils down to whether you prefer to deal with the continuous, ongoing risk of operating in a democracy or the discontinuous risk of operating in a dictatorship. The former will manifest itself in a chaotic environment of changing rules, fiscal and monetary policies and exchange rate regimes. The latter may show up in periodic upheavals in policy, nationalizations (real or quasi) and a requirement that you pay due respects (or more) to policy makers.

I have argued in my book on strategic risk taking that it is far easier to deal with continuous risk than discontinuous risk for two reasons.

1. The first is that market traded instruments work better at dealing with continuous risk, whereas insurance, often imperfect, is the tool you need for discontinuous risk. To illustrate, compare floating exchange rates to fixed exchange rates. The former create more day-to-day uncertainty for businesses but is eminently hedgeable using options or futures contracts. The latter allows for long periods of stability, interspersed with sudden revaluations and devaluations of currencies, much more difficult to hedge.

2. Managers of firms in the (artificially) stable environments created by dictatorships are lulled into a false sense of complacency and are completely unprepared for the risks that inevitably follow. Managers of firms in chaotic environments learn to cope with change, one reason why I think these companies may have a competitive edge in the more uncertain global economies of the future.

Friedman's arguments are not new. Mussolini's supporters initially thought of him as benign and argued that he made the trains run on time, an incredible accomplishment in Italy. In later years, they discovered his dark side. I do not trust any group of people, no matter how well trained and intentioned, to make decisions for me for the rest of eternity. So, I come down on the side of democracy, chaotic and frustrating though it may be, because I can manage its risks better (both as an individual and a business) than I can in a dictatorship. We will have a ring side view of this tussle, and the strengths and weaknesses of both systems, as we watch the Indian and Chinese economies struggle for dominance over the next few decades.



One year later: The lessons from the crisis

It is hard to believe that it has been a year since the crisis started - September 15,2008, to be precise. The papers are full of retrospectives, with opinions often overwhelming the facts. I am working on my book on what I learned from the crisis in terms of how I approached valuation and corporate finance. I will post the presentation that I am putting together sometime in the next week.

While most of the articles in the media this week either rehash old stories or focus on human interest (such as looking at where Lehman's employees are today), there are two that I found particularly thought provoking.

1. The first was an article by Joe Nocera in the New York Times asking a question that I think is important. Did Lehman have to fail so that the rest of Wall Street could be saved?
http://www.nytimes.com/2009/09/12/business/12nocera.html?_r=1&pagewanted=1&_r

His basic thesis is an interesting one. Rather than view Paulson's decision to let Lehman fail, as a catastrophic mistake (the conventional wisdom for many months after the crash), he believes that Lehman's failure and the subsequent panic allowed the government to take actions that it could never have justified before to save AIG. The failure of AIG with its tentacles in every aspect of business would have been far more disastrous than Lehman, according to Nocera.

There is some truth to his argument. The failure of Lehman was not the problem but a symptom of the problem - hopelessly over inflated securities on the books of investment banks and terrible choices on risk. Saving Lehman would not have only have not solved that problem and may in fact have made it worse, by signaling to other banks that they too would be protected. However, I believe that the real mistake was saving Bear Stearns a few months prior. If Bear had been allowed to fail, Lehman may not have had to collapse, but I do understand that I have the benefit of hindsight.

2. The second set of articles that I think are interesting look at how Wall Street has changed (or not changed) as a result of the crisis. The consensus view here seems to be that Wall Street has returned to its old ways, securitizing everything under the sun and paying outlandish bonuses to employees. That does not surprise me. I have discovered that Wall Street is incapable of introspection and has almost no historical memory, for two reasons. The first is a self selection bias: people who choose to be investment bankers and traders prefer to act, rather than analyze, and look forward, not back: that is their strength and their weakness. The second is that success on Wall Street is measured with output - deals made, trading profits generated - rather than input - the quality of the deal making, whether the trading profits came from a sensible, well thought out system.

After every crisis, you hear the cry, "Never again"!! My response is "It is only a matter of time!".



Access to webcasts...

I have been web casting my classes for a few years now and it has always been a struggle maintaining open access. New York University would prefer to have the web casts be behind a password and I would prefer that they be open access. I think I have the upper hand, at least for the moment.

I do know that access to the web casts has been curtailed over the last few days. However, this is more the result of IT system upgrades than a deliberate attempt by NYU to restrict access. The problem should be fixed by next week and access should resume. I am sorry!



Insider Trading: My Perspective..

The recent arrest of Raj Rajaratnam, the founder of Galleon Group , a hedge fund, on charges of insider trading has generated responses from across the spectrum. At the one end, it is evoking the usual breast beating about insider trading and how unfair it is to the rest of us "non-inside" investors.
http://www.businessinsider.com/henry-blodget-moral-of-galleon-insider-trading-bust-only-fools-try-to-beat-the-street-2009-10
At the other, there are some who are pointing out that this case illustrates how ineffective insider trading laws are and that they should perhaps be abandoned.
http://online.wsj.com/article/SB10001424052748704224004574489324091790350.html
It is clearly a good time to offer my perspective on insider trading:

1. What is insider trading?
In it's most general form, insider trading refers to some investors trading on "proprietary information" that is not available to the rest of the market. The legal definition of insider trading, though, is a little more difficult to nail down. In the United States, insiders (managers of companies, directors etc.) are allowed to trade, as long at they meet two requirements:
a. They do not trade ahead of information events - acquisitions and earnings announcements, for instance - where they have access to the information prior to the rest of the world.
b. They report their trades to the SEC in filings.

Put another way, it is not illegal for a CEO or directors in a company to buy stock in the company, if they feel that it is under valued on a long term basis, even if that feeling is based upon information that only they have access to (project details). It is illegal for them to buy stock just before an acquisition or a big positive earnings surprise.

Looking at the allegations about Galleon, it seems clear that if the stories are true, the firm clearly broke insider trading laws by trying to get access to information about acquisitions, earnings announcements and other forbidden event-based information.

2. Does insider trading pay off?
Interesting question! At first sight, the answer seems to be obvious. Insiders know far more about the company than we do and should be able to leverage the information advantage into excess returns. The evidence, though, is surprisingly inconclusive. Studies that have looked at insider buying and selling as predictors of future stock prices find only a weak correlation, i,e., insider buying (selling) is not that good a predictor of stock price increases (decreases) in future periods.

One caveat about these studies is that they focus on the insider filings with the SEC. To the extent that the real insiders, i.e., the ones who are trading on real information rather than perception of value, will never register with the SEC, the suspicion is that these insiders make huge profits on their information.

Since Galleon is in the news, I decided to take a look at the returns that Galleon has made in recent years to see if they were able to convert their "illegal inside" information to higher returns. The Galleon Diversified fund, the flagship for the hedge fund, was up 22% this year, but is down 18% since its peak. Given the market performance over the period, the fund ranks close to the average. Across time, it is possible that Galleon made money using its access to "tips" from its moles in companies, but that does not seem to have generated a huge return.

I do not find it surprising. When you rely on tips from "insiders" for your investments, you generally find that four out of five tips never pan out (either because the information is bad or because the market reaction to the information does not follow the script), even when they come from those supposedly in the know. Insider trading is not a sure bet; it may not even be a good bet.

3. What should we do about insider trading?
I would like to live in a world where all investors have the same access to information and but I would also like to be able to go one-on-one against Lebron James. Life is not fair and investor access to information will vary across investors.

To me, the line between insider trading and savvy investing is a very hazy one, especially if you a short term investor. Analysts and investors often step across the line without even realizing they have.
http://www.nytimes.com/2009/10/20/business/20insider.html

I also think that banning insider trading is akin to laws forbidding alcohol or drugs. It does not make the problem go away but instead drives it underground and essentially leaves the profits from insider trading to those who are most unscrupulous among us.

I would suggest that we eliminate or at least reduce insider trading laws & restrictions and increase the transparency of the trading process. If you are trading on inside information but people can see you trading (and whether you are buying or selling), the benefits you will get will be time limited. Not only will this reduce profits from insider trading but also speed up how quickly prices adjust to information.

As a final note, insider trading cases provide excuses for the rest of us, who fail in our investing objectives. I have heard many small investors complain: "The reason I am not making any money on my portfolio is because the game is fixed." Enough of the self pity. The reality is that if your portfolio has lost money, insider trading is way down the list in terms of factors that caused those losses. In fact, my advice to those who worry about insider trading is simple. Trade as infrequently as you can and base your decisions on intrinsic value. Insiders hurt you only when you play their game, which is to try to trade short term on news (or what you think is news...) and rumors...



Equity Risk Premiums: An Update

As many of you are probably aware, I am fixated on equity risk premiums. To me they are at the center of almost every debate about equity markets - whether stocks are too low or too high, whether current market conditions are the norm or an aberration, and whether equity investors truly understand the risk associated with investing in equities.

I had a few posts during the crisis, where I noted that the implied equity risk premium for the S&P 500 had climbed at a rate never seen before in history during the twelve weeks between September 12, 2008 and late November. In fact, I reported an implied equity risk premium of 6.43% at the start of 2009, up from 4.37% at the start of 2008. The big debate at that point was whether this crisis had damaged investor psyches so much that it had caused a permanent upward shift in risk premiums, or whether this was just another bump in the road and that we would revert back to the 4% implied equity risk premiums, pre-crisis.

I have just posted an updated version of my equity risk premium paper online:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1492717
In the paper, I graph out the implied equity risk premium from January 2009 to September 30, 2009. On September 30, 2009, the implied equity risk premium stood at 4.86%. While I had anticipated at the start of the year that the premium would drift back down, I expected it to take much longer than 9 months. One more reason for constantly updating equity risk premiums! Markets are full of surprises.

The new debate that is unfolding is whether markets have gone up too far and too fast, thus exposing themselves to a correction. I don't know the answer to that question but it can be framed around the implied equity risk premium. If you think that the crisis should have changed people's attitudes about risk and that a 6% equity risk premium is the new steady state, markets are over bought and the correction will be painful (a 15%-20% drop in the S&P 500). On the other hand, if your view is that what happened last year is just part and parcel of equity risk and that investors will soon forget the scars and go back to the 4% risk premiums of 2007 and 2008, the bull market has a lot of steam left on it (a 10% up movement in the S&P 500). I am not giving away too much when I say that the long term equity risk premium that I am using for mature markets, when valuing companies, has been 5-6% since January 2009. At its current level of 4.86%, I am within reaching distance, but I will respond to the market on this number. I am not a market timer!



Bond Ratings: Why, how and what next?

In the aftermath of the bond market calamities (for investors and issuing companies), the ratings agencies (S&P, Moody's and Fitch) have come under assault from all sides. Legislators and regulators have accused them of being too close to the companies that they rate, with the implication that companies/bonds are being over rated. Academics have piled on, arguing that there is little information in bond ratings and that ratings agencies offer poor and delayed assessments of default risk. Finally, a few former employees have come forward with claims that bond ratings, at least in some cases, are stale and not backed up by serious research.
http://www.nytimes.com/2009/10/11/business/economy/11gret.html

I would like to at least step back and consider some broad issues related to ratings:

1. Why do we need bond ratings in the first place?
As long as there have been people on the face of this earth, there have been lenders and borrowers. For much of recorded time, a lender (money lenders in ancient times, banks in more recent periods) assessed the credit quality of a borrower and set the interest rate accordingly. It was the advent of the bond market in the last century that changed the dynamics and created the need for ratings agencies. When a company issues bonds and investors price these bonds, these investors do not have the resources to assess credit risk on their own. Ratings agencies stepped into the gap and provide this credit risk assessment. Thus, the ultimate service provided by bond ratings is to bond traders, and bond issuers benefit only indirectly.

2. What is the information content in a bond rating?
Ratings agencies have access to all of the financial information that the rest of us do - financial statements, past and present, analyst reports, industry analysis etc. In addition, they can ask for private information specifically related to default risk, which can then be used to finesse or modify the rating. The problem with the private information is that it comes from the management of the firm, which of course has an interest in providing more good news than bad news.

The simplest way to measure whether the market thinks there is information in a bond rating is to look at whether market prices of bonds change when their ratings are changed. The evidence there is mixed. While there is a consistent price change, with bond prices increasing (decreasing) on bond upgrades (downgrades), most of the price change seems to happen before the rating is changed. In other words, markets seem to anticipate ratings changes. That does not make ratings less useful but they are often lagged measures of default risk.

3. Is there a potential for conflict of interest and bias in ratings?
Going back to the origins of ratings, it is clear that bond buyers should be the ones paying for the ratings and they do so now, albeit indirectly. Ratings agencies are compensated by the companies that are rated, which does create a conflict of interest, though the conflict is nowhere near as intense as some other conflicts that bedevil us (such as auditors who have consulting revenue from the companies they audit or investment banks operating as deal makers & advisors on M&A deals). The price paid by companies is a relatively small one (3-5 basis points of the size of the issue) and it is not as if companies that are down graded can pull up stakes and refuse to be rated. (Let's face it. There are more ratings downgrades in a quarter than equity research analyst sell recommendations in a decade.) The price paid by companies is then passed on to bond buyers as a slightly higher interest rate on the bond.

There is a bigger potential for conflict of interest with mortgage backed securities and other bonds that are issued against pools of assets, not by companies by often by intermediaries. There, Moody's and S&P do have an interest in growing the market and attaching higher ratings does increase market growth, which increases future revenues and so on...

There is much talk now of changing this model but the alternatives are not that attractive. One is to charge a small tax on every bond sold, collect the proceeds in an entity (probably government run) which will then pay the costs to have all bonds rated. The question then becomes choosing the ratings agency (ies) to do the rating and the pricing mechanism (fixed price, auction). The other is to increase competition among ratings agencies, with the argument that competition will make them worry about getting rating right, though this would exacerbate the conflict of interest, at least in the short term.

4. What should we do going forward?
Before we pile on ratings agencies and blame them for our bond losses, we have to recognize that they were not the only ones to under estimate default risk. Most banks in developed markets made the same mistake, as is clear by the losses being written off on loan portfolios. Thus, I would not blame the ratings mistakes primarily on conflicts of interest or poorly trained ratings staff or some conspiracy the0ry too dastardly to behold. Rather, I think ratings agencies were caught up in the mood of the moment, just as the rest of world was, where housing prices always went up, people had permanently stopped defaulting and recessions were a thing of the past.

In closing, my fear is that we will throw the baby out with the bath water and make radical changes in the ratings process. Having valued companies in markets with bond ratings and in markets without, I can tell you with absolute conviction that I would rather deal with lagged and flawed bond ratings than no bond ratings at all.



Crisis Lessons: Presentation...

A few posts ago, I mentioned that I was working on a presentation reflecting the lessons that I learned from the crisis. I had also promised to post the presentation when it was ready. You can get it be clicking on the link below:

Market Revelations: Lessons learned, unlearned and relearned from the Crisis

While you can read about the specific lessons that I have taken away from the last year in the presentation, here are the general points I want to make:

1. These are the lessons that I have learned. In other words, this is my personal odyssey and I do not expect everyone to have learned these lessons, nor do I feel the urge to impose them on others.

2. The common theme across the many lessons is that I am much more wary about using past or historical data, whether it be at the company level (profitability, risk etc.) or at the macro level (equity risk premiums). Mean reversion, i.e., the assumption that numbers revert back to historical averages, has served us well, at least in developed markets for a long time, but a blind adherence to it can decimate companies and portfolios.

3. At a gut level, I feel that I have a better understanding of risk and the need for risk premiums now than before the crisis. Fundamentally, I believe that this crisis was precipitated by a belief that we can measure and control risk, when the nature of risk is that it cannot be ever fully measured or controlled.

4. I would not classify myself as a behavioral economist, but I am more willing to give behavioral finance a place at the table when we think about solutions to corporate finance and investment problems, after the crisis, than before.

The bottom line is that I feel humbled by all the things I do not know about finance and markets and excited at the prospect of exploring these things more.



Leveraged Buyouts

Yesterday's New York Times had a story (a sad one) on the troubles at Simmons, a mattress company with a long and illustrious history in the United States.
http://www.nytimes.com/2009/10/05/business/economy/05simmons.html
In short, the company was targeted for a leveraged buyout by Thomas H. Lee Partners, a private equity firm, in a transaction that went awry, partly because of miscalculations by the investors and partly because of the market crisis. The article is clear about who the "bad guys" in this story are and it is the private equity investors, who profited while a good company and its employees were destroyed.

I am always suspicious when the financial press sees things in black and white, since my experience is that life is full of shades of grey, but this article gives me a chance to vent about leveraged buyouts. If the message here is that private equity investors act in their self interest, my reaction is "Duh! Who does not?". If the message is that debt is the enemy, I am afraid the culprit is not Thomas H. Lee, but the tax code, which is tilted towards debt for some reason that I cannot fathom in pretty much every market in the world.

My problem with the way leveraged buyouts have been framed by both its proponents and opponents is the focus on leverage as the center of the transaction. To me, there are three components to a leveraged buyout:
a. The change in financial leverage: Changing the mix of debt and equity can help you exploit the tax code and increase your overall value (at the expense of taxpayers).
b. Control: In badly managed firms, changing the operating characteristics, i.e. investment and dividend policy, of the firm can increase value,
c. Public to private: To the extent that being a publicly traded firm forces you to make decisions to satisfy stockholders and analysts focused on the short term (at least in theory), going private may allow firms to make hard decisions that increase their value.
A good candidate for a leveraged buyout will derive value from all three levers. It will be an under levered, poorly managed firm, where there is a substantial gap between managers and stockholders.

In a blog post from November, I pointed to an extended treatise on the topic, where I look at an LBO transaction that failed, where Goldman and KKR tried to take Harman Audio private, and failed. My conclusion was that Harman was the wrong company to target for an LBO, because it did not have significant excess debt capacity, was already fairly well managed and a big stockholder was the CEO of the company.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162862
What does this have to do with Simmons? I think that we are making a mistake when we assume that private equity investors are brilliant villains in LBO transactions. For every winner (like Thomas H. Lee in this specific transaction), there are many losers, and I would not be surprised if private equity investors are not net winners in this process.



The CRU Scandals: A Reflection on Academia

I am sure that you have been tracking the story of the hacked emails between top climatologists and the ensuing debate about whether those atop the discipline have stifled skeptics in the global warming debate. If you have not, here is a quick review:
http://www.washingtonpost.com/wp-dyn/content/article/2009/11/21/AR2009112102186.html?nav=hcmodule
I do not intend to wade into that debate but the entire controversy has held up a mirror to academic research in general and I don't think the reflected image is flattering.

Let us start with the ideal. Seekers of truth (Scientists, professors, Phd students... the academic research community) come up with interesting and provocative questions to answer, look at these questions objectively (and with no financial interests at stake) and with no preconceptions, develop theories and test them rigorously and then report these results without skewing them. Their research is reviewed by their peers, who bring the same objectivity and fairness to their assessments, and decide whether the research should be published.

As with most ideals, this one is utopian. Here is my more cynical view of how the process works.
1. Research what will be published, not what is interesting: When you first start climbing the academic ladder, the name of the game is to get published. Would you rather publish a ground breaking paper than an incremental one? Of course. But would you rather publish an incremental paper than have a ground breaking paper that does not get published? The answer again is affirmative. It is far easier to publish a paper than nibbles at the edges of big questions than one that asks and tries to answer big questions. If you pick up any academic journal and browse through the contents, you will see the evidence of this marginalization.

2, Bias in, bias out: Researchers are human and come in with biases and preconceptions, some of which are formed early in life, some during their academic experiences and some of which they acquire from their mentors and peers. Those biases then drive not only the topics that they choose to research but also how they set up the research agenda and in some cases how they look at the data.

3. Who you are matters: Where you went to school to get your doctorate, who your mentor is and what school you teach at right now all affect your chances of getting published. If you went to an elite school (and the elite can vary from discipline to discipline), worked with the right mentor (preferably a journal editor) and teach at another elite school, your chances of publication increase significantly.

4. Every discipline has an "establishment" view: There is an establishment view in every discipline. Papers that hew to this view have a much easier path to publication than papers that challenge the view. In finance, the establishment view for decades was that markets were efficient and that any evidence of inefficiency was more a problem with the models we had than with the underlying efficient market hypothesis. It has taken almost two decades for behavioral economists to breach this wall. Now, I sense that they are becoming part of the establishment and don't quite know what to do.

5. Peer review is wildly variable and sometimes biased: When you write a paper in a particular area, it will be sent out to other "experts" in the area for review. Some of them are scrupulously fair, read your paper in detail and provide you with extraordinary feedback that improves your paper. Others are defensive, especially if the paper challenges one of their pet theories, and find reasons to reject the paper. Still others are extremely casual about feedback and make suggestions that border on the absurd. While peer review, on average, improves papers, it does so at considerable cost.

6. Data abuse happens: As the volume of and access to data improves, it has become far easier to abuse the data by (a) selecting the slices of data that best fit your story (b) expanding sample sizes to the point that the sheer amount of data overwhelms the opposition and (c) reporting only a subset of the results that you get with the data.

I think peer review is useful and empirical testing is crucial. However, my advice to laymen looking at academic research is the following.
1. Don't assume that academics don't have an agenda and don't play politics. They do.
2. Don't let "research findings" sway you too much - for every conclusive result in one direction, there is almost always just as conclusive a result in the opposite one.
3. Just because something has been published does not make it the truth. Conversely, the failure to publish does not mean that a paper is unworthy.
4, Develop your own vision of the world before you start reading papers in an area. Take what you find to be interesting and provocative and abandon the fluff (and there is plenty in the typical published paper).
5. Learn statistics. It is amazing how much of what you see reported as the truth fails the "standard error" test.

One final note on the CRU email story. For the most part the faults of academic research create no significant damage because so much of the research is inconsequential. The scandal of the data manipulation and stonewalling of critics in this case is that it is so consequential, no matter what you think about global warming. If there is no global warming and the data has been manipulated to show that there is warming, the academics at the heart of this affair should be forced to answer to the coal miners, SUV assembly workers and others who lost their jobs because of warming-related environmental legislation. If there is global warming and the numbers were being cooked to make the case stronger, there is the real possibility that people will turn skeptical about warming about revert back to old habits. In either case, it behooves those involved in this mess to step down.



A tax on financial transactions: Good or Bad Idea?

In recent days, we have heard talk from Congress about imposing a tax on financial transactions. While there has been heated debate on the topic, there seems be more smoke than substance in most of the arguments. This morning, Paul Krugman, who seems to have made a speedy and seamless transition from economist to polemicist, has an article on why such a tax is a good idea:
http://www.nytimes.com/2009/11/27/opinion/27krugman.html?ref=opinion
As always, Krugman sees the villains here (the speculators, who else?), decides that this tax will not have much effect on the good guys (a group of long term investors, into which he puts himself and his readers) and sees potential benefits to markets from the action.

Very convenient, but not very balanced!!! I would like to provide a counter, by first examining the motives for a transactions tax and then considering the laws of unintended consequences.

Motives
As I see it, there are three motives for a transactions tax.
1. Revenue generation: As government budgets get squeezed and deficits mount, legislators are flailing around for ways to raise revenues in fragile economies. Given the sheer volume of trading volume in financial markets, even a small tax seems likely to raise huge revenues. (In a classic example of how governments compute potential revenues from taxes, the estimated tax receipts are computed by taking the existing dollar value of trades in a market and multiplying by the tax rate.... If only we lived in a static world...)

2. Punish bad behavior: As a bonus, the tax will fall most heavily on those who trade short term or in derivatives markets. If we assume, as Krugman has, that these trades are for the most part speculative, the tax punishes that "bad" behavior. (It is the same rationale that allows governments to raise taxes on tobacco and alcohol...)

3. Target the "right" entities: The perception on the part of many is that the biggest traders in derivatives markets are investment banks and hedge funds. The billions of dollars that these entities are reporting in profits, in conjunction with their absence of suitable remorse for their role in creating the banking crisis of last year, has made them easy targets. (I am quite surprised that legislators have not proposed a windfall profits tax on just the bad guys, at least as they see them... they would probably call it the Goldman tax!!)

So, what can go wrong?
1. Motives are internally inconsistent: There seems to me to be a direct contradiction between motives 1 and 2. Put another way, the only way in which this transactions cost will raise revenues is if the bad behavior in question (short term trading) continues in the future. I think legislators need to specify what their primary objective and not try to argue out of both sides of their mouths. (I know little or no chance of this happening, but no harm hoping..)

2. Speculation versus Investing: As I have argued before, I am very uncomfortable drawing the line between speculation and investing. While I might not see much benefit to short term trading, I can see how others might. To label myself as the investor and the others as speculators is self serving and wrong. Furthermore, the notion that derivatives trading is driven primarily by speculation is fantasy. I can see plenty of reasons why a long-term, value investor may use derivatives to protect and augment his returns.

3. Liquidity costs: Even if we accept the premise that short term investors create noise and pricing bubbles, long term investors benefit from the liquidity they bring to the system. In fact, the markets where long term investing is most difficult are markets where there no short term investors. (Consider the market for fine art or even real estate.... Transactions costs inflate for everyone and insiders end up dominating the market)

4. Market mobility: As trading moves of exchange floors into ether space, it is difficult to visualize how a transactions tax will work, unless it is globally coordinated. All you need is one rogue player for the system to start coming apart at the seams. Krugman argues that the clearing systems for many of these markets are centralized and that the tax can be therefore collected at these locations. While this may work in the short term, how long will it take for an offshore location (say the Cayman Islands) to set up a competitive system? (It will cost money but the potential benefits from the system will be huge.) Once that happens, any chance of regulating these markets, even in sensible ways, becomes remote.

All in all, I think this is a dumb idea that should be throttled early in the process. I am sure that you will hear variants of the concept, and they will all share a common feature. They will try to focus the tax on what they view as the markets or securities that they view as most speculative and argue that only the entities in these markets will be affected by the tax. I don't think so. Ultimately, we will all bear the cost.



Macro Bets: A general framework..

As many of you are aware, I am not a great believer in macro bets but I recognis4 that there are investors out there who not only like to make big bets on interest rates, currencies or commodities, but also make tons of money in the process. In fact, the subject of my last post, John Paulson, made a macro bet on housing and it paid off big time for him. Consequently, I thought it would make sense for me to put down my thoughts on macro bets.

Should you make macro bets?
The old rule in investing applies. If you are going to make macro bets, you need to bring something unique to the table - a competitive advantage that sets you apart from the hordes of other investors. Here are some potential advantages that you may be able to build on:

a. Time: If you have a much longer time horizon than the rest of the market (remember that this requires that you have patience and that you can live with the loss of liquidity), you may be able to bet on macro mis-pricing that is expected to persist for the short term but not the long term.

b. Trading: The second skill set you can exploit is your capacity to trade on a macro bet that others may not possess. This will generally require that you either create your own securities (synthetic calls and puts, forwards) to make money on the macro bet or that you creatively exploit securities that already exist out there (as Paulson did with the CDS market)

c. Information: As with individual stocks, there are two ways in which you can exploit information. The first is short term, where you can get ahead of macro information announcements and game them for gain. Thus, you you can try to forecast how the next Federal Open Market Committee is going to vote (I cannot think of a way legally that you could get access to this information...but you never know). The second is long term. As an example, you may be able to collect information on copper production at individual mines globally and make judgments on copper supply (and prices) in future periods.

d. Behavioral: There is evidence that investors behave in quirky (notice that I did not say irrational) ways when making investing choices. You can try to take advantage of these behavioral quirks as long as you are immune from them and believe that they will be reversed in the future. Thus, the "herd behavior" of investors can cause short term momentum in currency markets before the same behavior creates a "big correction". To take advantage of this, though, you have to be less affected by the herd than the average investor (As a kid, did you fight peer pressure or did you bend to it?) and you have to be able to gauge when the herd will turn...

What is the best way to make a macro bet?
If you are going to make a macro bet, keep it simple and make it a focused bet. If you believe that gold prices will keep going up, the best investing strategy is to buy gold futures or options.

All too often, we hear of investors finding convoluted ways of making macro bets. Buying a gold mining company, say Barrick Resources, because you believe that gold prices will go up exposes you to all kinds of other risk. The stock price of a gold mining company reflects multiple other factors: its success at finding new gold reserves, whether it hedges against gold prices or not and whether its gold reserves are in an unstable country.

It is true that in some cases, a macro bet can be combined with a micro bet. Thus, if you like Petrobras as a company (because you like its management and investment strategy), you could buy Petrobras and also make bullish bets on Brazil and oil. You should be clear, though, as to which factor is front and center in your investment decision, i.e., Are you buying Petrobras because you like the company? Like Brazil? Think oil prices are going to go up?

What are the risks of macro bets?
The risk with macro bets as with any investment strategy is that your underlying premise may be wrong and/or that the rest of the market does not buy into it. My skepticism about macro bets is based upon the difficulty I see in establishing a competitive advantage. When there are literally millions of other playing the same game and "private" information is difficult to obtain (without breaking the law), the game is a much more difficult one to win. Obviously, it is not impossible, as John Paulson and others have shown over time, but the odds remain against you.



The secrets behind John Paulson's success...

The banking and credit crisis of 2008 had few heroes and lots of investing legends who were humbled. Very few of these so called experts saw the crisis coming, and even those who did were unable to act on that belief.

One exception is John Paulson, a hedge fund manager/investor based in New York. He saw a bubble in the housing market in 2006 and created a hedge fund to bet on the bubble bursting; what made his bet unique was that his use of the Credit Default Swap (CDS) market to bet that sub-prime securities would collapse and he was right. Greg Zuckerman, a reporter at the Wall Street Journal, has a short article reviewing Paulson's strategy in the link below.
http://online.wsj.com/article/SB125823321386948789.html?mod=googlenews_wsj

Greg, whose writing I enjoy reading, is probably the world's leading authority on Paulson (other than Paulson himself), since he has spent the last year researching the man and has written a book on his investing acumen. You can get the book, titled "The Greatest Trade Ever" at your local bestseller:
http://www.amazon.com/Greatest-Trade-Behind-Scenes-ebook/dp/B002UBRFFU/ref=sr_1_1?ie=UTF8&s=books&qid=1258333719&sr=8-1

In his Wall Street Journal article, Greg has a collection of lessons that the average investor can learn from Paulson. While I agree with most of them, I do disagree with one point that he makes, i.e., that the bond market is a better predictor of problems than the stock market. The bond market is a better predictor of credit risk and default problems than the equity market, simply because it is far more focused on that risk. Equity investors juggle a lot more balls in the air- growth, risk and cash flows - and they can get distracted, especially about default risk. History suggests, however, that equities have led bonds in predicting economic growth and profitability.

Here is where I agree with Greg. I think equity investors will gain by paying attention to bond markets, just as bond investors will gain by being aware of developments in equity markets. We have compartmentalized investing to the point that investors are often unaware of when these markets become disconnected, which are the danger signals that one market has become mispriced. In the context of valuation, here is where I think this recognition is most useful.

1. Risk Premiums: In my paper on equity risk premiums, I have a section where I compare implied equity risk premiums and default spreads on bonds and not the correlation between the two over time. The periods when they have moved in opposite directions, such as 1996-99 (when equity premiums dropped and default spreads rose) and 2004-2007 (when default spreads dropped while equity risk premiums remained stagnant) were precursors to major market corrections - the dot com bubble in the equity market in 2000 and the sub-prime bubble in the bond market in 2007-08.
2. Distressed companies: When valuing equity in distressed companies, the threat of default constants overhangs the entire valuation. I believe that we can derive valuable information from the corporate bond market that can help up refine and modify the valuation of distressed companies. I describe this process in this paper.

If Paulson's lessons are heeded, we should see more joint work between equity research analysts and bond analysts and a greater willingness to look across markets for investing clues. I am not holding my breath!!!

P.S: For those of you who are conspiracy theorists, John Paulson is not related to former treasury secretary and Goldman CEO, Hank Paulso.

P.S2: A disclosure is in order. John Paulson just gave $ 20 million to the Stern School of Business at NYU, where I teach. Since did not partake in this gift, I think I can still be objective about his investing strategies.



The Agency for Financial Stability? Good idea?

In today's big news for bankers, Senator Chris Dodd has announced his intent to create an Agency for Financial Stability, which will be responsible for "identifying and removing systemic risks in the economy".
http://online.wsj.com/article/SB125786789140341325.html
Wow! What a brilliant idea? What next? How about an Agency for Everlasting Economic Growth? And an Agency for No More Defaults? Or an Agency for Full Employment?

The key part of this proposal is that it will strip away some of the powers of the Federal Reserve over banking and move them to this agency. Implicit in this proposal is the belief that the Fed has not taken its banking oversight responsibilities seriously and that this failure was at least partially to blame for the banking crisis last year. Implicit also is the belief that a different agency more focused on controlling risk would have prevented this from happening. Let's take each part separately.

Replacing the Fed
There have been many who have blamed the Fed and its chairmen (Greenspan and Bernanke) for the banking crisis last year. However, there are just as many who have blamed other institutions for the same crisis. Without revisiting that debate, let us consider some of the reasons that have been offered for why we need to take banking regulatory powers away from the Fed and see if they are justified.

1. The Fed is not professional: I don't quite buy into this critique. While I do not claim to be a Fed insider, my interactions with those who work at the Fed have reinforced my view that most Fed economists are competent and apolitical. In fact, I would wager that there is more competence and less political meddling in the Fed than there is in almost any Federal agency.

2. The Fed has conflicts of interest: This most incendiary of allegations is thrown around by conspiracy theorists. In their world, investment bankers regularly meet in back rooms with Federal Reserve decision makers and think of ways in which they can rip off the rest of the world. Again, I don't see the conflicts of interest. There is clearly no reason why the Fed cannot set monetary policy and regulate banking at the same time. (A variant of this argument is that economists who work at the Fed are looking to move on to more lucrative careers at investment banks and are therefore amenable to entreaties from investment banks...My counter is that the top decision makers at the Fed are already at the top of the profession and don't need favors from investment bankers).

3. The Fed is distracted: The most benign reason given for stripping the Fed of its banking powers is that it has too much to do and therefore is unable to allocate enough resources to banking oversight. This may very well be true but the response then would be to give the Fed the resources it needs and not to create another Federal Agency.

In summary, I see no good reason for this new agency. The only real critique that I have heard is that oversight failures at the Fed caused the last banking crisis. Since no other regulatory agency, in the US or elsewhere in the world, seems to have foreseen this crisis, I think it is unfair to pick on the Fed alone. I see no reason to believe that an Agency for Financial Stability would have somehow protected us against the risks that precipitated this crisis and lots of reasons to believe that it would have made it worse.

Systemic Risk
The essence of systemic risk is that it is risk that affects the entire financial system rather than just the risk taking entity. We have to be more precise about why this is a problem. It is not because the risk is systemic but because it is asymmetric in its effects. Put more simply, an entity (investor, investment bank or hedge fund) that takes systemic risk gets the benefit of the upside, if the risk pays off, but that the system (government, tax payers, other investors) bear the downside if there is a bad outcome.

As I read the description of the agency in yesterday's news, the message that came through was that it was the taking of systemic risk that was the problem and that the agency would reduce the problem by regulating it. That seems to me to miss the point. What you need is action to reduce the asymmetry in the pay offs. As I see it, this will require:

a. Monitoring reward/punishment mechanisms: While I have never been a fan of regulating compensation at private firms, I think we need to require that compensation systems not exaggerate the asymmetric payoffs from taking systemic risk. For instance investment banks that reward traders for making macro bets, with house money, are pushing the systemic risk envelope.... (I have no problem with rewarding traders for taking micro risks or investment bankers for doing lucrative deals... )

b. No bailouts: Firms that make systemic bets that go bad should not only be allowed to fail but every effort should be made to recoup assets that they own to cover the losses created by these systemic bets.

c. Systemic Risk Fund: This may be the controversial part of the package, but a proportion of all profits made from systemic risk taking should go into a general fund that will be used to cover future systemic risk failures. (This will require explicit definitions of what comprises systemic risk and measurement of the profits from the same... but I don't see a way around it.) This will work only if legislators are not allowed to access this fund and use it to cover pet projects. (The reason I make this point is that the fund will become very, very large during good times and legislators will be tempted to draw on the piggy bank.)

With global markets and offshore investing, we cannot outlaw the taking of systemic risk. All we can do is to try to bring some symmetry back into the process where those who make money on these systemic risks also bear the losses from taking these risks. We don't need a new agency to do this but we do need banking authorities who are proactive, more interested in winning the next battle and less in refighting the last one.



Bad companies and good investments...

One of the big news items of the week is Berkshire Hathaway's acquisition of a Burlington Northern, a large US railroad.
http://www.nytimes.com/2009/11/04/business/04deal.html
Since Berkshire Hathaway is Warren Buffett's brainchild, this has provided a platform for many analysts to read the tea leaves. Here is some of the spin that I have seen and what I think about the spin.

A significant number of the analysts have argued that Buffett is making a bet on the US economy recovering by making this investment. I find this puzzling at two levels. First, if you were going to make a bet on the US economy, railroads seem like a pretty poor choice. Unlike housing and consumer durables, railroads have not seen their earnings increase dramatically in good economic times. Second, Buffett has always expressed his skepticism about market timing and macro investing strategy and this investment would be a significant departure.

Here is my take on the investment. Railroads in the United States are the quintessential mature business. It is extremely unlikely that you will see much real growth in this business; constructing a new railroad or even adding new rail lines would have prohibitive costs in the US, given real estate costs and litigation issues. Companies in this business have earned returns on invested capital that have lagged the cost of capital for decades. Put another way, very few railroads would make the list of most glamorous companies or be featured in Tom Peter's list of excellent companies.

So, why would Buffett invest in a bad business? I have said some unfavorable things about Warren Buffett on this blog before. At the risk of repeating myself, I think he has been hypocritical on corporate governance and he plays the "I am just a hick from Omaha" role to perfection. However, I think his status as a great investor can be boiled down to his capacity to separate "great companies" from "great investments" . Put another way, Buffett has always recognized that a great company can be a terrible investment, if you pay too much for it, or that a mediocre company can be a great investment, at the right price.

Here is the bottom line. I don't think that Buffett's investment in Burlington Northern is a bet on the US economy or an expectation of a surge in profitability for railroads. I think it reflects a more prosaic choice. Buffett thinks he is getting a good deal for the company at the current price, and he has history on his side. The best investments in the market are often among the companies that are viewed as the least glamorous and most boring: Burlington Northern clearly fits the bill.



The market value of Tiger Woods

Tiger Woods has been in the news in these last few weeks, though not in the way he has been in the past. As his personal travails have mounted, his endorsements have dropped off. Now comes a study by two professors at UC Davis, looking at the companies that sponsor Tiger.
http://www.news.ucdavis.edu/search/printable_news.lasso?id=9352&table=news
They find that the collective market value of these firms dropped $10-$12 billion between November 27, the fateful day when Tiger drove into a fire hydrant outside his house, to December 17 (thirteen trading days later).

Note that Tiger is not the first high profile athlete whose market impact has been studied. A study of Michael Jordan's announcement that he would return to basketball (after he retired and tried baseball for a year) resulted in an increase of 2% in market value of his sponsor firms. In fact, an earlier study of firms endorsed by Tiger Woods in his glory days found that Nike and American Express gained about 1% in market value around the endorsement dates.

As an interesting aside, the UC Davis study also found that three firms, Tiger Woods PGA Tour Golf, Gatorade, and Nike, fared worst during the period after the Woods scandal came to light. Accenture, a consulting firm, showed no signs of loss in value. I would take this as an indication that Accenture has been wasting its money all these years, using Tiger Woods as a spokesperson.

On a more general note, I think this incident points to both the upside and downside of using celebrity endorsements. While there is a commercial benefit, it has to be weighed off against the potential cost of celebrities behaving badly and affecting the sponsor's reputations. For firms like Nike, both the benefits and the costs are large, since their customers are more likely to be swayed by celebrity endorsements and misadventures, but the net effect is likely to be positive. For firms like Accenture, I really do not see the net plus of using celebrity endorsements. As a business, it is unlikely that I pick my management consultant, based upon an endorsement by Tiger Woods.



Greece, EU and more on Implicit Backing for Debt

Building on the theme of my last post, i.e., that implicit guarantees for debt are common and potentially dangerous, Greece offers an illustration of both the upside and downside of implicit guarantees.

Greece has been in the news as both S&P and Moody's have lowered its sovereign rating, from A- to BBB+ (for S&P) and from A2 to A1 (for Moody's). The harsher downgrade from S&P drew Greece's ire:
http://www.ft.com/cms/s/0/d4bdc8f2-eb13-11de-a0e1-00144feab49a,dwp_uuid=2b8f1fea-e570-11de-81b4-00144feab49a.html
Questions have been swirling about Greece defaulting and how the rest of the EU will react to potential default.

Taking a longer term view, though, Greece's debt travails are a test of the EU as implicit guarantor. I visited Greece in 1998, before the Euro came into being, to talk about valuation and at the risk of infuriating Greeks, the country was more an "emerging" than a "developed" market. The Greek currency, the Drachma, had little power outside the domestic market and Greece had a sovereign rating of BBB- (below investment grade) in 1995.

Becoming part of the EU and adopting the Euro as currency in 2002 improved the credit standing of the Greece, Spain and Portugal. While some of the improvement can be attributed to the fiscal discipline required by the EU (including restrictions on budget deficits), some of it can also be traced to the belief that the stronger countries in the EU would provide backing in the event of debt problems.

The bigger question is whether this umbrella has been a net plus for the EU countries as a whole. For Greece, Portugal and Spain, the benefits clearly have exceeded the costs over the period. For Germany and France, the effect has been more ambiguous, with the benefits of having a bigger and more prosperous market weighed off against the costs of the subsidies offered to the weaker economies. The subsidies also skewed economic activity in strange ways:
http://www.nytimes.com/2009/12/28/world/europe/28olives.html

Collectively, having one currency has made it easier for businesses to operate across Europe and those European firms that have adapted to this reality have emerged as more vibrant. While it has made Europe more competitive with the US, the big winners over the last decade have been the emerging markets, especially India and China. The biggest cost, as I see it, has been the bureaucracy that the EU has created to regulate itself and the companies that operate within its borders. In a dynamic global economy, putting more shackles on European companies will not make them more competitive.



Dubai and the "implicit" guarantee

In the last two weeks, we have seen the damage wrought by the potential default of Dubai World, a Dubai-government controlled company that funded some of the most extravagant projects on the face of the earth over the last decade.
http://www.bloomberg.com/apps/news?pid=20601087&sid=aoFe12bwzZ2M

While the magnitude of the default was large, it is interesting that it has shaken markets as much as it has. After all, there have been other large loan defaults in markets over the decades. So, why the panic? I think the reason lies in the unraveling of what I would call the "implicit guarantee".

What is the implicit guarantee? Consider a standard loan agreement, where a lender assesses a borrower's credit worthiness in determining how much to lend and on what terms. Through the ages, though, lenders have been willing to lend to borrowers who may not meet their credit worthiness tests, because their loans are backed up implicitly by others with deep pockets. Thus the money lender who granted a loan to the wastrel son of a wealthy merchant was trusting in the "implicit guarantee" of the father to pay back the loan; family honor was assumed to trump the absence of a legal obligation.

So, what does this have to do with Dubai World? Dubai is a city-state, with limited resources and economic capacity. The projects that were funded with the loans showed little potential of generating the cash flows needed to service the debt. However, Dubai is part of the United Arab Emirates, which has significant oil wealth and lenders assumed that the UAE would step in and provide backing, when the payments came due. At least so far, that has not happened.

Why does this have global consequences? Let's face it. A significant proportion of all lending is based on implicit guarantees. From bondholders in companies that are too big to fail (where the government is the implicit guarantor) to banks that lend to troubled family group companies (expecting the parent group to step in and save them), it is the implicit guarantee that allows for the lending. To those lenders, the Dubai World default is the stuff of which nightmares are made. The initial worry was that other implicit guarantors would use this crisis as the opportunity to walk away from their implicit obligations. While that has not materialized, it should serve as a wake up call to those who have been cavalier about implicit guarantees.

What is the bottom line? I am not suggesting that implicit guarantees are necessarily bad but they can pose a danger when too large a proportion of the debt in a system is dependent on them. Since none of the parties involved - the lender, borrower and implicit guarantor - make the obligation explicit, it is possible for them to misjudge the extent of their indebtedness and for investors to make the same mistake. I have seen many Asian and Latin American family group companies that have little or no debt on their balance sheets but have unconsolidated subsidiaries with massive debt on their balance sheets (backed up by the implicit guarantee). If we assume that these firms will honor their implicit guarantees, they should be treated as highly levered firms.



Emerging versus Developed Markets: The margin shrinks in 2010

One final post based upon 2010 data. I have been interested in emerging markets, in general, and the challenges of valuing companies in these markets, in particular, for a long time. When I started on this endeavor in the 1990s, the fault lines between developed and emerging markets were stark and could be categorized on the following dimensions:

1. Financial markets versus Economy: In emerging economies, financial markets were a very small and unrepresentative sampling of the underlying economy. Thus, the bulk of the market capitalization in most emerging markets came from recently privatized infrastructure companies, a few large banks and family controlled corporations. In developed markets, especially the US, Japan and the UK, much of the economy was corporatized and publicly traded.

2. Liquidity and capital access: Emerging markets were subject to ebbs and flows in liquidity, with crises, where liquidity and capital access dried up for almost all firms in the market. Only those emerging market companies that had access to foreign capital were able to maintain life lines during these periods. In developed markets, it was accepted that while some segments of the economy would have trouble raising capital, liquidity and capital access would remain available to most mid cap and large cap firms.

3. Default risk in government: Investors in bonds issued by governments in emerging markets assumed that would be a significant risk of default in these governments, even when they borrowed in the local currency, and priced in this default in the form of high interest rates. Investors in bonds issued by governments in developed markets did not even give thought to the possibility of default in the local currency.

4. Government role in company/economic health: Governments in emerging markets played a much more intrusive (and larger) role in their economies and the fates of their companies (through both explicit controls and licenses and implict threats of nationalization or expropriation). They were also viewed as more volatile and unpredictable. Consequently, when valuing emerging market companies, assumptions about government competence (or incompetence) and actions (or inactions) could affect company value substantially. In developed markets, the value of a company was largely a function of its management qualities and competitive advantages, and governments were viewed as predictable, side players.

5. Currency and inflation: In emerging markets, there was distrust of the local currency, often motivated by bouts of inflation and political uncertainty in the past. This distrust manifested itself in many ways, from an unwillingness by any entity in that market to borrow/lend long term in the local currency, to all analysis being done in U.S. dollars. In developed markets, investors may have been susceptible to complaining about the strength/weakness of the local currencies but inflation was mostly viewed as a controllable problem and currency longevity was taken as a given.

The crisis of 2008 may have precipitated this shift, but it is a shift that has been occurring over much of the last decade. Today, the gap between emerging and developed markets has shrunk and, in some cases, disappeared.

a. Financial markets and economy: While there remain many emerging economies, where financial markets lag the economy, the biggest emerging markets (India, China and Brazil) have seen explosive growth in both the number of companies that are publicly traded and the portion of the economy that is covered by financial markets.

b. Liquidity and capital access
: In the last quarter of 2008, we witnessed the almost unimaginable sight of GE being unable to issue commercial paper. In effect, developed markets discovered that you could have a liquidity crisis that affected all companies and all sources of capital. At the same time, the expansion of local investor bases has made emerging markets more liquid and expanded capital access to companies in these markets.

c. Default risk in government
: As emerging market governments establish a track record of paying their obligations on time and without fanfare, and developed market governments (Greece, Iceland) reveal significant potential for default, the notion that there is no default risk in developed market governments is coming under assault. In fact, the argument that the US and the UK may not be AAA rated forever no longer sounds far fetched.

4. Governments and Economy: While I was valuing Citigroup and Bank of America early in 2009, I realized how much my valuations of these two firms was dependent upon government action or inaction and I found myself using techniques that I had developed to value emerging market companies in the 1990s. At the same time, I find myself valuing well run Brazilian and Indian companies, without paying much heed to the governments in the markets. (I am afraid I cannot say this yet for Chinese companies, because of corporate governance concerns)

5. Currency and Inflation: As I noted in an earlier post, I see a much greater willingness in large emerging markets to analyze investments and value companies in the local currency. Investors in these markets have more faith in their currencies and seem to be less scarred by inflation worries than in periods past. At the same time, investors in developed markets seem to be jumpy about potential inflation in the future; this fear may not be manifested in current inflation or interest rates but it can be seen in the flight to gold and talk about hyperinflation.

In closing, the gap between developed and emerging market companies is closing, both in economic and analytical terms. The former are displaying some of the most troublesome characteristics of the latter, whereas the latter are maturing. For analysts and investors, the lessons should be clear. Developed market investors who have become lazy over decades of stability need to wake up and use techniques that emerging market analysts and investors have used for that same period. Emerging market investors and analysts who have made their money by playing the macro and government forecasting game have to start thinking more seriously about company fundamentals and value. There is work to do!



Time to Split!!

As many of you are probably aware, Berkshire Hathaway has announced its intent to split its class B shares and the requisite "deep analysis" of whatever Buffet is doing has journalists chasing the story.
http://money.cnn.com/2009/11/06/markets/thebuzz/index.htm
Since Berkshire is not the first company to ever split its stock, it is worth looking at key questions that come up anytime there is a stock split.

1. Do companies split their stock often?
The answer is yes and no. Some companies are serial stock splitters, splitting their stock at regular intervals. Other companies let their stock ride. In fact, Berkshire Hathaway is a classic example of a company that has avoided splitting its shares, with it's class A shares trading at about $100,000/share.

2. Why do companies split their stock?
There are several reasons provided, though not all of them hold up to scrutiny:

a. Attract new investors to the company: There is a belief that some small investors and even a few institutional investors either cannot or will not invest in companies if the stock price rises above a threshold level. The "level" itself seems to be a malleable number and vary across companies. There is little evidence for this proposition and even if there were evidence, so what? Inherently, there is nothing good about attracting investors who have hitherto avoided buying your stock and it is entirely possible that these investors may bring with them preferences for dividends and other corporate finance policies that put them at odds with the firm's current policies.

b. Improve liquidity: This is the time honored argument provided by many companies when they split their stock. Having a lower-priced stock, they argue, will increase trading volume and improve liquidity. The evidence, though, points in the opposite direction. Aggregate trading volume does not increase significantly after stock splits and transactions costs go up (not down). The reason for the latter effect is that the bid-ask spread, as a percent of the stock price, tends to be higher for low-priced than high-priced stock. (Try a simple experiment. Try buying 100 shares of a stock trading at $200/share, 1000 shares of a stock trading at $20/share and 10000 shares of a stock trading at $2/share and figure out your total transactions costs with each, including commissions and bid-ask spreads.)

In the case of Berkshire Hathaway, the reason for the split lies in the recent acquisition of Burlington Northern. Berkshire had offered shareholders in Burlington a choice being paid in either cash or Berkshire class B shares. Since Berkshire's class B shares were trading at more than $ 3000/share, there were many small stockholders in Burlington who could not avail themselves of the stock offer. (If you owned less than $3000 worth of Burlington stock, you had to settle for cash.) This has tax consequences. When you as a stockholder in a target company accept cash on an acquisition, you have to pay taxes on capital gains immediately. If you receive shares in the acquiring company, you can defer paying capital gains taxes until you sell those shares.

3. How do stock prices react to stock splits?
Are stock splits good or bad news? There have been several studies of stock splits over the last few decades and the findings can be summarized as follows:

a. At the time of the stock split, there is, on average, a very small positive impact on prices (about 1-2%). In other words, when there is a two for one stock split on a $50 share, the new shares trade at about $25.25. This is usually attributed to a "signaling effect", where markets view stock splits as a sign that the company expects earnings or dividends to increase in future periods.

b. There is some debate about whether investors can generate higher returns in the period after the stock split. While many of the earlier studies indicated that stocks that split did not "beat the market" in the months after, more recent studies provide evidence that "stock split" stocks generate significantly higher returns.

c. As with all investments, there is another shoe waiting to drop. Studies also indicate that the volatility increases after stock splits. In a very general sense, a stock split seems to increase both returns and risk.

If you are interested in reviewing the literature, there is a good survey paper on the topic. You can get to it by going to:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1362259

The bottom line. Stock splits, for the most part, are cosmetic and should not play a central role in whether you invest in a company or not. The reason is simple. From an intrinsic value standpoint, changing the number of units you divide the value by cannot change the overall value of a business. If everyone gets the same percentage increase in units, there cannot be winners and losers within the firm. However, the evidence does suggest that they can play a secondary role in stock picking. Thus, when faced with investing between two otherwise equal companies, one of which has split its shares recently and the other not, you would go with the first one.

Two side notes. First, everything that I have said about stock splits also applies to stock dividends. In fact, stock dividends represent an even bigger pain in the neck, since they leave investors with strange share counts - 100 shares become 102 shares. Second, reverse stock splits, where a company whose stock is trading at a very low stock price offers 1 share for every four or five shares, seem to be more defensible from an economic standpoint, since the transactions cost argument works in your favor)



Bounceback in Multiples: The 2010 story

Building on the 2010 data, here is the other side of the data. As risk premiums have reverted back to pre-crisis levels, we are also seeing multiples also revert back to pre-crisis levels. This can be seen on a number of measures, both in the US and globally:

a. Price Earnings Ratios (PE): The median current PE ratio for US stocks, which plunged from about 19 in January 2008 to about 9 in January 2009, is now back to almost 15. Similar shifts have occurred in the trailing and forward PE ratios and in most sectors.

b. EV/EBITDA: The median EV/EBITDA multiple for US companies, which had dropped from about 9 in January 2008 to 6 in January 2008, had bounced back to 8 by January 2009.

The bounce back in multiples in emerging market companies has been even more robust. The shifts in multiples globally parallel the change in equity risk premiums that I noted in the last post.

The change in multiples in 2010 brings home a fundamental fact that the multiples of earnings, book value or revenues that we are willing to pay depends upon how risk averse we are (and the risk premiums that we consequently demand). That is one reason why I have always been wary of those who compare market multiples across time and pass easy judgments on whether stocks are cheap or expensive.



Reversal in Risk Premiums (or premia): The 2010 story

The big story from the 2010 updates is that that risk premiums across the board have reversed the rise that we saw during the crisis. The broad based nature of the shift can be seen by looking at the following:

a. Equity Risk Premiums: I have been tracking the equity risk premium at the start of every month since the start of the market crisis on September 12, 2008. On that day, the equity risk premium for the US was 4.37%. That number exploded to almost 8% in November 2008 and settled in at 6.43% at the start of 2009. In the first three months of 2009, the equity risk premium continued to rise (to more than 7% in early April 2009). Since then, though, the equity risk premium has dropped dramatically. On January 1, 2010, the equity risk premium was down to 4.36%, roughly where it was at the start of the crisis. If you are interested in the computation, download the excel spreadsheet that I used (and feel free to modify and adapt it as you see fit)

b. Bond default spreads: The market crisis had its origins in easy lending, reflected in the low default spreads that we saw for different bond ratings classes in late 2007. Bond default spreads almost tripled during 2008, thus outstripping the change you saw in equity risk premiums. In 2009, however, bond default spreads returned to pre-crisis levels. You can get to my latest estimates of default spreads by clicking here.

c. Sovereign spreads: When the market crisis unfolded, emerging markets were affected more adversely than developed markets, as manifested in collapsing stock prices and soaring sovereign default spreads. The default spread for Brazil in the Credit Default Swap mark rose to 7% in November 2008. Those spreads have decreased to pre-crisis levels (and below, for some markets). Brazil's CDS spread in January 2010 was hovering at about 1.5%.

While I am not surprised that risk premiums have come down, I am surprised at how quickly they have reverted back to old levels. In early 2009, my prediction would have been that equity risk premiums by the end of the year would be down to about 5%. At one level, the speedy recovery in risk premiums can be considered to be evidence of mean reversion- that markets quickly revert back to historic norms even after major crisis. At another level, the quick adjustment can be viewed as a sign of a market that is in denial. My gut feeling is that the market has gone up too far, too fast and that equity risk premiums will correct themselves over this year and move back up towards 5%, but I may very well be wrong again.



Data Update for 2010

If you have been tracking my website, you probably know that I maintain updated datasets for companies around the globe, classified by region (into the US, Emerging Markets, Europe and Japan). I report summary statistics on risk (beta etc.), profitability measures (margins and accounting returns) and debt/dividend measures for industry groups in each region.

I update the data at the start of every year and I have just completed the data update for January 2010. You can get the data by going to:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/data.html
I have added two new datasets this year - for just Indian and Chinese companies.

In coming blog posts, I will talk about what the updates tell us about companies and markets globally.



The Fed Effect: Central Banks and Equity Value

Last week, the Federal Reserve announced that it would increase the Fed Funds rate by 0.25%. While the increase was small and the overall rate still remains low, by historical standards, concerns about the implications to the stock market surfaced almost immediately.
http://www.nytimes.com/2010/02/19/business/19fed.html
While, at first sight, this seems like unmitigated bad news - higher interest rates, after all, hurt stock prices - the effects of central bank interest rate policies on equity values is a little more ambiguous. There are several forces that come into play:

a. The Interest rate effect: Did the Fed raise interest rates last week? Not really. First, the only rate that the Fed has direct control over is the Fed Funds rate, i.e., the rate at which banks borrow from the Fed for emergency short term funding, a very small proportion of overall loans. Second, while it is true that the Fed's actions can affect market interest rates, the effect is more at the short end of the term structure than the long end. Thus, an expansionary central bank can push short term rates down but has relatively little influence over long term rates. That is also the reason why yield curves can become downward sloping, when central banks adopt restrictive monetary policies. In both valuation and corporate finance, it is the long term interest rate that determines discount rates and value.

b. The Inflation effect: Monetarists have long argued that the primary job of a central bank is to keep the currency from being debased, by holding inflation in check. Building on that theme, it has also been shown fairly conclusively that the biggest factor driving long term interest rates is expected inflation. Thus, a central bank that raises short term rates may be viewed by markets as fighting inflation, which can cause long term interest rates to fall contemporaneously.

c. The Economic Growth effect: For better or worse, central banks have also been assigned the role of custodians of economic growth. Thus, central bankers have to weigh the inflation fears against the real growth consequences, when raising or lowering rates. Markets therefore view the central bank's final actions as signals of what the central bank thinks about future economic growth. Thus, it is argued that a central bank that raises rates will do so only because it has information that leads it to believe that economic growth is strong enough to withstand the rate increase. Ironically, a rate increase can then be viewed as good news about future economic growth.

So, what do I think will happen to stock prices if central banks raise interest rates? Rather than give you the classic, "It depends ..." response, let me take a stand.
- If the central bank is viewed by markets as informed, independent and credible, a rate increase should be good news for markets; the real growth effect should dominate the effect on short term rates.
- If central banks are viewed as weak and/or uninformed, their actions will have little effects on markets, in the most benign case, and have negative effects, in other cases. As an example of the former, think of Japan in the 1990s, where the central bank was viewed as ineffectual. As an example of the latter, think of almost any Latin American country's central bank in the 1980s.

The bottom line. It is in every economy's best interests to have a central bank that is viewed as strong and effective, since the actions of the bank may be the last, best defense against economic meltdowns. Unfortunately, central banks become easy scapegoats for politicians, when economies stumble. Take the president of Argentina, Christina Kirchner, who recently fired the Argentine central banker (after repeatedly misfiring):
http://online.wsj.com/article/SB10001424052748704533204575047631291330838.html
Count me among those who will not be investing in Argentine companies in the near future. And how about the US? Ben Bernanke, the Fed Chair, was made to jump through hoops by senators, before they voted on renewing his chairmanship. Not surprisingly, they wanted him to promise that he would put employment above inflation in his decision making..... Poltical short sightedness knows no borders.



Transactions Costs and Beating the Market

One of my books, Investment Fables, is directed at answering one of the most puzzling questions in investments: How is that there seem to be so many ways to beat the market on paper but that so few money managers seem to do it in practice? A key reason, in my view, is that transactions costs have a much greater impact on returns than we realize.

Let's start with the good news. Both academics and practitioners have found dozens of ways to beat the market. To see the academic list of market inefficiencies, try this link:
http://www.amazon.com/Inefficient-Stock-Market-Robert-Haugen/dp/0130323667
And here is a link to sure fire money makers from practitioners:
http://www.amazon.com/Ways-Beat-Market-Hundred-Stock/dp/0793128544
Wow! Hundred ways to beat the market! Each new finding in academia seems to offer fresh opportunities for the "smart, informed" investor. The latest wave of schemes build off the behavioral finance literature. In fact, two prominent behavioral finance economists have set up their own money management firm (showing you that academics are not immune from greed):
http://www.fullerthaler.com/

Most of these beat-the-market approaches, and especially the well researched ones, are backed up by evidence from back testing, where the approach is tried on historical data and found to deliver "excess returns". Ergo, a money making strategy is born.. books are written.. mutual funds are created.

Now let's look at the bad news. The average active portfolio manager, who I assume is the primary user of these can't-miss strategies does not beat the market and delivers about 1-1.5% less than the index. That number has remained surprisingly stable over the last four decades and has persisted through bull and bear markets. Worse, this under performance cannot be attributed to "bad" portfolio mangers who drag the average down, since there is very little consistency in performance. Winners this year are just as likely to be losers next year...

So, why do portfolios that perform so well in back testing not deliver results in real time? The biggest culprit, in my view, is transactions costs, defined to include not only the commission and brokerage costs but two more significant costs - the spread between the bid price and the ask price and the price impact you have when you trade. The strategies that seem to do best on paper also expose you the most to these costs. Consider one simple example: Stocks that have lost the most of the previous year seem to generate much better returns over the following five years than stocks have done the best. This "loser" stock strategy was first listed in the academic literature in the mid-1980s and greeted as vindication by contrarians. Later analysis showed, though, that almost all of the excess returns from this strategy come from stocks that have dropped to below a dollar (the biggest losing stocks are often susceptible to this problem). The bid-ask spread on these stocks, as a percentage of the stock price, is huge (20-25%) and the illiquidity can also cause large price changes on trading - you push the price up as you buy and the price down as you sell. Removing these stocks from your portfolio eliminated almost all of the excess returns.

In perhaps the most telling example of slips between the cup and lip, Value Line, the data and investment services firm, got great press when Fischer Black, noted academic and believer in efficient markets, did a study where he indicated that buying stocks ranked 1 in the Value Line timeliness indicator would beat the market. Value Line, believing its own hype, decided to start mutual funds that would invest in its best ranking stocks. During the years that the funds have been in existence, the actual funds have underperformed the Value Line hypothetical fund (which is what it uses for its graphs) significantly.

In closing, I am not trying to dissuade you from being an active investor; I am one. My point is that you should be careful about taking the claims by anyone - academic on practitioner - about market-beating strategies. The market is certainly not efficient, if you define efficiency as an all-knowing, rational market, but it certainly seems efficient, if you define efficiency as investors being unable to take advantage of market mistakes. Talking about making money is easy.. actually making money is far more difficult.



The Credit Default Swap (CDS) Market

The Credit Default Swap (CDS) market has been in the news recently, as Greece goes through the throes of imminent or not-so-imminent default. I thought it would make sense to put down my thoughts on the market:

a. What is a CDS?
A CDS allows you to buy insurance against default by a specific entity - government or corporate. Consider, for instance, the 5-year CDS against Brazilian default. On February 11, 2010, it would have cost you 137 basis points to buy this swap on the CDS market. In practical terms, if you had $ 100 million in $ denominated 5-year bonds issued by the Brazilian government, you would pay $1.37 million each year for the next 5 years for protection against default If the Brazilian government defaulted during the period, you would receive $ 100 million.

There are CDS available on more than 50 governments, dozens of quasi-government instiutions and many large corporations. You can, in effect, make your investment in any of these institutions close to riskfree by buying CDS on any of them.

One feature of the CDS market that needs attention is that there is the possibility of counter party risk on both sides. In effect, both the buyer and the seller may default. Thus, in the 5-year Brazil CDS example, the buyer may not be able to deliver $1.37 million a year for the next 5 years and the seller may not be in a position to deliver $ 100 million, in the event of default.

b. History and growth of the CDS market
The CDS market was devised by a group of bankers at J.P. Morgan as a measure to protect the bank and clients against potential default in the late 1990s. Initially, the market was a very small one, used by investors to to hedge default risk in large positions. In the last decade, the market exploded as both buyers and sellers flocked into it. By 2008, the dollar value of securities covered by Credit Default Swaps exceeded $ 50 trillion and in fact was larger than the actual bond market. Put another way, people were buying insurance against default risk in securities that did not even exist.

c. Why would anyone buy a CDS?
The answer may seem obvious. Investors will buy a CDS to protect an open position that they have in a bond with default risk. That facile answer can be challenged with an obvious riposte: if you want to take no risk, why not just buy a default-free investment in the first place. Clearly, though, the sheer volume of trading suggests that hedging is only part of the story. The other reason for buying a CDS is because you expect the default spread in an entity to widen in the near future. Thus, an investor who expects Brazil's default risk to increase in the future may buy a 5-year CDS at 137 basis points and turn around and sell it for a much higher price later, if he is right.

In fact, one critique of the CDS market is that it is less about hedging and more about speculating. The Greek and Portuguese governments have complained that the CDS markets have deepened their woes:
http://online.wsj.com/article/SB40001424052748703382904575058881703896378.html?mod=WSJ_Markets_section_Heard

d. Why would anyone sell a CDS?
Again, there are two reasons. One is to operate as a broker and make money of transaction volume. If this is the rationale, you would hedge your exposure to risk by both buying and selling CDS and keeping your net exposure close to zero. The other is to speculate. If you expect the default risk in an entity to narrow quickly, you could sell the CDS at a high price and cover at a lower price.

While banks, investment banks and hedge funds are the biggest sellers of CDS, the seller does not have to be a regulated entity though the major sellers are subject to bank capitalization requirements. There is the very real danger that an entity may be tempted to sell CDS to collect cash now and worry about the potential liabilities later (AIG and Lehman come to mind...)

e. What information is in a CDS spread (and changes in it)?
The price on a CDS market is a function of demand and supply. For better or worse, it gives you a measure of what the market thinks about the default risk in an entity at a point in time. Note that this is true, whether investors are hedgers or speculators.

The overlay of counter-party risk affects the prices of CDS. This is one reason why the CDS on even default-free entities will trade at non-zero prices. When perceptions of counter-party risk rise across the board, as they did after the Lehman default, the prices of all credit default swaps will go up.

f. How can we use that information in corporate finance/valuation?
There are at least two places where the CDS market can be put to good use:
a. Country equity risk premiums: The equity risk premium for a risky emerging market should be greater than the equity risk premium for a developed market. One way to compute the additional risk premium is to compute a default spread for the riskier market and the CDS price provides a good starting (or even ending) point. In the Brazil example above, this would translate into using an equity risk premium for Brazil that is at least 1.37% (the CDS price) higher than the premium for the US. In more sophisticated versions of this approach, the 1.37% will be modified to account for additional equity market risk.

b. Cost of debt: The cost of debt for a firm can be obtained by adding a default spread for the firm to a riskfree rate. While this default spread can be difficult to obtain for many companies, we can use the CDS spread for a company (if one exists) to the riskfree rate to get to a pre-tax cost of debt.

In closing, there is useful informaton in the CDS market that we ignore at our own peril, when doing financial analyses and valuation. While there is substantial volatility in the market, the prices in the market allow us to get a sense of what investors think about default risk in entities and the price they would charge for bearing or eliminating that default risk. While it does open the door to those betting on default risk changes, it makes no sense to shoot the messenger and to ignore the message. The default risk problems faced by the Greek, Spanish and Portuguese governments are of their own doing and have been a decade in the making. Blaming the CDS market for these problems makes no sense!



Thoughts on the riskfree rate

Early in my blogging life, September 20, 2008, to be precise, I posted my thoughts on riskfree rates generally and about using the US treasury bond rate as a riskfree rate, in particular. With the turmoil sweeping through the European sovereign bond market right now, the time may be ripe to revisit the topic.

Let us start by stating the obvious. Knowing what you can make on a riskfree investment is a prerequisite for any type of corporate financial analysis or valuation. In most textbooks on finance, though, the riskfree rate is taken as a given.

Backing up a bit, consider the three conditions that have to be met for an investment to have a guaranteed return over its life. First, the cash flows have to be specified up front; this essentially rules out any residual cash flow investment (equity) and puts into play investments where the cash flows are contractually defined (fixed income). Second, there can be no default risk in the entity promising the cash flows; a corporate bond rate can never be a riskfree rate. Third, there can be no reinvestment risk; a six-month treasury bill is not riskfree for a five year cash flow, since the rates in the future can change. The bottom line is that we generally try to find a long-term, default-free rate to use as a riskfree rate.

Given this premise, it is not surprising that most books suggest using the US treasury rate (ten or thirty year) as the risk free rate in US dollars. Implicit in this practice is the assumption that the US treasury is default free. One troubling story from last week related to Moody's potentially downgrading the US from Aaa (and thus introducing the possibility of default into the equation).
http://abcnews.go.com/Technology/wireStory?id=9732868

Now, let's think about a Euro riskfree rate. There are a dozen European governments that issue ten-year bonds and the link below provides rates as of last Friday.
http://markets.ft.com/markets/bonds.asp
Note that the rates vary from 3.11% for Germany to 6.66% for Greece. Since the bonds are all in one currency (Euros), the differences have to be due to default risk. Thus, the German Euro bond rate is likely to be closer to the riskfree rate in Euros than any of the other bonds; in fact, the true riskfree rate is probably a little bit lower than the German bond rate.

Let's now look at an even more complex scenario. Assume that you want a riskfree rate in Indian rupees. At the start of the year, the Indian government ten-year bond rate (denominated in rupees) had an interest rate of 7%. If we accept Moody's rating for India of Ba2 and estimate a default spread of 2.5% for Ba2 rated bonds, the riskfree rate in Indian rupees is 4.5%:
Rupee riskfree rate = 7% - 2.5% = 4.5%

One last rung of complexity. In some emerging markets, there are no long term government bonds in the local currency. Here, the choices are either to do the analysis in a different currency or in real terms.

Ultimately, if riskfree rates in different currencies are measured right, differences between rates should be entirely due to expected inflation. Once that is accomplished, valuations will become currency neutral (as they should be).

In summary, estimating riskfree rates is not always easy. I have a paper on the topic that examines the estimation of riskfree rates in more detail:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1317436
I hope you find it useful.



Goodwill: Plug Variable or Real Asset?

Of all the items on a conventional accounting balance sheet, none gives me more trouble than goodwill. It is not an insignificant item for some companies, amounting to a large percentage of overall assets, but it does not show up on the balance sheets of other companies. To anyone who encounters it, there are five questions that follow: What is it? Why it is there? What does it measure? Can it change over time? What do we do with it?

What is it?
While goodwill connotes something substantial, it is a plug variable. Note that it shows up on a balance sheet only when a company does an acquisition. Some accounting text books define it as the difference between the price paid for a target company and the fair value of its assets, but that would be a lie. Stripped to basics, goodwill is the difference between the market price paid for a target company and the book value of its assets, with a little fair value modification thrown in for good measure. Thus, if company A pays $ 10 billion for company B, and the book value of company B's assets is $ 4 billion, there will be goodwill of $ 6 billion on company A's balance sheet after the acquisition.

Why is it there?
The answer to that is very simple. Because balance sheets need to balance. There are two fundamental disconnects between market value and accounting book value:
a. Book value reflects historical cost (not current value): An acquisition lays bare one of the fundamental problems with an accounting balance sheet, which is that the values of assets (at least operating ones) are recorded at historical cost, rather than current value. An acquisition of another company is at current market value and has to be recorded as such by the acquiring company. If you cannot write up the values of the acquired company's assets to reflect the price paid, you will have to record the difference as goodwill.
b. Value of growth potential:  The fair value of a company reflects both the value of its existing assets and the expected value of future growth potential. The former is what is captured in accounting balance sheets but market value includes the latter. Thus, when an acquirer buys a target company, it will have to pay a premium on book value (which reflects the value only of existing assets), even if existing assets were fairly valued.
In effect, acquisitions create an inconsistency in accounting. While internal investments made by a firm get recorded at historical cost, acquisitions are recorded at market value. Goodwill then reflects the accounting attempt to make things whole again.

What does it measure?
So, what does goodwill measure? Building on the last part, the goodwill in an acquiring company's balance sheet is a composite of three inputs:
a. Misvaluation of existing assets: As we noted in the last section, if existing assets are misvalued, there will be goodwill even in the absence of growth. Consequently, the more existing assets are misvalued, the greater will be the goodwill.
b. Growth potential: Goodwill be larger, when you acquire a firm with greater growth potential, since the market value will reflect this growth potential but book value will not.
c. Overpayment by the acquirer: There is substantial evidence that acquirers over pay for target firms and this overpayment is attributed to multiple factors - managerial self interest and hubris, over confidence on the part of managers, and conflicts of interests. Whatever the reason, this overpayment, if it occurs, has only one place to go and that is goodwill.
This can be illustrated with a simple example. Assume that company A acquires company B for $ 1 billion and that the book value of company B is $350 million. Assume further that the fair value of company B's existing assets is $400 million and that the value of its growth potential is $ 500 million. If existing assets are not marked up to fair value, the goodwill of $650 million has three components:
the misvaluation of existing assets ($400 - $350), the value of growth assets ($500 million) and overpayment ($100 million).
Accounting changes over the last decade have been directed at addressing the first of these three - misvaluation of existing assets. Thus, appraisers, working under the tight constraints of both accounting standards and tax rules, are allowed to reassess the value of existing assets to better reflect their current value. In the example above, this would lead to existing assets being reassessed to $ 400 million and goodwill to $ 600 million. For the most part, there is little that accountants can do about growth potential, since those assets exist only in investor perceptions.

Can it change over time? 
 To the extent that goodwill is market-based, the value of goodwill will change from period to period. Thus, the value of existing assets and existing assets can change from year to year and the overpayment has to be recognized at some point in time. Until a decade ago in the US and still in most parts of the world, these reassessments of goodwill are put on auto pilot, with goodwill being amortized over 30 or 40 years, irrespective of the facts on the ground.
In the last decade, accountants have argued that the value of goodwill can be reassessed to reflect changes in the three components and the change should be reflected in earnings. While the amortization or impairment of goodwill tries to reflect this reassessment, there are three issues in how it is done:
a. Timing lag: To make their assessment of whether and how much to reassess goodwill, accountants look to markets. Thus, the goodwill accrued by Time Warner from the acquisition of AOL was impaired by $54 billion in 2002, but only because technology stocks had collapsed in the market in the previous two years.  Since everyone in the market already had made this adjustment, the actual impairment of goodwill was treated by the market as being of no consequence.
b. Unidirectional: Goodwill impairments almost always seem to lower the value of goodwill. If this were a fair reassessment, you should see a significant number of companies where the value of goodwill gets assessed upwards.
c. Composite adjustment: The impairment of goodwill is provided as one number, when it includes reassessments of existing asset values, growth potential and overpayment. Since the implications of each are different for valuation, it is one more reason why goodwill impairment is not a particularly useful piece of information.
In summary, goodwill impairment has become an earnings management tool for many companies rather than a test of fair value changes. In the process, it has lost its informational content and is of little help to investors.

What should we do with goodwill?
Here is the million or billion dollar question. Assume that you are valuing a company with a significant goodwill item on its balance sheet. How should it affect the way in which we value or view the firm?
a. Book capital and Earnings: The minute a company acquires another company, the characteristics of book equity and capital change. Rather than reflect just historical values (which is the case when a company has only internal investments), they incorporate market values for at least the target company's assets. Thus, book capital for an acquisitive firm includes the three components mentioned above for a target firm - a mark-to-market of existing assets, growth assets and overpayment. Since the rest of the acquiring firm's assets remain at their old values, the resulting book equity and capital is inconsistently defined. Earnings are also contaminated for a different reason. The impairment of goodwill can cause big swings in earnings from period to period. Since earnings and book capital are the key inputs into return on equity and return on invested capital (ROIC), the presence of goodwill can dramatically alter these returns.
To correct for goodwill, many  analysts adopt the policy of ignoring it all together in the computation. Thus, return on capital is measured as:
ROC = Earnings before goodwill amortization/ (Book value of capital - Goodwill)
However, I have a paper on measuring returns where I have argued that while it is perfectly reasonable to net out the first two components of goodwill - misvaluation of existing assets and growth potential- from book capital, overpayment should not be netted out. In effect, companies like Time Warner should not be allowed to wipe out their mistakes and return their capital to pre-mistake levels, since stockholders have paid the price for these mistakes. Of course, separating out what portion of the goodwill is for overpayment is tough to do, but we need to make an effort. (I propose that we call this stupid goodwill and contrast it with smart goodwill)
b. Valuation: In a discounted cash flow valuation, goodwill really has no direct effect, since we estimate the value from expected future cash flows. Those cash flows will reflect the true value of existing assets and growth potential. Thus, it is in incorrect to add goodwill on to a DCF value, since it double counts these values. If you are doing asset based valuation, where you try to estimate current market values for individual assets on the balance sheet, it becomes trickier, since goodwill is not a conventional asset. Here, there is no easy way out. You have to either take the accounting estimate of goodwill as a fair value or estimate the value of future growth (which would require a DCF). In relative valuation, goodwill does not really affect much if you are using operating income multiples (Operating income or EBITDA is pre-goodwill amortization anyway) but it can affect equity earnings multiples (PE ratio or PEG ratios), since those earnings per share can be affected by goodwill charges. Goodwill can become a problem with book value based multiples. In effect, if you do not adjust for goodwill, companies that do a lot of acquisitions will have lower price to book and EV to Book ratios (and thus look cheaper) than companies that grow with internal investments.
One final thought. Given that goodwill, as an item, really changes nothing about the underlying assets and their value, no company should make or change decisions based upon the accounting measurement and treatment of goodwill. If you pay too much for a target company, what accountants do with or to goodwill cannot undo the damage already done.



Accounting inconsistencies

In the next few posts, I plan to focus on the accounting inconsistencies that bedevil analysts. In particular, here are the items that I will highlight:

1. Goodwill: When a company acquires another, goodwill shows up on the balance sheet of the acquiring company. While the name connotes something of substantial value, goodwill as it is currently computed is really a plug variable, designed to make the balance sheet "balance". Goodwill skews book values of equity and capital and wreaks havoc on earnings.

2. Minority interests: This is perhaps the most misleading item on a balance sheet, at least to the non-accountant. While it suggests something of value that you own (an asset), it is a by-product of another accounting practice termed consolidation. In effect, a company that owns more than 50% of another is required to "consolidate" its financial statements and report 100% of that subsidiary's earnings, capital and assets as its own. Minority interest reflects the value of equity in the subsidiary that does not belong to the parent company and is thus a liability. Not only is the treatment of minority interest a problem in discounted cash flow valuations but it is also an issue when computing enterprise value and related multiples.

3. Investments in other companies: With a firm with minority holdings in other companies (less than 50%), accountants face a different issue. What is the value that should be attached to these holdings on the balance sheet? Unfortunately, there is no one template in accounting and these holdings are sometimes shown at original cost (what was paid to acquire the holdings), sometimes at an updated book value (reflecting retained earnings since acquisition) and sometimes marked to market. Thus, an unsuspecting analyst can make significant mistakes in valuation, if he or she makes an incorrect assumption about accounting treatment.

4. Extraordinary gains and losses: This should be simple, right. Any items that do not comprise regular operating income or earnings should be consigned to this line item. If that were the case, dealing with extrardinary items would be simple. Since they are extraordinary, we can assume that they will not occur in the normal course of events and ignore them. In practice, though, companies use extraordinary income (expenses) for line items that are recurrent but with shifting effects (exchange rates gains and losses), related to operating adjustments (restructuring charges) as well as a device to show higher operating earnings (by shifting operating expenses into the extraordinary expense column). Thus, separating the truly extraordinary from the ordinary has consequences for both discounted cash flow valuations (by changing base earnings) and earnings multiples (PE ratios, EV/EBITDA etc.)

5. Deferred taxes: Deferred taxes can show up either as assets or liabilities. A deferred tax asset reflects a company's belief that it has paid too much in taxes over prior periods and can thus expect to get tax relief in future periods. A deferred tax liability is a measure of the opposite - a company that has been able to use the tax code to good effect and paid less in taxes (legally) than it should have (assuming the statutory tax code were applied to taxable income) can reasonably expect to pay higher taxes in future periods and has to show this as a liability. While the logic for both items is impeccable, it is worth noting that they reflect expectations of future tax savings (in the case of deferred tax assets) and tax liabilities (in the case of deferred tax liabilities). There is no contractual obligation or time line for these expected cash flows and that can create problems in valuation.

6. Intangible assets: In the last decade, accountants have discovered that accounting standards are not consistent about how they deal with intangible assets as opposed to tangible assets. The rules on capitalizing the latter are well established and the assets on a manufacturing firm's balance sheets reflect the firm's investment in land, buildings and equipment. For firms with intangible assets, which can range from technological prowess (Google) to brand name (Coca Cola) to patents (Amgen), the treatment of the assets has generally been benign neglect. As a consequence, the earnings and book capital at these firms is skewed and can affect both intrinsic and relative valuations.

7. Leases: The biggest source of off-balance sheet debt in the world is leases. A firm that leases its assets (rather than borrowing money and buying these same assets) can hide these assets (and the implicit debt in these assets) if it can meet the accounting requirements for lease expenses to be treated as operating expenses. As a result, we understate the debt ratios of retail firms and restaurants and misvalue these firms.

While the accounting logic behind the treatment of each of these items make sense to accountant, I think that they lead to poor measures of earnings and value. The post that highlights each item will examine not only the potential problems created by the current accounting treatment but also present  solutions to those problem.



Government Default and Riskfree Rates

I have several posts on potential government default and riskfree rates. I noticed this story in Business Week.

I know that this is only one observation but it is a troubling one. In emerging markets, it is not uncommon for companies to borrow money at rates lower than the government, but the saving grace is that the borrowings are in a foreign currency. I can see why bond holders saw less default risk in dollar bonds issued by Petrobras in 2004 than in dollar bonds issued by the Brazilian government.

In this case, lenders are actually perceiving less default risk to Berkshire Hathaway than to the US Government, for a US dollar bond. I know that Berkshire Hathaway has a much healthier balance sheet than the US government, but the US government has the power to print currency. Thus, I would not read too much analytical significance into the 3.5 basis point different. However, I think the market is sending a message to the US government which might or might not be getting through: You have to get your financial house in order soon or you will pay a price. Let's hope that someone is listening.



How do you measure profitability?

I have assiduously stayed out of the health care debate that has dominated the news in the United States for the last year, since everyone involved in it seems to come out of it looking worse for the wear. However, there is one aspect of the debate which I have found fascinating, revolving around how profitable or unprofitable the health care business is for insurers, pharmaceutical firms and hospitals. Let me be clear up front, though. This is not a post about health care reform but about how best to measure profitability.

On one side of the debate, you have proponents of health care reform arguing that health care companies, in general, and health insurers, in particular, make huge profits. By extension, they also suggest that one way to reduce health care costs is to reduce these profits. On the other side of the debate, you have opponents of health care reform noting that health care firms really fall in the lower rung of the market in terms of profitability. Each side uses its own measure of profitability to make its point.

Generically, there are three ways to measure profitability and they all come with caveats:
1. Dollar profits: For shock value, there is nothing better than dollar profits. Since most of us are unused to thinking in billions of dollars, noting that an industry generated $ 100 billion in profits seems awe inspiring. In 2009, the aggregate numbers (in billions) for publicly traded firms in the health care business were as follows. In terms of dollar profits, pharmaceutical firms deliver much higher profits than other parts of the health care business. While $130 billion in pretax operating profits is large, note that the aggregate pretax operating income for the market is $3.5 billion. In terms of net profits, pharmaceutical firms account for almost 14% of the net profits for the entire market. The problem with dollar profits is that they have no moorings. A profit of $ 20 billion sounds large by itself, but does not look that large, if compared to revenues of $ 1 trillion or capital invested of $ 500 billion.

2. Profit margins: We can scale profits to total revenues. Looking at equity investors in firms, the most logical measure is net profit margin, obtained by dividing net profits by total sales. From the perspective of all claim holders in the firm, a more complete measure is the operating margin, estimated by dividing operating profits by revenues. The latter is less likely to be skewed by financing decisions. After all, a firm that borrows more will have less net income after interest expenses and a lower net margin. Looking at the health care business again, here are the numbers.
While pharmaceutical firms deliver much higher margins than the market, the rest of the health care business delivers margins in line with the market. I personally do not find profit margins, by themselves, to be particularly informative and here is why. As every introductory marketing book points out, there is a trade off between margins and turnover. In other words, you can set high prices (and high margins) and sell less or go for lower prices and higher sales. In retailing, for instance, you see both strategies at play. Walmart has low margins but uses its turnover ratio (measured as sales as a percent of capital) to end up with huge profits. Many luxury retailers have much higher margins than Walmart but struggle to report even meager profits. More generally, differences in the way business is conducted makes it impossible to compare margins across businesses.

3. Returns on investment: In my view, the only profitability measure that works across sectors is to measure the return generated on a dollar invested in a business. This return can be measured to just equity investors as the return on equity, obtained by dividing net income by equity invested in the business or to the entire firm as the return on invested capital, estimated by dividing after-tax operating income by capital invested (debt plus equity) in the business. Measuring the actual capital invested in a business is a difficult task and most practitioners fall back on using book values. Here are the return on equity and capital numbers for health care firms.
In my view, this table provides the most comprehensive measure of the profitability of each business. Pharmaceutical firms and health insurance companies generate returns significantly higher than their costs of equity and capital and relative to the market. I am not suggesting that returns on equity and capital are perfect. Since accountants can alter book value through their judgments and provisions, I have a paper on how best to adjust returns for the various problems in accounting measures:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1105499
I do update all of these profitability measures on my website at the start of every year. The 2010 updates are available at:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/data.html

My conclusion! Health care firms, at least in the aggregate, are financially healthy and generate returns on their investments that exceed their costs of equity (capital). While these excess returns may suggest to some that these firms are "too profitable" and that they should be taxed or regulated, two points are worth noting.
a. The first is that there is a survivorship bias, insofar as only the most successful firms in each group are represented in our samples of publicly traded firms. To illustrate, consider pharmaceutical firms. Many small biotechnology and pharmaceutical firms never make it through the FDA approval process and the capital invested in them gets wiped out when they go under. If we regulate or restrict the mature (and successful) pharmaceutical firms to generate only their cost of capital, where is the incentive to do research in the first place?
b. The second is that the aggregate profitability of the businesses should not obscure us to the reality that each of these businesses is splintered and that rules/regulations/market conditions vary widely across different products/services and markets. In other words, while insurance companies collectively generate profits, they can lose money in individual states (as Wellpoint was contending for its operations in California). Requiring the insured in other states to make up for the higher costs of health care in California will create a death spiral for the business.



Equity Risk Premiums and the Fear of Catastrophe

As many of you already know, I am a little fixated on the equity risk premium. More than any variable, it explains what happens in equity markets both in the short term and the long term. In fact, I have at least a dozen posts over the last year and a half on the evolution of the equity risk premium in the US and globally.

The equity risk premium measures what investors collectively demand as a premium over and above the riskfree rate to invest in equities as a class. In practice, many analysts use historical data to estimate this premium. Thus, if investors have earned 9% on stocks over the last 80 years and 4% on treasury bonds over that same period, the historical premium is 5% and it is also used as the equity risk premium in valuation. My problem with this approach is that it is not only backward looking (you want a premium for the next decade, not the last 8 decades) but yields extremely noisy estimates. On my website, for instance, I estimate the historical risk premium for stocks over treasury bonds from 1928 - 2009 to be 4.29% but I also estimate the standard error in this number to 2.40%.

It is to remedy these problems that I compute an implied equity risk premium, where I back out the premium from the current level of stock prices and expected cash flows; it is analogous to estimating the yield to maturity on a bond. While this approach requires its share of inputs - expected growth rates and cash flows on stocks - the estimate of the premium is not only forward looking but comes with a far tighter range on the value. Furthermore, it is dynamic and reflects what is happening in the world around you.

On September 12, 2008, a couple of weeks before I made my first posting to this blog, the implied equity risk premium in the US was 4.36%. In the next 13 weeks, that implied premium rose to 6.43%, varying more than it had in the previous 25 years put together. It taught me an important lesson: even in developed markets, equity risk premiums can change quickly and need to be updated frequently. Since the crisis, I have been updating premiums every month and the implied equity risk premium at the start of March 2010 was 4.44%, back to where it was before the crisis.

How do we explain this rapid back tracking to pre-crisis premiums? While some view it as irrational, there is a rational explanation. One component in the equity risk premium is the fear of catastrophe. What is a catastrophe? It is that infrequent event, which if it occurs, essentially puts you under water as an investor for the rest of your investing life. The Great Depression was a catastrophe for the US: an investor in US stocks in 1928 would not have recovered his principal for almost 20 years. The Japanese market collapse in the late 1980s was a catastrophe. Investors who had their investments in the Nikkei in 1989 will not make their money back in their lifetimes. In good times, that fear recedes and investors are lulled into complacency; stocks go down, but it assumed that the long term trend is always up. In fact, we hear nonsensical stories about how stocks always win in the long term; if these stories were true, the equity risk premium should be zero for really long term investors. In crisis times, the fear of catastrophe rises to the top of all concerns and drowns out all other information. In December 2008, there was the real possibility of a complete financial meltdown and the equity risk premium reflected that. In January 2010, that fear had dropped off enough that people were reverting back to the pre-crisis premiums. It is entirely possible that we over estimated the likelihood of catastrophe in December 2008 and are under estimating it now, but I think that it is the only explanation that I can provide.

I have pointed you to a paper on equity risk premiums that I have. I just completed my 2010 update to the paper. Most of the changes are in the data and the text of the paper itself is relatively unchanged. If you are interested, try this link:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1556382

You can rest assured that I will nag you on this topic for as long as I maintain this blog.



The Goldman indictment

I waited a couple of after the indictment of Goldman to post my thoughts on it, since I have mixed feelings on the topic. If you want to take a look at the indictment, you can go here:
www.sec.gov/litigation/complaints/2010/comp-pr2010-59.pdf
As most of you who have followed my work know, I have been been more negative on the products and practices of investment banks than most of my academic brethren. I think that investment bankers promise more than they can deliver and that there is far less value in most of the products that they sell than they claim in their sales pitch. On the Goldman indictment, my sympathies lies with Goldman because I feel that this it is selective prosecution, based upon 20/20 hindsight, designed to advance a larger agenda of "financial regulation and oversight" by the Federal government and Goldman happens to be (at the moment) every one's favorite bogeyman.

First, the background. The deal that has Goldman in hot water is titled Abacus and was a multi-billion dollar Collateralized Debt Obligation (CDO), a fancy terms for a bond backed up by assets, and in this case, the backing came from real estate mortgages. On the face of it, the deal looks unremarkable. In fact, Business Insider was able to get its hand on the pitchbook used by Goldman for the deal:
http://www.businessinsider.com/check-out-the-66-page-presentation-on-goldmans-abacus-cdo-deal-2010-4
The pitchbook has all the hallmarks of a standard sales presentation - the obligatory disclaimer that runs 3 pages, 63 more pages that reveal less than they should, uninformative (but colorful) graphs, and tables filled with enough numbers to numb the brain (which is the objective).

So, what made this deal stand out? Here are some of the factors for its being singled out:
1. A "big loser": The securities bundled in the Abacus deal were priced at the height of the housing bubble. Like other housing backed securities it did lose money. However, it was one of the "biggest losers", with losses exceeding in the billions.
2. The John Paulson connection: The seller of the securities in the Abacus deal was the hedge fund headed by John Paulson, one of the few winners in the housing bubble. His subsequent notoriety, chronicled in a book, has made him into a sage, at least in hindsight, about the housing bubble and its implosion.
3. Goldman was the intermediary: Among investment banks, Goldman Sachs was viewed as the only one that was able to cut its losses in the mortgage backed securities debacle and escape relatively unscathed. The fact that it was the broker in this transaction has evoked suspicion that is was partnering with Paulson to take advantage of the suckers on the other side.

The indictment of Goldman seems to rest of two claims:
1. According to the SEC, Goldman Sachs claimed wrongly that Paulson was buying the securities (packaged under Abacus), when it was the seller. I checked through the sales presentation that I linked to earlier to see if there was an explicit mention of Paulson but I did not find any. It is entirely possible that Goldman left the implicit understanding that it was a buyer (I assume that the SEC has something - emails, phone calls, phone video - to back up its claim).

2. Goldman had advance knowledge of the collapse of the housing market and took advantage of their clients: Even the SEC seems to recognize that this is a much weaker legal argument, but the Senate committee investigating Goldman Sachs had no qualms about making this the center piece of its accusations. Using emails from from Fabrice Tourre, who in addition to being an employee of Goldman seems to have forgotten that emails are not erased on the server when you delete them on your computer, senators accused Goldman of knowing that the housing market was going to collapse and actively exploiting investors by selling them securities that would be destroyed by this collapse.

I know that these are legal issues subject to the legal rules on what comprises reasonable. However, if this case were subject to what the rest of us (who are not lawyers and have the benefit of common sense) think as reasonable, it just does not stand up to scrutiny:

1. What if Paulson were the seller rather than the buyer and why should the buyer of these bonds (ACA) have cared? Implicit in the SEC's argument that holding back on the identity of the seller (Paulson) was somehow a deal breaker for the buyers of the securities involved in the Abacus deal. Notwithstanding the halo that Paulson might have acquired as a soothsayer in the housing bubble, he was a voice in the wilderness in 2007 on housing prices. I seriously doubt that ACA would have not bought these securities, even if they had known that Paulson was the seller. In addition, I don't think any intermediary in this market (securities) is required to reveal to the buyer the identity and motives of the seller.

2. Goldman knew the housing market was going to collapse and took advantage of its clients: I find this argument to be beyond absurd, especially given the evidence to back it up. In fact, let's take this argument at face value. If Goldman were that prescient about the housing market in 2007, there was a dozen other ways (most of them more profitable and less work than Abacus) that they could have made money on this belief. So, why construct this convoluted way to make money? Furthermore, investment banks are not monolithic when it comes to views about markets. Having worked with investment banks for almost 30 years, I can guarantee you that at any point in time, views about whether a particular market is under or over priced (equity, bonds, real estate) diverge across an investment bank. For every strategist/analyst at the bank who is bullish, there is one who is just as strongly bearish. Thus, I find Tourre's emails (about what he thinks about the market) to be sensational but completely irrelevant to this discussion. (As an analogy, think of the following: If you were a real estate broker who believes that houses are over priced, should you stop selling houses to clients who want to buy houses?)

Did Goldman take advantage of "naive" clients"? Probably, but that is the nature of trading. All trading is predicated on exploiting the lack of information or good sense on the part of the the investor on the other side of the trade. I don't like what they did because it is bad business practice, in general, to take advantage of your customers. However, it is not illegal. If it were, home buyers should be suing brokers who sold them houses in 2007 and 2008 while secretly believing that these houses were overpriced, customers should be suing electronics salesmen who sold them video disc players, knowing that DVD players were the standard of the future, and voters should be suing politicians who told them that their pension and health care benefits were secure, while undercutting the basis for these benefits.

I know that a lot of people would like to see Goldman fall, and that some of them work at Goldman's competitors. While I understand the urge to bring the mighty back to earth, I think that failing to support Goldman at this time is a huge mistake. To me, this case reveals everything that is wrong with both politics and law - the use of ex-post evidence to back up a case (Paulson made money of the housing crash.. so, he must have known that the crash was coming), suspicious timing (just in time for the new law on regulating bank) and scapegoating.



Currency Choices in Valuation

I am currently in Bogota, Colombia, doing a seminar in risk. One of the topics that came up yesterday was about the choice of currency to do a valuation in, and how it affects your inputs. In particular, the question that I was asked was whether an analyst should value a Colombian company in Colombian pesos or US dollars, and the implications of this choice. Here is how I responded:

Which currency should I do my valuation in?
If you do your valuation right, it should not matter. Your value for a company should be the same, no matter what currency you choose to value it in. Thus, a company that is under valued by 20%, when you do your valuation in pesos, should remain under valued by 20%, when you do your valuation in US dollars.
Given this proposition, you should pick the currency with which you are most comfortable with and where it is easiest to get the financial information. My instinct, given the latter requirement, is to do valuations in the local currency since most financial statements are richer and more detailed in the local currency. Your choice of currency should not be a function of the investor for whom you are doing the valuation. Thus, you should not try to value a Colombian company in US dollars, just because the investor for whom you are doing the valuation is dollar based.
 
How is my discount rate affected by my currency choice?
In the context of discount rates, the input that is most influenced by the currency choice is the riskfree rate. If you work with a higher inflation currency, the riskfree rate will be higher. In the Colombian context, the Colombian peso riskfree rate was 6.5% and the US dollar riskfree rate was 4% last week. The difference of 2.5% is entirely attributable to differences in expected inflation.

Just as a side note, while getting a US dollar riskfree rate is easy (I used the T.Bond rate), I had to work a little harder to get the riskfree rate in pesos, since the peso-denominated Colombian government bond does have some default risk embedded in it. In particular, I subtracted out the default spread for the Colombian government (about 2%) from the bond rate (8.5%) to get to the riskfree rate.

The other inputs remain pretty stable. Betas should measure the business risk of the company. I have never understood the rationale of a widely used practice of using betas against the S&P 500, when doing dollar based analysis, and switching to betas against local indices, for local currency analysis. Those of you who follow my work know that I am firm believer in using sector or bottom up betas. For Ecopetrol, the Colombian company, I estimated a beta of about 0.80, based on the fact that it was an oil company, and used that beta for both US dollar and Colombian peso analysis. Even more dangerous is the practice of using the US equity risk premium, for US dollar analysis, and the much larger Colombian equity risk premium, for peso analysis. The company is a Colombian company and you cannot make the country risk go away by switching currencies. Both the dollar and the peso analysis therefore should use the higher Colombian risk premium.

As a final note, the cost of debt should be in the same currency that you estimate the cost of equity in and this is true no matter what currency the company actually borrows in. Therefore, if the company borrows in US dollars but you are doing your analysis in pesos, you will have to restate the cost of debt in peso terms.

How are my cash flows affected by my choice of currency?
The key rule here is that your cash flows have to be in the same currency as your discount rate. Thus, if you decide to do your analysis in pesos, you cash flows have to be in nominal pesos. If you decide to do your analysis in dollars, your cash flows have to be in nominal dollars. If it is a company with Colombian operations, this will often mean that you have estimate the cash flows in pesos and convert them into dollars. You have to use forward or expected exchange rates (and not the current spot rate) to make the conversion. In fact, if you want to preserve consistency, your expected exchange rate has to be computed from either interest rate or purchasing power parity. In the context of Colombia, for instance, the 2.5% higher inflation in Colombia that I have built into the riskfree rate will translate into an expected devaluation in the peso of about 2.5% a year.


Can I avoid this currency choice altogether?
You could, if you do your analysis in real terms. Thus, your discount rate has to be a real discount rate; the real riskfree rate is about 2% (I used the inflation-indexed US treasury to get this) and you can build the rest of the inputs on top of this rate. Your expected cash flows should be real cash flows; thus, you cannot count the inflation component of growth. Again, if you do it right, you should get the same value.

The bottom line: Make your choice of currencies at the start of the process and stay consistent with that choice all the way through. If you are wrong about expected inflation, it will cancel out - both your discount rates and cash flows will change. If you are inconsistent about inflation, applying one rate to cash flows and another to discount rates, your valuation cannot be salvaged.



Stock versus Flow: My thoughts

When analyzing companies, the three financial statements that we primarily use are the income statement, the balance sheet and the statement of cash flows. We obtain the inputs for earnings and cash flows from the income and cash flow statements and the numbers for debt, cash and working capital from the balance sheet.

While all three statements are governed by accounting standards and are audited, there is a key difference between them. Income and cash flow statements represent flow statements: they measure how much the company earned and spent over the period. Balance sheets capture the values of assets and liabilities at a point in time and thus represent "stock" statements.

So what? Stock statements are inherently less trustworthy than flow statements, because the numbers may not be representative of what the company did over the course of the year. This can be manifested in almost every number extracted from a balance sheet:

a. Debt: The debt that is reported on December 31 of a fiscal year will reflect what was owed on that day. A company can therefore pay down debt on December 30 and borrow again early the next year, manipulating its debt figures. In fact, there is a story in the Wall Street Journal about banks doing exactly this to make themselves look less indebted and thus safer.
http://online.wsj.com/article/SB10001424052702304830104575172280848939898.html 
Another common way in which debt can be kept off the books is by using lines of credit or seasonal financing during the course of the year but to pay them down by the end of the year.

There a couple of clues that we can use to detect this practice. One is to look at quarterly balance sheets, in additional to the year-end balance sheet, with the intent of finding big changes in debt from quarter to quarter. While enterprising companies may still be able to hide debt, it is much more difficult to do so on a quarterly basis. The other is to look at interest expenses as a percentage of the year-end debt. If a firm has debt for the bulk of the year, it has to pay interest expenses on that debt, even if it retires the debt towards the end of the year. As a result, the book interest rate (interest expense/ book debt) will be disproportionately high (relative to what you would expect the company to pay.

b. Cash: The cash on a balance enters intrinsic valuations as an add-on to the estimated value of the operating assets and relative valuations when we use enterprise value multiples (where cash is netted out of debt). However, the cash balance on the balance sheet may bear little or no resemblance to the actual cash balance today (which is really the number we should be using in intrinsic and relative valuation). This is one reason why some firms actually trade at negative enterprise values, where market equity is updated to reflected today's value but debt and cash remain frozen at year-end values.

c. Working capital: Net working capital is the difference between non-cash current assets (inventory and receivables) and non-debt current liabilities (payables and other accrued liabilities). Any of these numbers can be altered over short periods. For instance, receivable collections can be stepped up and inventory cleared (how about those year end clearance sales) just before balance sheet dates to make working capital look smaller.

In closing, I am not suggesting dynamic balance sheets. That would be too expensive and not quite practical. However, I am suggesting that we be more careful about balance sheet based analysis. Never trust a single balance sheet; if you can get quarterly balance sheets, do so; if you have access to the current numbers (on cash, debt and working capital), even better. The last may seem unrealistic but if you are the acquirer in a friendly merger, you should be able to demand and get this information from the target company.



Cash and Cross holdings

I am sorry about the long break between posts but I was on the road for much of the last two weeks and grading exams prior to that. I started my road trip with sessions in Slovenia and Croatia and continued on to India to make a presentation to the Tata Group, one of India's premier family groups, with a long history of operating in every aspect of Indian business. As part of the preparation, I did value a Slovenian pharmaceutical company (Krka), a Croatian tobacco company (Adris Grupa) and four Tata companies (Tata Chemicals, Tata Steel, Tata Motors and Tata Consulting Services). The presentations and the spreadsheets containing the valuations are online and can be accessed by going to:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/country.htm

Without belaboring the details, there were two key issues that came up when valuing Adris Grupa and the Tata Companies.

1. Cash holdings: Adris Grupa, as a tobacco company with significant operating cash flows, has accumulated a very large cash balance; it amounts to 20% or greater of the overall value of the firm. Adris is clearly not the only company that accumulates cash and it is not a phenomenon just restricted to emerging markets. Technology companies in the United States, such as Apple and Microsoft, have also been avid cash accumulators. While the conventional valuation practice with cash has been to add the cash balance to the value of operating assets, thus adopting the common sense rule that a dollar in cash has to be worth a dollar, there is substantial evidence that markets do not always treat cash as a neutral asset. In particular, markets seem to view companies that generate poor returns on their operating assets (less than the cost of capital) and accumulate cash with disfavor, while being much more sanguine about companies with good investment track records and substantial cash. Apple, for instance, is clearly not being penalized (and may be even be rewarded) for its large cash balance; after the most recent decade, investors trust the company to find good uses for the cash. In the Adris valuation, one of the concerns I raised was that the company's return on capital has lagged its cost of capital.It is therefore possible that the market may be discounting the cash holdings; a Croatian kuna in cash may be valued at less than a kuna.


2. Cross holdings: The Tata companies that I valued, with the exception of Tata Consulting Services, shared a common feature. A third to half the value that I estimated for each company came from  holdings in other Tata companies. In effect, investing in any Tata company is a joint investment in that company and a portfolio of 25-30 other Tata companies. While one reason for this cross holding structure is corporate control - it allows the family to preserve its control of the group companies - there are also more benign reasons, rooted in history. In the decades before the 1990s, Indian investors had little access to financial information from the company, let alone analyst reports or investment analysis. In that period, these investors had to essentially buy companies based on how much they trusted the promoters of the company, and a trusted family name became a proxy for research. In addition, when capital markets are undeveloped, having an internal family group capital market, where excess cash at some companies can be redirected to other companies that need the cash can be a competitive advantage.

The Indian equity markets today are different. While Indian companies have their own share of scandals and investment advice/ equity research can be tainted, the market is wider (thousands of publicly traded companies) and much deeper (more investors both from Indian and from outside). The cross holdings at family group companies can now become a valuation problem for two reasons:

1. To value one company, you have to value dozens:  Consider a firm with holdings in 25 other companies. Even if we could access information on these companies (because they are public), a thorough analysis of the firm would require a valuation of 26 companies. (Using the book value of these holdings, which are not marked to market, will yield skewed estimates. Using the market values of these holdings risks feeding any market mistakes into your valuation).
2. Some cross holdings cannot be valued: With many family group companies, some of the companies in the group are privately owned and never go public. As a consequence, there is little or no information that can be used to value companies. We have no choice but to use book value.

If you carry these concerns through to their logical conclusion, it is possible that investors either unconsciously (by using book value) or consciously (by discounting the market value of the cross holdings) will reduce the values of family group companies below what they would have been worth as independent companies. In effect, the sum of the parts will be greater than the whole. I have a paper on valuing cash and cross holdings that explores the technical details of this discount:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=841485

In my next post, I hope to examine the link between corporate governance and the phenomenon of cash and cross holdings.



"We are not in Kansas anymore"

It looks like that they have found the culprit for the 1000-point intraday swing on the Dow 30 on May 6. It turns out that rather than the hedge funds that were initially suspected, it was a Kansas-based money management firm, Waddell & Reed Financial, that traded 75000 e-mini S&P 500 contracts between 2.32 and 2.51 pm on May 6. That amounted to 9% of the trading volume on e-mini contracts during that period and all of the trading was executed by one trader at the firm. Incidentally, the CME report that uncovered this news also found that neither the trader nor the firm were acting imprudently or were at fault. This news item may still leave you a little bemused. How does one trader at a small money management firm cause a drop in market value of billions? And how can they not be at fault if they caused a market collapse? So, here is my attempt at providing an explanation.

What are e-mini contracts?
E-mini contracts are future contracts on the S&P 500. The "mini" in the name refers to the fact that each contract is $50 times the level of the index. (If the S&P 500 is at 1200, each contract is for a notional value of $60,000) E-mini contracts were introduced in the late 1990s by the Chicago Mercantile Exchange to provide a "smaller size" alternative to the long-standing S&P 500 futures contracts which were set to $500 times the level of the index; they have since been dropped to $250 times the level of the index.

How do investors use these contracts?
As with all futures contracts, there are speculators and hedgers in the e-mini market. The speculators buy or sell the e-mini to try to profit from overall market movements. Thus, a bullish (bearish) investor will buy (sell) e-mini contracts and make money if they are right on market direction. (If you buy 100 contracts and the S&P 500 moves up 80 points, you will make 100* 80 * 50 = $400,000; the 50 refers the fact that the futures contract is $50 times the index) The hedgers use the index to protect existing portfolio positions. Thus, a portfolio manager who wants to either protect profits already made or one who desires a floor on his or her losses will sell e-mini futures. (A portfolio manager who has $ 1 billion in equities can sell enough futures contracts to ensure that the value of the position does not drop below $ 900 million. Generally speaking, the more insurance you want, the more futures contracts you will have to sell. In more technical terms, you are creating a synthetic put on your portfolio, using options, and the number of futures contracts you will need to sell can be extracted using an option pricing model)

In many ways, the hedging position with futures is a lot more volatile than the speculative position, simply because the degree of selling is tailored to what the index does. As the index falls, the selling will often accelerate. partly because the point at which different portfolio managers hedge can vary. Thus, some portfolio managers may begin their hedging when the market drops 3%, others at 5% and still others at 10%.


How can futures affect the level of the index?
With financial futures, there is a third player that we have not mentioned in the section above, the arbitrageurs. Arbitrageurs have neither a market view nor do they have a portfolio to hedge. Instead, they are looking to make riskless profits, To prevent these profits, the futures price and the spot price are linked together in a rigid relationship:
Futures Price = Spot price (1 + riskfree rate - dividend yield)
To see why, assume that the S& P 500 is at 1000 right now, that the riskfree rate is 5% and that the dividend yield is 2%. Assume also that the one-year futures price on the index is 1045. Here is the arbitrage:
1. Borrow 1000 at the riskless rate and buy the index today at its spot price of 1000.
2. Sell the one-year futures contract at 1045.
3. During the next year collect dividends on the stocks in the index (2% of 1000 = 20). At the end of the year, deliver the stocks in the index in fulfillment of the futures contract and collect 1045. Pay the interest at the riskfree rate on the initial borrowing of 1000 (from step 1) and pocket the difference:
Profit = 1045 - 1000*.05 +20 = 15
To prevent this profit from occurring, the futures price has to be 1030. There are points at which you can quibble - being able to borrow at the riskfree rate and knowing the dividends for the next year - but they are minor ones, especially for the larger institutional players. The overall dividend yield on the S&P 500 index is very predictable and you can borrow at close to the riskfree rate, especially if you can back the borrowing up with marketable securities (as is the case here).

This futures-spot relationship creates the link. If one (spot or futures price) moves, the other has to follow. Thus, if there is an imbalance in the futures market, the futures price will change and the spot will follow. On May 6, here is how the script unfolded. The sell order placed by the trader at Waddell and Read was large enough to cause the e-mini futures price to drop significantly and the spot market had to follow. The fact that the trade was entirely driven by liquidity or hedging concerns (and not by information) resulted in a swift correction of both the spot and futures markets, with both reversing the losses by 3.30 pm.

What should be done about this?
I think that the May 6 collapse was an aberration. In what sense? The trade by the W&R trader occurred at a point in the day when the market was already skittish - it was down 250 points as worries about Greek default were rampant. When traders get antsy, they look for clues in trading by others. In other words, they assume that large trades, especially anonymous ones, must be coming from more informed traders (such as the Greek central banker) and they follow the trade.

While there is always the potential for this type of panic with or without futures markets, the existence of futures contracts has made it easier to create this type of panic. To the regulatory-minded, the solution seems simple. Ban futures trading or add more restrictions to the trading.  I disagree with the sentiment and think more harm than good will come out of it. As an investor who uses futures contracts very rarely and only to hedge, I still benefit from the liquidity created by these markets and bear little or no cost, simply because I choose not to trade frequently. In fact, as an intrinsic-value driven, long term investor, selling panics such as these can actually be opportunities to take positions in companies that I have always wanted to buy. For short term traders, though, futures markets may increase intraday volatility and thus their perception of risk in equities. I cannot speak for them but they are short term traders by choice!!



Will the financial overhaul bill fix what's wrong with banks?

On Friday, congressional conference committee members announced that they had reached agreement on the final contours of the financial overhaul bill. The bill is expected to be put to a final vote in the next week and perhaps be ready to be signed into law by July 4. Knowing the speed with which Congress completes tasks, I will not hold my breath, but it is time to examine what's in the bill and whether it will accomplish its stated objective: to put financial services firms (and especially banks) on a firmer footing and to prevent another banking crisis.

The bill is almost 2000 pages long, which scares the daylights out of me, but it supposedly contains the following ingredients (I will admit that I have not read whole chunks of this bill and what I have read is mind numbingly boring):
Regulatory framework: In addition to allowing regulators to seize and break up troubled financial service firms, the bill allows regulators to recoup the costs of the bailout by making other financial service firms with more than $50 billion in assets pay a fee. In tandem, it reduces the Fed's emergency lending powers and prevents bankers from having a say in who gets to be a Fed president. The Office of Thrift Supervision will cease to exist and the Fed will retain oversight of community banks.
The Volcker Rule: The rule restricts banks from trading with their proprietary capital and from investing more than 3% of the capital in hedge or private equity funds. It also limits banks from bailing out hedge funds that they have invested their capital in.
Derivatives: Standard derivatives (on foreign currency, interest rates etc.) have to be traded on exchanges and backed up by clearing houses, with standardized capital and margin requirements. Banks can still create customized derivatives for clients, but only in restricted circumstances. Banks have to create separate entities for their swap business.
Consumer Agency: There is a new federal agency (Consumer Financial Protection Bureau) that is supposed to protect consumers from fraud/misinformation in financial service company products (including mortgages) by regulating these products and enforcing the regulations.
Investor protection/ power: The SEC can set standards for brokers who give investment advice and hold them to the same fiduciary duty requirements already governing investment advisers. Hedge funds and private equity funds have to register as investment advisers and provide information on trades.
Securitization: Banks that package assets and securitize them are required to hold 5% of the credit risk on their balance sheets.
Credit Rating firms: Allows investors to sue ratings firms for "knowing or reckless" failure in assigning ratings.

The reviews are already coming in. On the one hand, there are some who believe that this reform is too little, too late and that it will do nothing to prevent the next crisis. These critics feel that Congress should have returned Glass-Steagall to the books and broken up big banks. At the other extreme, there are some who believe that the heavy hand of regulation will destroy the competitiveness of US banks, by making them less profitable and valuable, and move the derivatives and swaps businesses to offshore locales. Strange though it may seem, I think that both sides are right on some issues and wrong on others.

Focusing just on the bank-related portion of the bill, there are three questions that I would like to address:
1. Will this bill prevent financial service firms from becoming "too big to fail"?
I don't see how this bill will reduce the likelihood that banks will become "too big to fail". While the bill doles out some punishment to larger banks - the fees on banks with more than $ 50 billion in assets and the exemption of smaller banks from some of the regulations - there is nothing in the bill that will prevent banks from becoming larger. In fact, given that a ton of regulation is going to emerge from this bill, I will predict that the largest banks will have a competitive advantage when it comes to playing the "rules" game and get even larger. I will also predict that the requirement that banks carve out the swap business and other risky businesses will make them more complex and less transparent. From a valuation standpoint, I am not looking forward to valuing either JP Morgan or Bank of America in a couple of years.

2. Will it reduce "bad" risk taking at banks?
The focus of this bill is clearly directed at trying to prevent "bad risk taking" by banks, where "bad risks" are defined as very large risks, which if they pay off, deliver large profits to the bank, but if they fail, become systemic risk that taxpayers are called upon to cover. The separation of the swap businesses at banks, the restrictions on derivatives and the limits on investing proprietary capital in hedge funds seem to be directed at this bad risk taking. On all counts, the lawmakers are reflecting the conventional wisdom of both academics and practitioners on the roots of the 2008 banking crisis and the legislation is written to prevent a re-occurrence. Having watched investment banks operate for 30 years, I believe that they will find new and never-before-seen ways of taking large risks. I will predict that the next crisis will look nothing like the last one, and that this legislation will not only do little to prevent it but will actually contribute to it (by driving risks underground and away from the regulatory eye). Until we deal with the compensation structures at these institutions, where decision makers profit from upside risk and are relatively unaffected by downside risk, we are designed to repeat our mistakes over and over again: "Groundhog Day" in financial markets.


3. Will it make banks less profitable?
Interesting question. At first sight, the answer seems to be yes, since there are restrictions on banks investing in hedge funds and limitations on their derivatives and swaps businesses. On a pure return on equity basis, these are some of the highest return businesses for banks but they are also the highest risk businesses. As an investor in banks, I have always looked at these businesses with a jaundiced eye: they earned high returns but I am unconvinced that they earned high excess returns (over and above the risk-adjusted cost of equity). My prediction is that, if this legislation is passed and put into effect, the returns on equity at banks will decrease, as they return to safer businesses, but their excess returns may very well increase, as the regulations scare away new entrants. Bottom line: Banks may become less profitable (if you define it in terms of return on equity) but in the process become more valuable.

Like all legislation, this one is written with the best of intentions. I hope it succeeds but I don't think it will.



Valuation Approaches...

I have always believed that valuation is simple at its core and that we choose to make it complex. Furthermore, the determinants of value have not changed through the ages; all that has changed are the estimation practices. One of my pet peeves relating to valuation is when an entity (usually a consultant, academic or an appraiser) takes a standard valuation equation, does some algebra, moves terms around and then claims to have discovered a new and "better" valuation model.

Each consulting firm has its own proprietary value measure, with a fancy name and acronym (Economic value added (EVA), Cash Flow Return on Investment (CFROI), Cash Return on Capital Invested (CROCI) etc.) that it markets to its clients as the magic bullet for value creation. To make themselves indispensable, consultants usually add computational twists that require their presence. To get a sense of how these measures are marketed, you can check out books on each (usually written by the measure's developers):
CFROI
EVA
CROCI
All of these models share two themes. First, they relate the value of a business to excess returns (returns earned over and above the cost of capital or equity). Second, each claims to be easier to use, more intuitive and better than the other models out there.

With analysts, the search for a better valuation approach usually takes the form of concocting new multiples or modifying existing ones. Consider the PEG ratio, a favored tool of analysts following high tech (and growth) companies. The PEG ratio is obtained by dividing the PE ratio by the expected growth rate in earnings per share, and companies that trade at low PEG ratios are considered cheap. It is viewed as a less time-intensive and assumption-free substitute for intrinsic valuation.

As analysts and consultants push their favored approaches to the forefront, it is no surprise that most of us feel overwhelmed by the choices that we face. Which of these dozens of approaches will yield the right value? How do I pick? At the risk of being simplistic, let me offer a solution. Pick the approach that you feel most comfortable with and use it correctly. The value you obtain will be identical to the value you would have obtained using any alternate approach. I have an extended survey paper that I wrote on valuation approaches (and their history) in 2005 that can be downloaded online, if you are interested:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1625010
Valuation is not rocket science. Valuing companies may not be easy but the challenges we face are not in valuation theory but in estimation practice. Put another way, we know exactly how to value companies. What we do not have a handle on is how best to estimate growth, risk and cash flows. So, let's stop concocting new models and theories and start thinking more seriously about how best to estimate cash flows for a cyclical firm, risk for a regulated company and growth for young start-up firm. The second edition of one of my books, The Dark Side of Valuation, is dedicated to this concept. You may not like or agree with some of the solutions that I have to estimation challenges, but I hope it will start you thinking about how best to deal with these challenges.



What is "fair value"?

What is the fair value of an asset? Sounds like a simple question but the question has taken on a life of its own, given recent changes in both accounting and legal standards. In both contexts, the rule makers contend that their objective is to ensure that assets are recorded at fair value and have created rules to ensure that this happens.

Let us start with accounting. The push towards fair value accounting has now become an article of faith for accounting standards boards. In the United States, FAS 157 (the very fact that we are at rule number 157 tells you something about how accountants think - the more rules the better) provides a synopsis of what the accounting definition of fair value. I have expressed my skepticism about fair value accounting before on this blog and made my case for why this is not only a good idea

In legal circles, the hypocrisy about fair value is even greater. Appraisers are supposedly unbiased and fair in their estimates in value, no matter who they work for or which side of the legal divide pays them. The Internal Revenue Service has made this requirement explicit in its guidelines for appraisers. All of the valuation appraiser organizations - The National Association of Certified Valuation Analysts (NACVA), American Institute of Certified Public Accountants (AICPA), American Society of Appraisers (ASA), Institute of Business Appraisers (IBA)- argue that their members provide fair, unbiased estimates of the values of businesses.

I have a simple definition (and test) of fair value. If an asset is valued at fair value, the appraiser (or his client) should be indifferent to being either  a buyer or a seller at that value. If you are an appraiser valuing your business for tax purposes, would you really be willing to sell your business at the appraised value? If the answer is yes, you have stayed true the notion of fair value. If the answer is no, the talk about fair value is just talk... If you are the tax authority valuing the same business (for tax purposes), would you be willing to buy the business at the appraised value? If the answer is no, you too are guilty of hypocrisy.

Let's be honest. Asking "biased" appraisers to estimate fair value is a hopeless task; the bias comes from the way appraisers get compensated/ paid.  Either change the way that we hire/pay appraisers or accept that each side's appraisers are going to come up with valuations that reflect which side of the divide they are coming from.



Parent versus Consolidated financial statements

My last post on valuing the Tata companies, all of which have significant holdings in other companies, has raised a natural follow up question. When valuing a company, is it better to use stand-alone parent company financial statements or should we use consolidated financial statements?  More generally, which of these two should you focus on as an investor/manager/regulator?

Accounting Background
The question of whether to use parent-company or consolidated statements becomes an issue only when a company has cross holdings in other companies. To illustrate the difference, consider a simple example, where company A owns 60% of company B. Company A can report its financial results in a parent company statement or in a consolidated statement.
a. If it chooses to report the financial results in a parent company statement, the operating income statement will center on just company A's operating results. The revenues and operating income will reflect only company A's operations. However, there will be a line item on the income statement, below the operating income line, which will include 60% of the net income of company B.
On the balance sheet, only the operating assets and liabilities of company A will be recorded. However, there will be a line item on the asset side of the balance sheet that reflects the accountant's estimate of the value of the 60% of company B; the rules on how to estimate this value and how often it has to be updated can vary from country to country.
b. If the financial results are in a consolidated statement, the operations of company A and B will be combined. As a result, the revenues, operating income and other operating numbers (depreciation, cost of goods sold) will reflect the sum of those numbers for companies A and B. In a similar vein, the assets and liabilities on the balance sheet will reflect the combined values of companies A &B, notwithstanding the fact that company A owns only 60% of company B. The accounting adjustment for the 40% of company B's equity that does not belong to company A takes the form of minority interest, shown on the liability side of the consolidated balance sheet. Again, the rules on how to estimate this value and how often it gets updated varies across countries.

A final note on consolidation. Consolidated statements exclude intra company transactions. Thus, if company A sells $ 100 million in products to company B, the parent company financials will show revenues of $100 million for company A and costs of $ 100 million for company B, but the consolidated statements will net them out and show nothing.

Why would a company choose to use one versus the other?
It is not always a choice. In the United States, companies are required to consolidate financial statements, if they own a controlling stake of a subsidiary (defined as >50% of the outstanding equity). They do not have to consolidate minority holdings in companies. In general, US companies are required to report only consolidated statements and do not have to provide parent company financials, but these consolidated statements represent a mix of consolidation (for majority stakes) and parent company rules (for minority stakes).

The rules for consolidation are similar in international accounting standards. In much of Europe and in many emerging markets, companies will report both parent company and consolidated statements in the same annual report, with wildly different results. What does add to the confusion is that the rules on consolidation still vary across markets.

All of the Tata companies that I valued had both parent company and consolidated financial statements in their annual reports. Tata Steel, for instance, had a parent company statement, where its holding of equity in Corus Steel was shown as an asset on the balance sheet and a consolidated statement, which reflected the combined revenues and operating results of the companies, with a minority interest item reflecting the portion of Corus Steel that is not owned by Tata Steel.

Valuation fundamentals
 In theory, you can value a company using either parent company or consolidated statements, with the following key differences:
a. Parent company financials: If you value a firm, using parent company financials, you are using the operating income and cash flows (cap ex, depreciation, working capital) of just the parent company. Consequently, discounting the cash flows at the cost of capital yields a value for just the parent company. To value the equity in this company, you will have to subtract out net debt in the parent company and add the value of equity in cross holdings, using either the book value of these holdings as a base or through an intrinsic value of the subsidiaries.
b. Consolidated financials: If you value a firm, using consolidated financials, you have valued the parent firm and its consolidated subsidiaries together, since your earnings and cash flows reflect the combined earnings and cash flows of the companies. To get to the value of equity in the company, you will have to subtract out the net debt of the combined companies and the estimated value of the portion of the equity in the subsidiary that does not belong to the parent company. Again, this estimate can be based upon the book value of minority interest or on the intrinsic value of the subsidaries.

Which set of statements for valuation?
If I had access to full information on both the parent and the subsidiaries, I would value a company based upon its parent company financials and then value every one of its subsidiaries, using their individual financial statements. I have two reasons for this bias:
1. This would give me the maximum flexibility in terms of valuation inputs - the cash flows, growth and risk can be very different across parent companies and subsidiaries. The final value of equity in the company would then be the summation of the values of equity holdings in the parent company and all subsidiaries.
2. It allows me to avoid the two items in consolidated financial statements that give me headaches - goodwill (and whatever accountants choose to do with that cursed item) and minority interests (where I have trust an accountant to estimate the value of a holding)


In practice, though, this ideal is not easy to reach. In many cases, there will be incomplete or no financial statements available for subsidiaries. In this case, it becomes a choice between two imperfect estimates of value, the book value of the holdings in subsidiaries in parent company statements or the minority interests in consolidated statements.  The more homogeneity there is between the parent company (same business, same growth and profitability trends), the greater the argument for using consolidated financial statements, valuing the combined company and subtracting out the estimated value of the minority interests in the subsidiary. As

In the case of Tata Steel, for instance, I chose to value Tata Steel as a stand alone company in 2009 and added the book value of the Corus holding to arrive at the value of equity in Tata Steel overall. I could have valued the company using consolidated statements and subtracted out the value of minority interests. The choice ultimately was driven by the fact that Tata's Steel's consolidated statements were still in a state of flux in 2008-09, two years after the acquisition of Corus. As Corus is integrated in Tata Steel, the consolidated statements should become more informative. In fact, the 2009-10 consolidated statement looks far more settled and I may try to value the company based upon these numbers now.


More generally, which statements should you use to assess a company?
While the answer I have given is valuation focused, there are many constituent groups that use financial statements. Bankers and ratings agencies look at them, so that they can assess default risk. Portfolio managers and investors use the numbers from financial statements to compute ratios and multiples (PE, EV/EBITDA..) Since the rating is for a company, with its cross holdings, and the multiple is for the equity in the consolidated company, there is an argument to be made that we should be looking a consolidated statements. However. this makes sense if and only if the parent company has holdings in subsidiaries with very similar fundamentals - risk, growth and cash flows. If not, it would make more sense to judge the parent company and its subsidiaries separately and to make comparisons to different peer groups.



What if nothing is risk free?

Every discipline develops its own dogma and finance is no exception; we make assumptions about how markets are structured and investor behavior that underlie much of our theory. Those within the discipline either take these fundamental assumptions as given or are reluctant to question them. Over the last few months, I have been working on a new book titled "What if?", where I am looking at how financial theory and practice would change, if the bedrock assumptions of finance were violated or no longer true. I just finished my first installment, where I look at how investment practice and corporate finance would change if there is nothing that is guaranteed or risk free. You can get the paper by going to:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1648164

In an earlier post, I examined the mechanics of how best to estimate the risk free rate when there is no default free entity. Through most of that post, I focused on emerging markets, where governments are often prone to default, but left untouched the basic presumption that developed market governments like the United States, UK and Germany are default free. But that presumption has been put to the test by the banking crisis of 2008 and the Greek default drama of 2010.

I start by looking at how the presence of a risk free investment changes the way in which we construct portfolios and make corporate finance decisions. In particular, the presence of a risk free investment allows for separation between risk preferences and portfolio composition. Thus, two investors with different degrees of risk aversion can end up holding the same portfolio of risky assets and adjust for risk, by altering the proportions of their wealth that they put into the risk free asset. In corporate finance, the presence of a risk free investment can alter investment, financing and dividend policy.

So, what makes for a risk free investment? The issuing entity has to have no default risk, which restricts us to government securities, because governments alone have the power to print currency. The catch, though, is that governments sometimes default. While the explanation for default is simple, when governments borrow in foreign currencies, it is more complex when governments borrow in their own currency. The trade off that leads to domestic currency default - the debasement of the currency that comes with printing more currency versus the pain of default - has resulted in governments defaulting on local currency borrowings. If the probability of such default exists, even if slight, government bond rates are no longer risk free.

The most common and widely used measures of government default are sovereign ratings from S&P, Moody's and Fitch. While ratings and default rates are highly correlated over time, suggesting that ratings agencies do a good job, on average, there is also evidence that ratings changes are lagging indicators. An alternative measure of sovereign default risk comes from the Credit Default Swap (CDS) market, where investors can buy or sell insurance against default by governments. CDS prices tend to update faster than sovereign ratings, but come with more volatility.


The absence of a risk free investment can have significant effects on both portfolio management and corporate finance. When investors lack a safe haven, they will  become more risk averse and charge higher prices for risk. Higher prices for risk will translate into lower prices for all risky investments; we should expect to see stock prices and corporate bond prices decline. When firms have no risk free investments, lenders to these firms will be more wary about lending to them (leading to lower debt ratios) and investors may be less inclined to allow companies to accumulate cash (since that cash will be invested in risky assets).



A Corporate Governance Risk Manual

About a year ago, I agreed to do a series of seminars for the IFC, an arm of the World Bank that invests in privately owned businesses, primarily in emerging markets. The focus of the seminars was risk governance and the audience was directors in companies. While I was leery of getting entangled in the layers of bureaucracy that characterize the World Bank, I agreed to do it for two reasons. First, I had done the bulk of the work already in my book on Strategic Risk Taking (published by Wharton Press), published a couple of years ago. Second, I thought it would be interesting to talk about risk management, from a broader perspective.

Risk management, as practiced currently, is splintered among different disciplines. The risk hedging and measuring part has been taken over and reshaped by the finance folks, using numerical measures of risk such as beta and Value at Risk. The risk taking part has been hijacked by strategists, many of whom talk a good game, but are reluctant to put their ideas to any numerical test. Economists have largely sat out the debate, preferring to debate risk aversion in the rarefied world of utility functions. Statisticians have nipped at the edges, primarily pointing out what the rest of the crowd is doing badly.

I put together a presentation for a one-day seminar on risk management, from a corporate governance standpoint, and  delivered it in four venues: Antigua (Caribbean), Bogota (Colombia), Lima (Peru) and St. Petersburg (Russia). I have turned over my slides for others to use in more venues, but my task is done. For closure, I decided to pull together the slides and create a manual for directors. While the IFC will be officially printing and distributing a variant of this manual, I want to make it available to anyone who wants it. You can download this manual by going to the following link:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1681017

For those of you who have my Strategic Risk Taking book, this is a compressed version, with the added bonus of tasks that you can use to assess how good risk management is in your firm. For those of you who do not have the strategic risk taking book, this manual captures the essence of my argument.



Past performance is no guarantee of future performance... but is anyone listening?

Most mutual funds end their advertisements with this statement: "past performance is no guarantee of future results". I don't know why they bother because investors don't seem to act like they care. In fact, one phenomenon that we know characterizes investors is that many of them try to invest in whatever asset class, fund or stock has done well in the past.

I was reminded of this return chasing phenomenon by an article I read on Permanent Portfolio, a fund that has been around a while but has generally struggled to survive for most of its life, with about $ 50 million in money under management a few years ago.  Starting in 2007, the fund's assets have exploded and it is now up to $ 5 billion. Its growth coincides with its superb performance over the period.
http://online.wsj.com/article/SB10001424052748704858304575497662644720960.html?mod=WSJ_hps_MIDDLEThirdNews
So what? Only about a third of the fund is invested in stocks; 25% is invested in gold and silver and 35% in cash. Its performance over the last three years can be explained largely by the fact that it is under weighted in stocks and over weighted in precious metals. In other words, its success comes almost entirely from its asset allocation, rather than asset selection.

History provides a cautionary note on why return chasing often comes to a bad end. Momentum investing, which is what this comprises, requires two components to succeed:
1. Long runs in returns. You need asset prices to move in the same direction for long periods. If good years are followed by bad years and vice versa, you will end up with whip lash as a momentum investor. In statistical terms, you need strong positive correlation in returns across time. Whether there are long runs in returns is an empirical question and there is evidence that is hopeful. There have been long historical runs (positive and negative) in returns in stock and bond markets and even longer runs in currency and commodity markets. The evidence is less positive when it comes to individual stocks; while there is some short term momentum, it is much weaker than in the asset marekts. Thus suggests that momentum investing is more likely to pay off for market timers playing the asset allocation game than for individual stock pickers.

2. Detecting the end of the runs: All good things come to an end and long runs in prices (up or down) end at some point in time, with the size of the correction directly proportional to how long the run lasted in the first place. A momentum investor can see years of positive returns wiped out in the course of a few weeks or even days. The evidence is not as positive on this factor. Models and investors that claim to detect imminent market corrections don't do very well, at least in the long term.  However, there may still be hope. I am not a great believer in technical analysis, but this is is one place where price and volume charts may help, especially in assessing how close to the cliff you are. I have a chapter on momentum investing in my investment philosophies book that you may find interesting and you can download it by clicking below.
http://www.stern.nyu.edu/~adamodar/pdfiles/invphil/ch7.pdf

If you are a momentum investor, making money on your gold investment right now, I am happy for you. I just hope that you have a mechanism that  will tell you when it is time to get out. With momentum investing, knowing when to sell is even more important than knowing when to buy.



Checks and Balances: Eisner and Disney

I just read about a forthcoming book, written by Michael Eisner, ex-Disney CEO, titled "Working Together: Why great partnerships succeed". My first reaction was incredulity.. What next? Madonna on "The Importance of Celibacy" and Bernie Madoff on "Investing Wisely"...

As some of you may know, I have used Disney as my laboratory case study in my applied corporate finance book through three editions and fifteen years. I love the company and its products but have not always cared for its management. In fact, I have been particularly harsh about Eisner, who I think did serious damage to the company, especially in the last decade of his tenure.

While I have not had a chance to read Eisner's book yet, I was interested to read that he used his partnership with Frank Wells as one of the great partnerships that succeeded. On that count, I completely agree. When Eisner came to Disney as CEO, from Paramount, the company was moribund; its theme parks were getting old, its animated movies lacked pizzazz and the ghost of Walt Disney wandered through the halls. Eisner, with his then side-kick Jeff Katzenberg, brought a fresh energy to the company that was complimented by the operating savvy of Frank Wells, Disney's Chief Operating Officer. Wells operated as a check on Eisner, channeling his visions to practical success. By 1994, the two men had turned Disney around and put it on the path to being an entertainment powerhouse.

In 1994, Wells died in a helicopter crash and the only person in the company capable of reining in Eisner was gone. Eisner packed the Disney board with me-too directors, far too eager to rubber stamp whatever he did, and he let his manias and paranoia run rampant. Disney made investments it should not have made (buying Capital Cities was a mistake; it is revisionist history to claim, as Eisner does, that he bought ABC to get ESPN, since he could have bought just ESPN for a fraction of the $ 18 billion he paid for the entire company) and did not make investments it should have (buying Pixar early in the game for millions rather than wait a decade and pay billions), fired people who should not have been fired and did not fire people it should have. By 2003, stockholders in Disney were in full revolt and deservedly so; the company's earnings had plateaued and its stock under performed the market.

My larger point, though, is not about Disney, but about why we needs checks and balances in positions of power. Even the smartest, best-intentioned individuals have weaknesses. At some point in time, without constraints, these weaknesses rise to the surface and subsume the successes. When we push for stronger, more independent boards of directors, it is not because we operate under the illusion that such boards will make bad managers into good ones, but that they will keep good managers from going over to the dark side. We will never know how much good Eisner could have continued to do in Disney, if he had a strong board of directors to guide him, confront him and sometimes stop him or slow him down.



Capital Structure: Optimal or Opportunisitic?

Contrary to the prediction of doomsayers during the banking crisis of 2008, firms seem to be returning with a vengeance to the debt markets. Today's story in the Wall Street Journal provides some details:
http://online.wsj.com/article/SB10001424052748703453804575479712501514050.html?mod=WSJ_hps_LEFTWhatsNews

Finding the right mix of debt and equity to fund a business remains one of the key components of corporate finance. The contours of the choices are clearly established.
On the plus side: Using debt instead of equity to fund investments generates tax benefits in most countries, since interest expenses are tax deductible and dividends are not. Debt may also provide some "discipline" to managers of mature companies with large positive cash flows.
On the minus side: Debt increases the possibility of financial distress and/or bankruptcy, with all its potential costs. The tussle between whats good for stockholders and bondholders' interests manifests itself in covenants that restrict investment and financing choices and in monitoring costs.
 There are tools for assessing optimal capital structure as well. One is the cost of capital; in effect, the mix of debt and equity that yields the lowest cost of capital is the "optimal" mix. Another is Adjusted Present Value (APV), where a firm is first valued as if it were all equity funded (unlevered) and the net value added from debt is computed as the difference between the tax benefits and the expected bankruptcy costs. The mix that maximizes overall firm value is the "optimal" mix.


So, what has changed between a few months ago and now that would explain this surge of debt financing? It is unlikely that the tax benefits of borrowing have surged or that expected bankruptcy costs have dropped; the former explanation would have made sense if corporate tax rates were expected to rise in the future and the latter would have worked if the economy had strengthened significantly over the period.  I think the answer lies in evidence that behavioral finance has uncovered about how companies make financing decisions; my colleague at NYU, Jeff Wurgler, has the seminal paper on the topic. Rather than weigh the costs and benefits of debt and come up with optimal or target debt ratios, firms seem to make their financing choices based upon perceptions of the cheapness (or costliness) or debt as opposed to equity. Thus, they tend to flood the market with bond offerings, when they perceive the cost of debt to be low and with equity offerings, when they perceive their stock to be over priced. I would term this "opportunistic capital structure". The drop in treasury bond rates and the decline in default spreads (as the Greek crisis has receded) has led to much lower borrowing rates, especially for highly rated companies.


What's wrong with this? There are two potential dangers:
a. Perception may not be reality: Perceiving the cost of debt is low does not make it so. When CFOs make assessments of the relative costs of debt and equity, they are trying to be market timers. Given the sorry track record that portfolio managers have on timing equity and bond markets, I would be wary about CFOs who claim special powers on this issue.
b. Short term gain versus long term pain: Even if CFOs are good market timers and the cost of debt is low (relative to equity), is it a good idea to go out and fund your projects predominantly with debt? I don't think so. Over time, the firm will end up with too much debt, and over time, the cost of debt will revert back to historic norms. As with homeowners who borrowed because rates were low between 2004 and 2007, the day of reckoning will come and it will be painful.

Here is my compromise solution. Rather than pick an optimal or target debt ratio, a firm should choose a range for the optimal; in other words, a 20-40% optimal debt ratio, rather than 30%. Firms can then be opportunistic but only within this range; thus, you would move to a 40% debt ratio, if you believe that that the cost of debt is low or to a 20% debt ratio, if you think your equity is over priced. That would constrain over confident CFOs from pushing the debt ratio to unsustainable levels.
 



Time for class!!

I am getting ready for the first day of my Fall 2010 Valuation class and am just as excited as I was the day that I taught my first class. I taught my first valuation class in 1986 and have taught it every year since (twice a year, in most years). I am often asked whether I get bored, teaching the same class over and over. Not for a second, and here is why:

1. The issues that we face in valuation change constantly. When I first started teaching the class, the big issue was recapitalization, as many large US companies were shifting to using more debt in their capital structure. In the 1990s, interest shifted to valuing technology companies, in general, and young technology companies, in particular. The last decade saw the rise of emerging market companies in the first part and the banking crisis, towards the end.  My lectures and notes reflect these shifts.

2. First principles endure: While the issues and challenges that we face in valuation change constantly, I have adhered to the same first principles over time. In fact, it is these first principles of valuation that I return to, at times of uncertainty and crisis, to look for answers. I truly believe that if you "get" these first principles, you are capable of answering any question in valuation, and I view that as one of the primary objectives for this class.

3. The audience changes: As any teacher knows, the material may stay the same but the experience of a class can change, depending on audience interaction and background.

4. It is theater: I love having an audience (even if it is a captive one), especially since I get to review their performance, rather than the other way around. What actor would not kill for this set up?

I invite you to join in and follow the class. The lectures will be webcast, though not in real time. You can download them and watch them on your computer or iPod, or watch it as a streaming video. You can get the lecture notes, follow my emails and even take the quizzes/exam (you have to grade them yourself, but I will put my grading template online). Everything you need should be at this link:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/equity.html
Just a note of caution. You will not get credit for the class but I hope that the material is worth the effort. Let me know if there is something I can add (at low cost in terms of time) to the website to make your experience better.



Unstable risk premiums: A new paper

I am back from a long hiatus from posting, but I had nothing profound (even mildly so) to post and I was on vacation for a couple of weeks and Latin America last week.

As many of you have read in my postings, I am working on a book where I look at shaking up some of the fundamental assumptions that underlie modern finance. My first chapter on "what if nothing is risk free?" was posted about four weeks ago and you can still get to it by going to:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1648164
My second chapter builds on a theme that has been a bit of an obsession for me on risk premiums and how they have become more unstable, unpredictable and linked across markets. The paper titled,
A New Risky World Order: Unstable Risk Premiums - Implications for Practice, is now ready to download and you can get to it by clicking on the link below.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1669398

The paper is long (about 60 pages) but hopefully not verbose. A great deal of what I say in the paper, I have said before in my papers and posts on equity risk premiums. The difference in this paper is two fold.
  1. I expand my analysis to look at risk premiums in different markets - default spreads in bond markets and real asset premiums in real asset markets. In the process, I can examine how risk premiums in different markets have begun more moving together and how divergences across markets can be used to fine tune both investment and corporate financial decisions.
  2. I do present a template that can be used by practitioners to choose between the bewildering array of risk premium estimates that are out there. When should you use a current premium and when should you use a historical premium?

I am working on my third chapter of the book: What if nothing is liquid?, where I hope to look at what would happen to valuation and corporate finance practice, if markets essentially shut down. I hope I will have something interesting to say.



Nassim Taleb and the Nobel Committee

I just read this article, where Nassim Taleb, who seems to have taken on the mantle of the "anti-theorist" in finance, argues that the Nobel committee should be sued for giving the prize to Harry Markowitz, Bill Sharpe and Merton Miller.
http://www.bloomberg.com/news/2010-10-08/taleb-says-crisis-makes-nobel-panel-liable-for-legitimizing-economists.html
Taleb has written a few books, "Fooled by Randomness" and "The Black Swan", which have brought him acclaim and his warnings seem to have been borne out by the recent crises. (I have put down my thoughts about these books in an earlier blog post.) I think he badly misplays his hand by arguing that Markowitz, Sharpe and Miller are to blame for the excesses in financial markets. In fact, let's take each of their contributions to finance and put them to the test:

a. Let's start with Merton Miller, who was the oddest target of all. (Perhaps, the story got the name wrong and Taleb really blamed Bob Merton, not Merton Miller...) Miller and Modigliani argued that great firms acquire that status by taking good investments (that generate higher returns than it costs them to raise capital), and that finessing capital structure or messing with dividend or buyback policy adds little or no value at the margin. Since much of the advice and deal making in Wall Street is directed towards capital structure solutions (recaps, leveraged transactions) and dividend policy (buybacks, special dividends), it would seem to me that what corporate finance departments at investment banks do is in direct violation of what Miller would have propounded.

b. How about Markowitz? The singular contribution to finance that Markowitz made to finance was his recognition that the risk in the investment has to be measured as the risk it adds to a portfolio rather than the risk of it standing alone. In effect, his work is a statistical proof that diversification eliminates a significant portion of risk in investments. It is true that he worked in a simplified world where an investment's worth is measured on only two dimension - the expected return (which is good) and standard deviation (which is bad), but his conclusion that diversification reduces risk would hold with any of the distributions that Taleb claims are more realistic descriptions of investment behavior. The mean-variance framework has been critiqued and adapted from within and without the discipline for forty years, starting with Mandelbrot in the 1960s and continuing through to the behavioral economists today. Perhaps, you can indirectly critique the dependence on the normal distribution for the failure of risk management systems such as VaR, but that is na stretch.

c. Bill Sharpe is targeted for his role in the development of the CAPM. Let's face it. Betas and the CAPM have become the whipping boys for everything that goes wrong on Wall Street! That's right. It was beta that drove the creation of those mortgage backed securities. And those homeowners who were borrowing up to the hilt and buying houses they could not afford.. The fault lay in their "betas" and not in them...

I have been with and around traders and investment bankers for much of the last three decades and most of them are too busy to obsess about financial theory. There are a few rogue bankers who think that they are smarter than everyone else, have contempt for the average individual and believe that they can create wealth out of nothing. They are not believers in efficient markets (how can they, if their success depends on claiming to find market inefficiencies?) and have little time for betas or mean-variance theory (in their view, these are abstractions, when deals and trades make money). In short, they are nothing like Miller, Markowitz and Sharpe, who in spite of all of the faults you can find with their work, were open to honest intellectual debate. In fact, in their arrogance and self-righteousness, these "investment bankers" remind me of someone else! Mr. Taleb, do you happen to own a mirror?



Inflation, deflation and investing

I must confess that I have never seen such dissension and disagreement among economists about whether we are going into a period of inflation or one of deflation. On the one side, there are those who are alarmed at the easy money, low interest rate policies that have been adopted by most central banks in developed markets. The surge in the money supply, they argue, will inevitably cheapen the currency and lead to inflation. On the other side, there are many who point to the Japanese experience where a stagnating economy and weak demand lead to price deflation. I have given up on trying to make sense of what macro economists say but you probably have a point of view on inflation and are wondering how inflation or deflation will affect your portfolio.

To understand how inflation affects the value of a company, let's get down to basics. The value of a company can be written as a function of its expected cash flows over time and the discount rate appropriate for these cash flows. In its simplest form, the value of a stable growth firm can be written as:
Value = (Revenues - Operating Expenses - Depreciation) (1- tax rate) / (Cost of capital - Stable growth rate)
Assume now that inflation jumps from 1% to 5%. For value to be unaffected, everything has to increase proportionately. Thus, revenues, operating expenses and depreciation all have to increase at the inflation rate, the tax rate has to remain unchanged and the discount rate will have to increase by that same percentage. So, what might cause this to break down?
a. Lack of pricing power: Even though the overall inflation rate may be 5%, not all firms may be able to raise prices by that magnitude. Put simply, firms with loyal customers, a strong brand name and significant competitive advantages will be able pass inflation through better than firms without those benefits.
b. Input costs: By the same token, not all input costs will increase at the same rate as inflation. If oil prices increase at a rate higher than inflation, an airline that lacks pricing power may find itself squeezed by higher costs on one side and stagnant revenues on the other.
c. Tax rate: The tax code is written to tax nominal income, with little attention paid to how much of the increase in income comes from real growth and how much from inflation. Thus, the effective tax rate you pay may increase as inflation increases.
d. Cost of capital: The effect on higher inflation will be felt most directly in the risk free rate, which will rise as inflation rises. However, equity risk premiums (which determine cost of equity) and default spreads (for cost of debt) may also change.

Historically, higher inflation has not been a neutral factor for stocks. Stocks have done worse during periods of high and increasing inflation and much better in periods of lower inflation. This graph, which I borrowed from a Wall Street Journal article, illustrates the stark divide:
That may seem puzzling because we are often told that it is bonds that are hurt by inflation and that stocks are good inflation hedges. Here is why I think the logic breaks down. When inflation increases, equity investors are hurt for two reasons. The first is that the discount rate (cost of equity and capital) increases more than proportionately, because risk premiums increase with inflation. For instance, the equity risk premium in the United States increased from 3.5% in 1970 to 6.5% in 1978 and default spreads also widened. The second is that the tax code is not inflation neutral. For companies that have substantial fixed assets, depreciation is based upon historical cost and not indexed to inflation. Consequently, the tax benefits from depreciation become less valuable as inflation increases; think of it as an implicit increase in your effective tax rate.

If I believed that high inflation was around the corner, I would first shift more of my portfolio from financial assets to real assets. Within my equity allocation, I would invest more of my money in companies that have pricing power (allowing them to pass inflation through to their customers), inputs that are not very sensitive to inflation (so that costs don't keep up with inflation) and few fixed assets (to prevent the depreciation tax impact). I can think of several technology, consumer product and entertainment companies that fit the bill. As a bonus, I would like the companies to have long term debt obligations at fixed rates; inflation is likely to dilute the value of the debt. These companies are likely to see their cash inflows increase at a rate faster than inflation and will be able to buffer the impact of inflation on discount rates. In my bond portfolio, I would steer my money to short term government securities, inflation indexed treasury bonds (TIPs) and floating rate corporate notes; they are least likely to be devastated by higher inflation.

If deflation was my concern, I would invest more of my portfolio in financial assets; bonds, even with 2.5% interest rates, would be a bargain. Within my equity allocation, I would steer away from cyclical companies. At least in recent decades, deflation has gone hand-in-hand with low or negative economic growth. Consequently, I would invest in companies that sell non-discretionary products and necessities.  In my bond portfolio, my holdings will be in more credit worthy entities, since default is a very real possibility in poor economic conditions.




Jerome Kerviel is sentenced: Ruminations on risk and trading scandals

A French court has sentenced Jerome Kerviel, the SocGen trader who caused the company to lose 5 billion Euros, to five years in prison and a fine of 4.9 billion Euros.
http://www.guardian.co.uk/business/2010/oct/05/jerome-kerviel-jail-sentence
I think we can safely assume that Mr. Kerviel is now bankrupt for life. Reading about the case did raise a question in my mind. How can one person cause this much damage and how did the damage remain undetected until too late? I know that people have pointed to the asymmetric reward structure (where huge bonuses are paid if you make large profits and you really don't share in the losses) at banks as a culprit, but I think there are three "behavioral" factors that contribute to disasters such as this one.

1. Selection bias: Experimental economists have been exploring differences in risk aversion across sub-groups of people and their conclusions are fairly strong. For the most part, their studies find that younger people tend to be less risk averse than older people, single people are less risk averse than married folks and men are less risk averse than women (especially young). Now think about your typical trading room in any investment bank. It is over populated with 25-35 year old males, selected primarily because they had the right "trading" instincts. In fact, I think you can safely assume that if you were picking the least risk averse group in a population, it would look a lot like that trading room.

2. House money effect: You tend to be much less careful when taking risks with "house" money than with your own. Traders almost always are playing with house money, especially when they are doing proprietary trading, and not surprisingly are more cavalier about taking risk than they would be with their own money.

3. Break even effect: Here is a phenomenon that every casino owner knows. When a gambler loses money, he tries to make it back, and the deeper he gets in the hole, the rasher he becomes in his risk taking. So, a trader who loses $ 100 million will try to win it back with big bets (even if those bets don't make much economic sense); the more he loses, the wilder his risk taking will become.

One of the problems with the risk management systems that we have is that they deal with the symptoms and not the causes of erratic and bad risk taking. If we want to reduce the likelihood of more Jerome Kerviels in the future, here are some things we should do:

a. Create more diverse trading rooms: I am not a fan of diversity for the sake of diversity, but I think that opening up trading rooms to a wider range of people will dampen some of the excess risk taking. Maybe we should hire every trader's mother or grandmother to trade side by side with him; in fact, I would give her the next desk. Seriously, though, this will require investment banks to revamp their hiring processes and look more kindly on those "not cool" kids on campus who right now would not make the cut.

b. Restrict or eliminate proprietary trading: I know that proprietary trading is viewed as too lucrative to let go by banks, but I have my doubts as to whether it actually generates long term profits for any of its architects. One side cost of the increase in proprietary trading at banks has been the increase in house money that traders have to play with.

c. Information systems: To stop the "break even" effect from kicking in, we have to intervene much earlier when traders start losing money to prevent them from accelerating the cycle. To intervene, we need to know how much traders are making or losing in real time and have automated or computerized systems step in and stop trading at a defined loss point. Traders will try to devise ways around the system, but the system has to be responsive enough to adapt.



High dividend stocks: Do they beat the market?

I was browsing through the Wall Street Journal this weekend and came across this story about "high dividend" stocks:
http://bit.ly/b0MrBt
Briefly summarizing, the author argues that investing in five high dividend paying stocks is a better strategy for an investor than investing in an index fund, and that the "loss of diversification" is made up for by the higher returns generated on the dividend paying stocks.

It may be surprise you, but I don't disagree with the core of this strategy, which is not a new one. In fact, in what is known as the "Dow dogs" strategy, you invest in the five highest dividend yield stocks in the Dow 30. A more detailed sales pitch for this strategy can be found here:
http://www.dogsofthedow.com/
Over time, its proponents argue that the strategy would have paid off richly for investors.

To add even more ammunition to dividend seekers, studies over the last three decades have also shown that stocks in the top decline in dividend yield generate about 2-3% higher returns, after adjusting for risk, than the rest of the market. This newsletter nicely summarizes the evidence:
www.tweedy.com/resources/library_docs/papers/highdiv_research.pdf

So, is this a winning strategy? In my book, "Investment Fables", I have a chapter on this strategy which you can download by clicking below:
http://pages.stern.nyu.edu/~adamodar/pdfiles/invfables/ch2new.pdf
Briefly summarizing, I argue that as with all investment stories, there are caveats and these are the most significant ones for "dividend" heavy strategies:
1. Dividends are not legally binding: Unlike coupons on bonds, where failure to pay leads to default, companies can cut dividends without legal consequence. The fact that "dividends are sticky" and companies don't usually cut dividends does not take away from this point.
2. Higher tax liability: At least in the United States, for much of the last century, dividends have been taxed at a higher tax rate than capital gains. (Since 2003, the tax rates on the two have been the same, but that law is set to expire on December 31, 2010, returning us to the old tax laws).
3. May be "liquidating" dividends: When companies are in decline, they may pay large liquidating dividends, where assets are sold to fund the dividends. While these dividends are cash flows, they are not sustainable and will run out sooner rather than later.
4. Sector concentration: If you pick the highest dividend yield stocks across a market at any point in time, you may find yourself holding stocks in one or two sectors. In early 2008, for instance, you may have ended up with five banks in your portfolio. If there is a shock to that sector, your portfolio will collapse.
5. The market "knows" something you do not: Remember that the dividend yield for a stock shoots up almost always because the price drops, not because the dividend is increased. In other words, it is a sudden drop in the stock price that makes the stock look attractive. It is true that markets make mistakes, but it is also true that sometimes price drops of this magnitude occur because there is a serious problem looming on the horizon.

Here is how I would modify the strategy to protect myself against these three issues:
1. Look for companies with positive earnings, low debt burdens and high cash balances. They will be under less pressure to cut dividends.
2. Use this strategy for "tax protected" portions of your portfolio. Even in the US, investments made in pension plans are allowed to accumulate income, tax free. Even if you cannot pick individual stocks in your pension fund, you may be able to redirect the money to a high dividend yield mutual fund.
3. Steer away from companies with dividend payout ratios that exceed 80% and have negative revenue growth. That may help keep liquidating companies out of your portfolio.
4. Try for some sector diversification. In other words, classify companies at least broadly into sectors and look for the highest dividend yield stock in each sector, rather than across the whole market.
5. Check every news source that you can find for news stories or even rumors about the company. 

In short, buying high dividend yield stocks makes sense for a long-term, tax-advantaged investment. One point that I disagree on is that this strategy requires you to give up on diversification. I don't see why you cannot construct a reasonably diversified portfolio (of 30-40 stocks spread across sectors) of high dividend yield stocks.



Are complex models the answer?

There seems to be consensus that conventional economic models did a poor job predicting the magnitude of the last crisis and that we need to do better. In today's Wall Street Journal, we see the beginnings of one response:
http://online.wsj.com/article/SB10001424052702303891804575576523458637864.html?mod=WSJ_economy_LeftTopHighlights
In short, a physicist, a psychoanalyst and an economist believe that they can build a bigger model that captures the complexities of the real world and does a better job of forecasting the future. Good luck with that! While I wish them well, my response is that this will go nowhere or worse, go somewhere bad.

To those who believe that complex models with more variables are the answer to uncertainty, my response is a paper by Ed Lorenz in 1972, entitled Predictability: Does the flap of a butterfly's wing in Brazil set off a tornado in Texas?, credited with creating an entire discipline: chaos theory. In the paper, Lorenz noted that very small changes in the initial conditions of a complex models created very large effects on the final forecasted values. Lorenz, a meteorologist, came to this recognition by accident. One day in 1961, Lorenz inputted a number into a weather prediction model; he entered 0.506 as the input instead of 0.506127, expecting little or no change in the output from the model. What he found instead was a dramatic shift in the output, giving rise to a Eureka moment and the butterfly effect. (One of my favorite books on the topic of Chaos is by James Gleick. It is an easy read and well worth the time.. for investors and economists)

Complex models work best with inputs that behave in thoroughly predictable ways: software and engineering models come to mind.  They break down when the inputs are noisy and the relationships are unstable: macro economic models are perfect lab experiments for chaos. The subjects (human beings) belong in strange and unpredictable ways, the variables that matter keep shifting and the relationships between them change over time. In fact, I will wager that the models that worked worst during the last crisis were the most complex models with dozens of inputs and cross relationships.

So, what is the solution? My experience in valuation suggests that you should go in the other direction. When faced with more uncertainty, strip the model down to only the basic inputs, minimize the complexity and build the simplest model you can. Take out all but the key variables and reduce detail. I use this principle when valuing companies. The more uncertainty I face,  the less detail I have in my valuation, recognizing that my capacity to forecast diminishes with uncertainty and that errors I make on these inputs will magnify as they percolate through the valuation. More good news: if I am going to screw up, at least I will do so with a lot less work!!



The insider trading scandal: Thoughts about the hedge fund business

As many of you are aware, the last week has been filled with news stories about imminent arrests in an insider trading scandal that supposedly entangles multiple hedge funds and bankers at a couple of large investment banks. I am being leery about naming names, even though they are now in the public domain, since these selective leaks  can be devastating not only to the individuals named but also to the entities that they represent. While some may feel that "they" deserve this, I think we still live in a country where you are innocent until proven guilty.

So, I am going to use this story to talk about a bigger question. Not insider trading, because I have put my views on the topic down in a previous blog post, but about the hedge fund business. Note that many of the targets in this investigation are hedge fund managers. Since I have no reason to believe that hedge fund managers are any more immoral or unethical than any other random group of money managers, the question then becomes: What is it about the hedge fund business that seems to drive this constant search for an information edge? Or why do we not see more traditional mutual fund managers involved in these scandals?

At first sight, hedge funds and mutual funds share much in common. They both solicit money from investors, promising to deliver above-market returns to them and they get compensated for managing this money. But there are three significant differences:
1. Constraints on investing: Mutual funds are far more constrained in where and how they invest than most hedge funds are. Some of these constraints are imposed by regulators, some are self imposed and some are the created by clients.
a. Long versus long/short strategies: Most mutual funds can only buy stocks (The Investment Company Act of 1940 that governs mutual funds puts significant restrictions on short sales by funds), whereas hedge funds often can both sell short on some stocks and go long on others.
b. Investment choices:  There are several mutual funds that are judged based on "tracking error", measured by how far their returns deviate from a specified index's return. This constraint, usually imposed by clients, is designed to prevent fund managers from straying too far from the companies in the index. Hedge funds generally can invest not only in whatever company they want but many invest across asset classes.


2. Clientele mix: Hedge funds attract investments from either the very wealthy or institutions (pension funds, for instance). In fact, most of them actively discourage small, individual investors by requiring a large, minimum investment. Mutual funds tend to attract individual investors. At the risk of a gross generalization, institutional and wealthy investors are more demanding than individual investors; they move their money out of loser funds and into hot funds far more quickly than other individuals do. Put another way, if the herding effect is a phenomenon that affects all investors, it seems to affect wealthier and institutional investors more. (Some hedge funds put withdrawal restrictions on investors to counter.)

3. Financial leverage: Hedge funds are far more likely to use borrowed money to lever their bets. Most mutual funds either do not borrow money or do so on a very restrictive basis.

4. Compensation systems: Mutual funds generally make their money in two ways. All mutual funds cover their expenses from the money under management; the management; these management expenses are public information and can be accessed at services like Morningstar. A subset of funds also assess a one-time up-front sales charge (load), when you invest, where a certain percent of what you invest is taken by the fund at the time of the investment. Hedge funds assess an annual load (1% or 2% of the invested amount each year) and a percentage of the profit on the investment (10 or 20% of the profits).

You may be wondering at this stage what all of this has to do with insider trading. Consider why people seek out insider information. If they succeed, they can buy or sell a stock prior to that information becoming public; when it goes public, the stock will pop up or down, depending on whether the information is good or bad news.

All four differences highlighted play into why hedge fund managers see more gain from seeking out and exploiting private information:
  1. Hedge funds can exploit both good news and bad news, by buying stocks in advance of the former and selling short ahead of the latter. Mutual funds can only buy on good news (though they can sell any existing holdings of companies on which bad news lies ahead).
  2. While money management at any level is a rat race, where funds try to keep their own clients and coax clients away from their competitors, the race becomes more frenetic with hedge funds. A hedge fund that lags its peer group can enter a death spiral, where losses spur withdrawals which feed into more losses.
  3. If the "inside information" is precise, you can use even more debt in your investment strategy, creating huge payoffs on your investment, when the information becomes public. Financial leverage acts as a multiplier on profits from insider trading.
  4. The compensation system at hedge funds essentially gives every hedge fund manager a call option: they make 10 or 20% of all profits, no matter how large, and do not share in losses. Trading on information ties in well with this system, since it delivers skewed returns: most of the time, information turns out to be worthless, but when it is relevant information, the payoff is very large. Thus, even if insider information is noisy and provides little benefits or even creates costs for investors over the long term, hedge fund managers may still benefit personally from its use because of the upside call built into their compensation systems...
In summary, hedge fund managers are far more likely to be "information traders" than mutual fund managers and "insider information trading" happens to be one of the more lucrative (albeit illegal) manifestations of the same. So I am not surprised to see them ensnared in insider trading scandals more frequently. (I think the clustering of hedge funds around Stamford, Greenwich and other old-wealth Connecticut towns also adds into the mix. I would assume that there are hedge fund managers constantly rubbing shoulders with each other in every expensive restaurant in those towns...  trading stories and comparing returns...

In closing, though, I am not sure that all of this seeking out of information is generating a payoff for hedge funds. In the aggregate, they continue to either match or under perform actively managed mutual funds (which, in turn, under perform index funds), when fees and transactions costs are factored in. It is entirely possible that some of the "super" performers among hedge funds got there because they had access to private information that no one else had. I just don't think it is likely! As Shakespeare would put it, this seems like much ado about nothing!



How do you evaluate risk taking?

The GM IPO is the news of the week. The fact that GM has been able to go public and that the government may not only get its money back on its investment but may even make a profit has led to some celebration in the White House:
http://www.whitehouse.gov/photos-and-video/video/2010/11/18/president-obama-gm-ipo
I don't begrudge the White House its victory dance that the GM bet looks like it has paid off, but it is an auspicious moment to examine how we judge risk taking, in general. As I see it, risk taking can be judged on four dimensions.

1. Outcome: The nature of risk taking is that you win some of the time and lost some....  It is human nature to judge the quality of risk taking by looking at the outcome of the risk taking. Success is thus vindication and failure is calamity. If you follow this to its logical ends, if you succeed, you are a good risk taker and if you fail, you are not. This is the theme that is being tapped into by both Warren Buffet when he wrote his thank you note to the government for TARP and by the White House for its GM investment. "Things worked out well in the end... So, it must have been  a sensible decision up front"...


2. Process: A more complicated way of judging risk taking is to look at whether the risk taking made sense at the time that the risk was taken, with the information available at the time,  rather than with the benefit of hindsight. At least in theory, it is possible that even the best-deliberated risky decisions can have bad outcomes, if fate does not cooperate, and that terrible choices when faced with risk can have "good" outcomes. Playing devil's advocate, however, it is much more difficult and more work to evaluate process than outcome.

3. Side costs and benefits:When risk taking creates costs and benefits for others, judging risk taking by its outcome for just the risk taker may not be fair, since it is conceivable for risk takers to make money while creating costs for society. It is also possible for risk taking activity to create losses for the risk takers while generating benefits for society. A fair assessment of risk taking will require us to consider these side costs and benefits into account.

4. Future risk taking behavior:It should not be surprising that how we take and reward/punish risk taking in the present can affect how people take risks in the future. If risk taking of a certain type consistently is rewarded, you will see more of it in the future. If in contrast, risk taking of a different type leads to punishment/losses, you will see less of it in the the future. If markets are viewed as "too easy" on risk takers, there will be more risk taking in the future in the future.

When does it make sense to judge risk taking on outcome alone? If a risk taker takes many risks over time and is right on average on a consistent basis and there are no significant side costs and benefits, it is reasonable to argue that success is the result of good risk taking.  A portfolio manager who beats the market each year for 10 years must be doing something right in terms of risk taking. However, judging a large risk taking venture with significant side costs and benefits and consequences for future risk taking on whether it makes money or not may not be sensibel.

Returning to the GM investment, the judgment on whether it was successful becomes more nuanced when we consider the other factors, even if the government's original investment makes money.

a. Did the government investment in GM make sense at the time of the investment, given what was known then? Tough to tell, since we do not know what the government knew at the time of the intervention. Given what the rest of us knew at the time, it would have been difficult to justify the billions invested in the company. However, it is possible that the authorities had information about GM's assets and liabilities that we did not. So, I will give the benefit of the doubt to the government on this point.


b. What were the side costs and benefits of the government investment? On the plus side , GM's salvation prevented thousands of layoffs at the company and budgetary chaos at at least one state (Michigan). On the minus side, the government's intervention on GM's behalf has cost other carmakers a chance to make inroads in this market. To the extent that the other car makers are foreign (Toyota or Honda), this may seem like a good thing, but the belief in free markets cannot stop at the borders. It is also conceivable that GM's salvation may have cost Ford a chance to make inroads into the market and secure its position for the long term.

c. What are the long term lessons for risk taking behavior?
It is undeniable that GM made some really bad strategic and management decisions in the the last three decades. In the face of default, the government stepped in, upended bankruptcy and tax laws (which conveniently were written and interpreted by government officials) and saved the company. Other firms that took more prudent decisions in the face of risk were put at a disadvantage. It would seem to me that the lessons learned on risk taking from this experience are the wrong ones: if you take risks, make sure that you are a big firm with the right connections.

Bottom line. As a taxpayer, I am happy that the GM investment looks like it will break even or better.. As an investor, I am less happy about the long term consequences of this success. I am afraid that it sends the wrong signals on risk taking to the market and investors.



Amateur Athletics

This post spans two topics I love - finance and sports- and what triggered it was the hullabaloo over Cam Newton, Auburn's quarterback, and the purported attempts by his father to extract money from Auburn. The National Collegiate Athletic Association (NCAA) will be the ultimate arbiter on whether rules were broken and the penalties that will follow, but this entire debate about college sports strikes me as hypocrisy of the highest order.

Let us start with basic facts. College sports in the United States is big business and big money, generating hundreds of millions of dollars in revenues for the big name colleges, the television networks and bookmakers. I got my MBA and Phd at UCLA and I know that no faculty member at UCLA brought in a fraction of the revenues that the UCLA basketball coach did and none was as widely recognized in campus. In college football, Auburn is ranked second in the country and could very well be playing for a national championship this year. The New York Times has an article on the impact that Cam Newton at quarterback has had on Auburn's economics:
http://www.nytimes.com/2010/11/14/weekinreview/14belson.html


Here comes the hypocrisy. The NCAA likes to maintain the illusion that college sports is not  business and that college players are amateurs. While this may in fact be true for most athletes at second and third tier schools, playing lower profile sports, it is certainly not true for college football and basketball at Division I schools. The NCAA then has rigid rules on what college players can receive in return for playing their sports: not only can they not get monetary gifts from the school but the ban extends to cover the most trivial of gifts. From an economic standpoint, this strikes me as a modern version of indentured servitude. If you are a superb basketball or football player, you have to play for a college of your choice (that is the NCAA's concession to free choice) for nothing, before you can play professional football or basketball. The colleges and the networks make millions but the players (who are the stars of the system) get scholarships, worth a few thousands and risk career ending injuries while doing so.

As I watch the "amateur" label debated in college athletics, I am reminded of similar debates that occurred in tennis and the Olympics. For decades, we kept our best tennis players out of the big tournaments in the interests of maintaining the illusion that these tournaments were just for amateurs; I can only imagine how many Wimbledons that Rod Laver would have won, if he had been allowed to play in his prime. For decades, the Olympics forced great sprinters and athletes to pick between being champions and making a living, before bowing to the reality that you cannot win the 100M by practicing just on weekends.
Don't get me wrong. I love college sports, but I think it is time to strip the hypocrisy out. My proposal is that we create two classes of college athletes: The first would be "student athletes", who get scholarships, but focus on taking classes (regular classes, not Mickey Mouse ones) like other students and get college degrees. Some of them may find that they are good enough to become professional, but most of them will play college sports and then move on to bigger and better things in life. The second would be "semi-pro" athletes, who will be allowed to earn an income (we can put caps on the income and restrict what colleges can pay, if need be) while they played and earn money from advertisements and sponsorships. They would be required to be visible on campuses and allowed to take classes, if they choose to.  Colleges would also be required to set aside a portion of their revenues to cover the health and personal costs incurred by college athletes. I think I would still enjoy watching UCLA play basketball... while knowing that the Bruins on the court are making a reasonable living while playing the game.



The secret to investment success: Self Awareness?

I know that there are many who claim to have found the secret ingredient to investment success, though few actually deliver. However, I want to present an unconventional ingredient that I think most academics and practitioners miss when they talk about investment strategies: your personal make-up as an individual.

In one of my books, Investment Philosophies, I start with a puzzle. There are many different investment philosophies out there and they range the spectrum both in the tools they use (charts for some, fundamental analysis for others..) and their views on markets (markets learn too slowly, markets over react). In fact, some of these philosophies directly contradict others. But there are two puzzles. The first is that there are a few investors within each philosophy who have succeeded in using that philosophy to great effect over their lifetimes: there have been successful technical analysis, value investors, growth investors and market timers over the last few decades. The second is that within each philosophy, success seems to be elusive for most of those who try to imitate the Warren Buffets and Peter Lynchs of the world.

My explanation for the puzzle. Every investment philosophy works but only for some investors and not all of the time, even for them. Each investment philosophy requires a perfect storm to succeed: not only do the times and circumstances have to be right for the philosophy but the investors using it have to be psychologically attuned to the philosophy.

Consider, for instance, the investment philosophy that many argue is the best (or at least the most virtuous) investment philosophy for all investors. Good investors, they claim, invest long term in companies that are fundamentally under valued, usually in the face of market selling. Here is the problem. The strategy sounds good and makes money on paper but requires three ingredients from investors for success: a long time horizon, a strong stomach and a willingness to go against the grain. If you are an impatient investor, who has a worry gene and care about peer pressure, adopting this strategy will be a recipe for disaster. Not only will you end up abandon your investments well before they pay off, you will make yourself miserable (and physically sick) in the meantime. For this investor, a short term momentum strategy makes a lot more sense.

As you think about what investment philosophy is right for you, here are some things about yourself that you may want to think about:
1. Are you a patient or impatient person?
2. How do you respond to peer pressure?
3. Are you a "worrier"?
4. Are you a details person or a big picture person?
A little self introspection will pay off much more than investing your money in another "get rich quickly" book or investnebt  idek, 

Ultimately, what I am arguing is that there is no one best investment philosophy that works for all investors. The right investment philosophy for you will depend upon your time horizon as an individual and what you believe about how markets make mistakes. In the table below, I list the investment philosophy that fits best given your time horizon and views on the market:


Momentum
Contrarian
Opportunisitic
Short term (days to a few weeks)
·      Technical momentum indicators – Buy stocks based upon trend lines and high trading volume.
·      Information trading: Buying after positive news (earnings and dividend announcements, acquisition announcements)
·      Technical contrarian indicators – mutual fund holdings, short interest. These can be for individual stocks or for overall market.

·      Pure arbitrage in derivatives and fixed income markets.
·      Tehnical demand indicators – Patterns in prices such as head and shoulders.
Medium term (few months to a couple of years)
·      Relative strength: Buy stocks that have gone up in the last few months.
·      Information trading: Buy small cap stocks with substantial insider buying.
·      Market timing, based upon normal PE or normal range of interest rates.
·      Information trading: Buying after bad news (buying a week after bad earnings reports and holding for a few months)
·      Near arbitrage opportunities: Buying discounted closed end funds
·      Speculative arbitrage opportunities: Buying paired stocks and merger arbitrage.
Long Term (several years)
·      Passive growth investing: Buying stocks where growth trades at a reasonable price (PEG ratios).
·      Passive value investing: Buy stocks with low PE, PBV or PS ratios.
·      Contrarian value investing: Buying losers or stocks with lots of bad news.
·      Active growth investing: Take stakes in small, growth companies (private equity and venture capital investing)
·      Activist value investing: Buy stocks in poorly managed companies and push for change.



QE2 or the Titanic?

The big news of the moment (other than the election) is the Fed's decision to inject $ 600 billion into the economy, as a monetary stimulus to get the US out of a recession. Here is Bernanke's rationale:
http://www.washingtonpost.com/wp-dyn/content/article/2010/11/03/AR2010110307372.html

Will it work? For a monetary stimulus to actually stimulate the economy, it has to change how consumers behave. Since consumers do not get any of the cash directly, the only instrument that the Fed can hope to affect is interest rates. In theory, the monetary stimulus will push down interest rates and thus unleash more borrowing by consumers and companies. I see four problems:

1. Level of interest rates: If short term rates were 5% and long term rates were 7%, I can see the potential for lower interest rates inducing more borrowing and higher consumption. But short term rates are already close to zero and long term rates are at historic lows. If people are not borrowing money at 4% (long term mortgage rates are down to that), what makes the Fed think that a 3.5% rate will induce them to do so? As for companies borrowing money, why should they when they are sitting on huge cash balances?

2. Existing leverage: The average US household already has too much debt, some of it reflecting a hang over from excessive credit card and other borrowing in the good times and a great deal of it a result of the housing boom and bust. Assuming QE2 works, is it a good idea to induce consumers to borrow more? It may create some short term growth, but are we not setting ourselves up for the next bubble bursting?
3. Inflation fears: The power of monetary stimulus rests on the credibility of the central bank. If investors trust the central bank to keep inflation in check in the long term, they will respond to the stimulus by lowering interest rates. If, on the other hand, that trust is lost, a stimulus can actually be counter productive. The pumping of money into a system that is already flush with cash and facing potential deficits down the road will raise the inflation bogeyman, which in turn will push up interest rates. I am not convinced by Bernanke's twin rejoinders: that existing inflation is very low and that the last stimulus did not create inflation. That was because the last stimulus did not work. If this one does, then what?

4. Currency devaluation: Related to inflation fears is the effect on the US dollar, which has been under selling pressure for a while. A dollar devaluation will also make imported goods more expensive in the US, and given the trade deficit, that has to feed into price increases in the future.

Having listed these concerns, I must confess I am not a macro economist (and have no desire to be part of that crew). The Fed presumably has access to "experts", who have thought through all of these issues and decided that the benefits overwhelm the costs. At least, I hope so...

I don't know about you, but I am starting to wonder about these multiple stimuli. Using the analogy of the emergency room,  those electric paddles used to shock a faltering heart back into a rhythm are a godsend for someone with cardiac arrhythmia, but I also know that they sometimes do not work. That is when the cardiac surgeon is called in for more radical remedies or worse. To stimulate the US economy, we tried QE1 and it did not work, we tried FS1 (Fiscal Stimulus 1) and it did not work either. Now we are trying QE2  and if we listen to Paul Krugman (who must be having seances with Keynes every night), we should try mega FS2 next...Perhaps, it is time to accept the reality that there is something fundamentally wrong with the economy that stimuli will not fix. And perhaps, it is time to call in the surgeons! (Let's not even think about the other alternative)

And for those of you who may be wondering about the title of this post, here is the original QE2.





Corporate finance in illiquid markets

In corporate finance, we examine how a business decides what investments to take (the investment decision), how much to borrow to fund these investments (the financing principle) and how much to return to stockholders (the dividend principle), if it wants to maximize its value. Traditional corporate financial prescriptions on each of these dimensions assume that both capital and asset markets are liquid. Introducing illiquidity into the process changes the game in significant ways.


a. Investment Principle: In most corporate finance books, the capital budgeting chapters wend their way through familiar territory. The best decision rule for investment analysis for a value-maximizing firm is the NPV rule and firms should accept all positive net present value investments. Within the NPV rule, you estimate expected cash flows on each investment and discount these cash flows back at a risk-adjusted rate. The expected cash flows are assumed to be available to the firm (to reinvest elsewhere or to pay dividends) and the risk adjusted for in the discount rate is macroeconomic or market risk.

How would introducing illiquidity alter this process? First, illiquid capital markets limit access to external funds (from both equity and debt) and may act as an impediment to taking every positive NPV investment. Second, if not all positive net present value investments can be accepted, the firm is better off getting the most bang for the buck. Thus, using a percentage return such as IRR to judge investments, instead of NPV, may allow a firm to generate the most value. Third, not all cash flows are equally liquid. Firms can be restricted in their use of cash flows, if they face regulatory or lender-imposed constraints or invest in countries with remittance restrictions.  Finally, the discount rates (costs of equity and capital) will be higher for firms, if there is illiquidity, since there will be transactions costs associated with raising money. Firms facing more liquidity constraints are therefore less likely to take longer term infrastructure investments, with large negative cash flows up front and positive cash flows on the back end.


b. Financing Principle: The optimal mix of debt and equity for a firm is the one that maximizes its value. If we hold operating cash flows fixed, this is usually achieved when the cost of capital is minimized. In conventional corporate finance, then, the optimal financing mix is the one that minimizes the overall cost of capital, with neither the cost of equity and debt reflecting liquidity concerns. In the APV approach, it is the dollar debt level that maximizes value, after taking into consideration the tax benefits of debt and expected bankruptcy costs.

Using both the cost of capital and APV approaches, bringing in illiquidity into the equation will alter the dynamics. Illiquidity will push up both the costs of debt and equity and the effects on the optimal debt ratio will then depend on whether the equity or the debt market is more illiquid. If the equity market is illiquid and the debt market (bonds or bank loans) is liquid, the optimal debt ratio will rise in the face of illiquidity. In contrast, if the equity market is liquid and the debt market is not, the optimal debt ratio will fall as liquidity concerns rise. In the APV approach, illiquidity will raise both the probability of bankruptcy (since distressed firms will be unable to raise new financing to keep going) and the cost of bankruptcy (since assets will have to be sold at much bigger discount in an illiquid asset market). The net effect should be a decline in the use of debt by illiquid firms.


c. Dividend policy: There are two big questions that animate the dividend principle: How much cash should you return to stockholders (and how much should you hold back)? What form should you return the cash in, dividends or stock buybacks? In conventional corporate finance, firms are advised to return any cash that they have no use for in the current period back to stockholders, since it is assumed that they can return to liquid capital markets and raise new funding. It follows that cash balances should be minimal. And the form in which cash gets returned will be a function of investor taxes. If dividends and price appreciation are taxed at the same rate, investors should be indifferent between the two. If dividends are taxed more highly, firms should use stock buybacks.

Introducing illiquidity into this decision changes the answers to both questions. Firms that are more concerned about illiquidity should return less cash to stockholders and hold back more cash. Thus, you would expect cash balances to be higher at small and emerging market companies or during liquidity crises. The evidence seems to back this proposition. Investors faced with illliquid markets will value dividends more, simply because they represent cash in hand, whereas price appreciation is more risky (since you have to sell your stock to get it). Consequently, you should expect dividends to rise in the face of higher illiquidity, while stock buybacks to fall off.

In summary, you should expect firms in illiquid market to invest less in long term projects, to use less debt to fund these investments and to accumulate more cash, while paying out more in dividends.

I have a paper on the effects of illiquidity on financial theory, where I look at the implications for corporate finance in more detail:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1729408



Making money off illiquidity: Two Strategies

At first sight, illiquidity is bad news for investors, since it gives rise to transactions costs, which, in turn, can lay waste to investment strategies. In a post from a few months ago, I examined how transactions costs can explain why so many strategies that look good on paper don't deliver their promised upside.

However, in this post, I want to take the "glass half full", optimistic view of the phenomenon. Illiquidity or potential illiquidity is not all bad news for investors. After all, to beat the market, you have to have an edge over other investors and here are two competitive advantages that can be created out of illiquidity.

a. Illiquidity arbitrage: Not all investors value liquidity equally. To the extent that you need or care about liquidity less than the typical investor in the market, you should be able to exploit this difference to make money. How? Wait for a period of illiquidity (either on the entire market or on an individual stock), where asset prices are marked down by typical investors, who observe the illiquidity and price it in. Then, step in and offer to buy assets. You will get these assets at a bargain price (from your perspective) but at a fair price (from the perspective of the median market participant). Wait for the illiquidity to ease and then sell the asset. This may very well be the biggest weapon that an old-time value investor brings to the market. In fact, Warren Buffet did exactly this type of bargain hunting during the banking crisis of 2008, taking large positions in Goldman Sachs and GE, during their most illiquid days. (I know... I know.. technically, this strategy is not arbitrage, since it is not riskless.. )

"This is easy. I too can be a liquidity arbitrageur", you may say, but it is easier said than done. There are two factors that are at least partially under your control. The first is the use of financial leverage in your investment strategy. Borrowing money to fund investments may increase your expected upside, if things go well, but it also increases your need for liquidity.  The second  is a combination of patience and a strong stomach. Buying during periods of illiquidity will expose you to down side risk, at least in the short term, and you have to be able to ride it out. But the desire for liquidity is also a function of  factors that are not  in your control. First, if your income stream is stable, predictable and in excess of your spending needs (Do you have tenure?) and you have have less need for liquidity. Second, it is subject to what I will loosely term "acts of God". A sudden illness, accident or unforeseen event (Did you invest with Bernie Madoff?) may quickly eliminate whatever buffer you thought you had. Third, if you manage other people's money, it is their need for liquidity that will drive your decisions, not your own. It is one significant advantage that you and I have on the most skilled portfolio manager.

b. Illiquidity timing: Both the level of illiquidity and the price demanded for it change over time in the market. An investor who can forecast changes in illiquidity well can profit off these changes. But how does forecasting liquidity translate into a payoff? You have to be able to shift into liquid assets, before the market becomes illiquid, and into illiquid assets, ahead of periods of liquidity. With the former action, you cut your losses and with the latter, you gain as the illiquid asset regain their value. This is particularly true, if you use financial leverage and invest in illiquid assets, as many hedge funds do. In fact, one study argues that liquidity timing may be one of the biggest competitive advantages in the hedge fund business.

How do you get to be a good liquidity timer? First, you have to track not just the standard investment measures - multiples and fundamentals - but also liquidity measures - trading volume, short selling and bid-ask spreads. In fact, those technical indicators that fundamentalists view with such contempt, such as trading volume and short sales, may be useful in detecting shifts in liquidity. Second, you have to be clear about how exposed an individual asset is to market shifts in liquidity - a liquidity beta, so to speak. In my extended paper on liquidity (linked below), I describe ways in which you may be able to estimate this beta.

For more on liquidity betas and the potential for making money off illiquidity, you may want to look at this paper that I just posted on liquidity and its effects on financial theory and practice:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1729408



Asset selection & Valuation in Illiquid Markets

In my last post, I looked at how the asset allocation decision can be altered by differences in liquidity across asset classes, with the unsurprising conclusion that investors who desire liquidity should tilt their portfolios towards more liquid asset classes. Assuming that you have made the right asset allocation judgment, how does illiquidity affect your choices of assets within each class? In other words, if you have decided to invest 40% of your portfolio in stocks, how does illiquidity affect which stocks you buy?

To select assets within each asset class, you can either value each one on its fundamentals (intrinsic valuation), compare its pricing to how similar assets are priced (relative valuation) or price it as an option (contingent claim valuation). In each case, illiquidity can affect value.

 a. Intrinsic Valuation: There are many different intrinsic valuation approaches but they all share a common theme. The value of an asset is a function of its expected cash flows, growth and risk. In discounted cash flow valuation, for instance, the expected cash flows discounted back at a risk adjusted discount rate yields a risk-adjusted value. In conventional valuation, the expected cash flows are unbiased estimates of what the asset will generate each period and the risk adjustment is for non-diversifiable market risk (with equity) and for default risk (with debt). Nowhere in this process is illiquidity considered explicitly. Not surprisingly, we tend to over value illiquid assets.

So, how do you bring illiquidity into intrinsic valuation? There are two choices. The first is to estimate the risk adjusted value, using the conventional approach, and to then reduce this value by an illiquidity discount. That discount can be estimated by looking at  on how the market prices illiquid assets. For instance, studies have looked at restricted stock (stock issued by publicly traded companies that cannot be traded by investors for one year after the issue), pre-IPO transactions (where co-owners sell their stake in the months prior to an announced IPO) and companies with multiple classes of shares traded on different venues (with different liquidity characteristics). These studies generally yield large discounts (25-50%) for illiquid assets and  private company appraisers have generally used these studies to back up the use of similar discounts when valuing non-traded businesses. Perhaps, this approach can be extended to publicly traded companies.

The second is to adjust the discount rate for illiquidity, pushing it up for illiquid companies. The illiquidity premium added to the discount rate is usually estimated by looking at the past. In its crudest form, you can assume that the premium that small cap companies or venture capitalists have earned over the market (about 3-4% on an annual basis over the last few decades) is due to illiquidity and add that number on to the cost of equity of any "illiquid" company. In its more sophisticated version, the adjustment to the discount rate can be linked to a measure of illiquidity on the company - its turnover ratio, trading volume or the bid-ask spread. One study concludes that every 1% increase in the bid-ask spread pushes up the discount rate by 0.25%. Thus, the cost of equity for a stock with a beta of 1.20 and a bid-ask spread of $0.50 (on a stock price of $ 10), with a riskfree rate of 4% and an equity risk premium of 6% is:
 Cost of equity = 4% + 1.20 (6%) + 0.25% (.5/10) = 12.45%
With both approaches, the value will decrease with illiquidity.

 b. Relative Valuation: In its most common form, relative valuation involves screening the market for cheap companies, with one screen for pricing (low PE, low price to book, , low EV/EBITDA) and one or more for desirable fundamentals (high growth, low risk, high ROE). If you ignore illiquidity, your cheap stock portfolio will end up with a lot of illiquid stocks. The simplest way to incorporate illiquidity is to add it as a screen. Thus, in addition to screening for high growth and low risk, you could also screen for high liquidity (high float, high turnover ratios, low bid-ask spreads, high trading volume etc.). The tightness of the liquidity screen can then be varied to fit your liquidity needs as an investor.

 c. Contingent Claim Valuation: All option pricing models are built on two principles: replication (where a portfolio of the underlying asset and a riskfree investment is created to have the same cash flows as the option) and preventing arbitrage (the replicating portfolio and the option have to trade at the same price) . Both principles require liquidity: you be able to trade the option, the underlying asset and the riskfree asset in any quantity and at no cost. Illiquidity in any one of these markets will throw a wrench into the process and cause the option pricing models to yield incorrect values, with the imprecision increasing with illiquidity. So, what are your choices for bringing illiquidity into the process? You can try to modify the models to incorporate illiquidity explicitly but option pricing models are complicated enough already and this adds an additional layer of complication. Alternatively, you can adjust the inputs into the option pricing model. My choice would be the underlying asset value (S): using a lower value for illiquid underlying assets will reduce the value of call options on those assets.

In summary, no matter which approach you use, illiquidity is not a neutral factor. The investments you make within each asset class will reflect both the illiquidity of the investment and your own liquidity needs (and preferences) as an investor.

I have a paper on the effects of illiquidity on financial theory, where I examine the effects of liquidity on valuation in more detail:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1729408



Asset allocation for illiquid markets

In my last post, I argued that illiquidity is not a minor problem restricted to a few stocks. In fact, it can affect all stocks, at least during some time periods, with its effect varying across stocks. I also noted that much of financial theory is built around the presumption that markets are liquid.

So, how would financial theory and practice change, if illiquidity is explicitly incorporated into the process? Let's start with the first step in investments, asset allocation, where you decide how much of your overall wealth you will invest in different asset classes - treasuries, corporate bonds, stocks, real estate, collectibles. In fact, defining asset classes loosely, private equity, hedge funds and mortgage backed securities can be considered new entrants in the game, vying for portfolio dollars.

In the classic mean variance framework, the optimum asset allocation mix is the one that maximizes expected returns, given a risk constraint. Thus, you feed in the expected returns and standard deviations of different asset classes, in conjunction with their covariances with each other, and let optimization work its magic. Here is the catch. The average returns, standard deviations and correlations all come from historical data. With illiquid asset classes, standard deviations tend to be under estimated (for a completely illiquid asset, there will be no trading and the standard deviation will be zero) and the covariances consequently will be misestimated. In fact, the least liquid asset classes often look like they offer the best risk/return tradeoffs, if you don't control for illiquidity. Plugging these values into the optimization framework will generate weights that are too high for the illiquid asset classes, for the typical investor. In the last decade, especially, this has led many endowment funds to over invest in real estate, private equity and hedge funds, categories notoriously over exposed to the vagaries of illiquidity.

So, how would you bring illiquidity into the mix and what are the consequences? There are two routes you can follow. In the first, you adjust the expected returns of illiquid asset classes downwards to reflect the expected cost of illiquidity.  That would make these asset classes less desirable and counter act the underestimation of standard deviations. The other is to restate the optimization problem thus: Maximize expected return subject to the constraints that risk be below a "stated" level and that liquidity be greater than a specified constraint.


With both approaches, the "right" asset allocation mix will vary across investors. Investors who desire or need more liquidity will tilt their portfolios towards more liquid asset classes (large market cap stocks, highly rated corporate bonds) . Investors who value liquidity less may actually gain by tilting their portfolios away from more liquid asset classes towards less liquid ones (real assets, small cap and low priced stocks, low rated corporate bonds).

I have a paper on the effects of illiquidity on financial theory, where I look at asset allocation in more detail:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1729408



All assets are illiquid

Much of financial theory is built on the premise that markets are liquid for the most part and that illiquidity, if it exists, occurs in pockets: it shows up only with very small, lightly traded companies, emerging markets and privately owned businesses. In fact, almost the prescriptions we provide to both investors and corporate finance reflect this trust that both security and asset markets are liquid.

To see how unrealistic the assumption of liquidity is, consider what a liquid market would require: you should be instantaneously be able to sell any quantity of an asset at the prevailing market price with no transactions costs. Using that definition, no asset is liquid and the only question then becomes one of degree, with some assets being more liquid than others.

Given the premise that all assets are illiquid, here is a follow up question: how do you measure illiquidity? One obvious measure, especially in securities markets, is the total transactions costs, including not only the brokerage costs, but the bid-ask spread and the price impact from trading. The other is waiting time. In real estate, for instance, illiquidity manifests itself in properties staying on the market for longer periods. Days on market (DOM) is a widely reported statistic in real estate and is used to measure the health (and liquidity) of different markets.

There is significant empirical evidence that illiquidity varies across asset classes, within assets in a given asset class and across time.
  • Across asset classes, illiquidity is more of a problem in real asset markets (real estate, collectibles) than in financial asset markets. Within financial asset markets, the US treasury market is the most liquid, followed by highly rated bonds and developed market stocks, with low-rated (junk or high yield) bonds and emerging market stocks bringing up the rear.
  • Within each asset class, there are wide variations in liquidity. In the treasury market, the just-issued, standard maturity treasuries (3 month, 6 month, 10 year) are more liquid than the seasoned, non-standard maturity treasuries. Within the stock market, larger market cap and higher priced stocks are more liquid than smaller market cap, lower priced stocks.
  • Liquidity also varies widely over time. While the long term trend in liquidity in equity markets has been towards more liquidity, liquidity moves in cycles, increasing in bull markets and decreasing in bear markets. Punctuating the long term trend are crises, like the 1987 sell-off in the US and the 2008 banking crisis, where liquidity dries up even for the largest market cap companies. During these crises, illiquidity manifests itself in many ways: trading halts, higher bid-ask spreads and bigger price impact when trading.
None of this evidence would matter if investors did not care about illiquidity but there is clear evidence that they do: liquid treasuries have lower yields (and higher prices) than illiquid treasuries and investors demand higher returns on stocks with lower trading volume and higher bid-ask spreads. One study find that every 1% increase in bid-ask spreads increased expected returns by 0.25%, and these higher required returns push down asset prices. Adding to the problem, the price that investors charge for illiquidity also varies over time, spiking during periods of crises: illiquid assets get discounted even more during these periods.

If illiquidity varies across asset classes, across assets and across time, and investors price in this illiquidity, it seems prudent that both portfolio  and corporate financial theory be modified to reflect the potential for illiquidity. Alas, given the length of this post, that has to wait for the next one.



Tax policy

As some of you may be aware, I report average effective tax rates for US companies, by sector, at the start of every year. Yesterday, that data was picked up by the New York Times and has got plenty of publicity since.
http://www.nytimes.com/2011/01/28/us/politics/28tax.html?_r=1
Today, I have heard from both sides of the debate. from tax lobbyists  that feel that the low tax rates reported for some sectors do not reflect reality and also from those who believe that companies in the US don't pay their fair share.

Before I dive in, I want to be clear that the tax rates on my website were never intended for a tax policy debate. My interests are more mundane - computing cost of capital and value - and tax rates are raw material that I use to these numbers. Here is how I compute the averages. I compute the effective tax rate for a company by dividing its taxes paid by the taxable income; if the company is losing money and pays no taxes, I set its tax rate to zero.  For my purposes, I need an average tax rate for all companies in a sector, money making as well as losing, to compare valuation multiples and costs of capital across sectors. That is the number (a simple average of effective tax rates for all firms in a sector) that was reported on my site and picked up by others.

However, that average may not be an indicator of what a profitable firm in that sector pays as taxes, especially if there are  large numbers of money losing firms (as is the case with the biotechnology sector). To remedy this, I have decided to expand my tax rate table to include an additional statistic - an average tax rate for only money making firms. If you get a chance, you can see the data here and download it.
http://www.stern.nyu.edu/~adamodar/pc/datasets/taxrate.xls
Note that these tax rates are much higher than the original averages. The average tax rate across companies that have taxable income is more than 29%, whereas the overall average across all firms (including the money losers) is just above 15%.

You can draw your own conclusions from the data, but here is my reading:
1. The average US company pays its "fair share" of taxes: I know that there will be many who disagree with me on this premise but the facts back me up. I computed the average effective tax rate for companies globally and here is what I got:
 
Global Region Number of firms Effective tax rate Taxes as % of Revenues
Australia, NZ and Canada 3834 26.65% 3.38%
Developed Europe 4818 28.49% 2.51%
Emerging Markets 17079 21.63% 3.15%
Japan 3584 38.30% 2.39%
United States 5472 29.35% 3.01%
World 34787 27.17% 2.82%
The average money-making firm in the US pays about 29% of its taxable income in taxes, which is higher than the tax rate paid by most European, Asian or Latin American companies. Only Japanese companies have higher effective tax rates.To be fair, the taxable income may be lower in the United States than in other countries because of sundry deductions, but here is a comparison that dispenses with this problem. The average US company pays 3% of revenues in taxes, roughly similar to what companies in other countries pay.
2. There is much higher variance in tax rates across companies in the US than in other countries: Here is where I think our excessively complicated tax code has an effect. There is much higher variance across the tax rates paid by companies in the US, as companies in some sectors are given tax deductions and credits and others are not. I will wager that US companies spend more on tax lawyers and consultants than companies elsewhere.
3. There is a much bigger difference between the effective and marginal tax rate in the US than in other countries.  Note that the average effective tax rate across companies is less than 30% whereas the marginal tax rate in the US is close to 40% (with state and local taxes). The difference is far smaller in countries with simpler tax codes. In Japan, for instance, the marginal tax rate is 41% but the average effective tax rate is 38%.

Having laid that data question to rest, here are my thoughts on the tax policy questions, for what they are worth.
1. Investment decisions should be driven by economics and not the tax code:   The more complexities (and goodies) that we build into the tax code, the more we risk having investment decisions determined by tax law and not by economics.  I would rather have all companies pay a 25% tax rate on taxable income, with no special deductions and credits, than have an average tax rate of 25% with wide variations across investments and companies.
2. Borrowing decisions are driven by marginal tax rates: Decisions by firms on how much to borrow are driven by the marginal tax rate and having a high marginal tax rate will induce more borrowing across the board. If you use load the tax code with deductions and credits, you have to raise the marginal tax rate to compensate and with it, you raise the amount of debt that companies will carry. If we truly want to bring down financial leverage at US companies, we have to start by making the marginal tax rate lower.

Do I think that this latest move to simplify the tax code and lower tax rates will work? I am not hopeful and here is why. To keep that change revenue-neutral, we also have to start stripping the tax code of some of the deductions and credits. Unfortunately, that will make it a zero-sum game, at least in the short term, where some sectors will have to pay more in taxes while others will save. In the long term, I believe it will make the economy stronger, but who has the patience of the long run, when it comes to taxes?



Buybacks and Stock Prices: Good or bad news?

XYZ Inc., a publicly traded company, has the following characteristics:
a. 100 million shares trading at $ 10 a share. (Market cap = $1000)
b. A cash balance of $ 200 million, earning 2% a year annualized.
c. Total net income of $ 40 million (giving the company a PE ratio of 25 today).
XYZ Inc. uses its cash balance of $ 200 million to buy back shares. What will happen to the share price after the transaction?
a. It will go up
b. It will go down
c. It will remain unchanged
Classic corporate finance question, right? Let's see what the answer will be at the two limiting extremes: an extremely "lazy" market and a completely rational one.

a. Markets are really lazy: Here is how it goes. Assuming that you can buy the shares back at the current price (unrealistic, but you have to start somewhere), you will buy back 20 million shares with the $ 200 million, reducing the number of shares to 80 million. The loss of the income on the cash (2% of 200 million = $ 4 million) will reduce net income by $ 4 million to $ 36 million.
Earnings per share = $36/80 = $0.45
Applying today's PE ratio of 25 to this earnings per share:
Price per share = $0.45 * 25 = $11.25
Even if you iterate and reduce the number of shares bought back (by dividing the $ 200 million by $ 11.25), you will still end up with a hefty increase in the price per share. In fact, for the math to work out, this is all you need for a buyback to increase price per share:
a. Current E/P ratio > Riskfree rate (Current E/P ratio for this firm is =1/25 =4% > Riskfree rate of 2%)
b. PE ratio remains has to remain unchanged after the buyback.
You are implicitly making the assumption that the market was mispricing cash prior to the buyback and here is why:
Net income from cash (prior to buyback) = $ 4 million
Since you are assuming that the PE ratio of 25 applies to all income, the estimated value of cash is $ 100 million (25*4), half of the actual cash balance of $200 million.

b. Markets are rational: Is equity in the pre-buyback firm as safe as equity in the post-buyback firm? After all, the firm is eliminating not just 20% of its assets, but its safest asset. Presumably what is left behind in the firm will be riskier than before and you will therefore pay a lower multiple of earnings for the stock. As a limiting case, assume that the market was valuing the cash correctly before the transaction. The implicit PE ratio for cash is 50 (1/ riskfree rate=1/.02). The observed PE for the company is then a weighted average of the PE for risky operating assets and riskless cash, with the weights based on the income you make on each one:
PE for stock = 25 = PE for operating assets (36/40) + 50 (4/40)
Solving for the PE of the operating assets, we get:
PE for operating assets = (25-5)/.9 = 22.22
New price per share = 0.45 * 22.22 = $10.00
In a rational market,  where assets are fairly priced, a buyback by an all-equity funded firm will have no effect on the stock price because it is a value neutral transaction.

So, what will actually happen after the buyback? I think that either extreme is unlikely to hold, but looking at both allows us to crystallize the factors that will determine the effects of a stock buyback:
a. Market's valuation of cash: A buyback reduces the cash balance at the company by the amount of the buyback. The effect it will have on the stock price will depend upon whether the market was pricing cash as a neutral asset (a dollar in cash is valued at a dollar). If the market was "discounting" cash in the hands of a company (viewing it as likely to be wasted), a buyback will increase the stock price. If the market was attaching a premium to the cash (viewing it a strategic asset), a buyback will decrease the stock price.

b. Financial leverage: In the example above, the buyback had no effect on the firm's debt ratio because the firm had no debt and was using cash to fund the buyback. However, a firm that borrows money to fund a buyback will change its debt ratio, and consequently may change its cost of capital. In what direction? It depends on whether the company was under levered, correctly levered or over levered prior to the transaction. An under levered firm will lower its cost of capital with a buyback funded with debt and thus increase its value (and price per share). A correctly levered or over levered firm will increase its cost of capital by borrowing money (the higher cost of equity and debt from the additional borrowing will overwhelm the advantage of using debt) and see value (and stock price) go down.

c.Value of operating assets: The value that the market attaches to operating assets is a function of expectations about future cash flows. A buyback can alter this value assessment by changing market expectations: this is the signaling story for buybacks but it can cut both ways. In its positive form, a firm that buys back stock is signaling to the market that it's stock is cheap and that investors are under estimating the cash flow potential from operating assets.  In its negative form, a firm that buys back stock is telling the market that its growth opportunities are starting to dry up and that future cash flows may not have the growth that investors had presumed.

The net effect of all three of these variables will determine the stock price impact of stock buybacks. Using them to make overall judgments, here is what I would expect to see in response to a stock buyback:
  1. The most positive impact on stock prices should be at mature firms that have a history of earning poor returns on operating assets and are under levered. You get a triple whammy at these firms: the market probably is discounting cash at these firms because it does not trust the management, the firm is under levered and there is little likelihood of the buyback being viewed as a negative signal (since expectations for growth were low to begin with).
  2. The most negative impact on stock prices will be at high growth firms with a history of generating high returns on operating assets and little debt capacity. Cash at these firms is unlikely to be discounted (and may be even be viewed as a strategic asset), there is little potential for value gain from financial leverage and the buyback is more likely to be viewed as a negative signal about future growth potential.
In my earlier post on Apple, this is why I argued against a buyback. Apple meets two of the three criteria for the second group: superb returns on operating assets and perceptions that there is still growth potential. It is true that Apple has some debt capacity (though its effect on value is muted). The debate about whether and when Apple should use this debt capacity is a good one to have, but I think that the argument for using debt right now is weak. That will change, as the debt capacity continues to grow, and returns on operating assets weaken (as they inevitably will).

A stock buyback is not a magic bullet. If you are a firm that should not be doing buybacks, don't go down that road, even if every other firm in your sector is doing so. You may be able to fool the market initially and get a stock price pop, but the truth will eventually come out to hurt you (perhaps after the top managers have cashed out their options and moved on.. but that is another story...)



Stock Buybacks: What is happening and why?

S&P's most recent update indicates that US companies, after a pause for about a year after the banking crisis, are back in the buyback game. In the third quarter of 2010, the S&P 500 companies bought back almost $ 80 billion of stock, up 128% from the third quarter of 2009. Note that this is part of a long term shift away from dividends towards buybacks in the United States, as is evidenced by the figure below which reports total dividends and buybacks at US companies starting in 1988:


Note that aggregate dividends amounted to $ 100 billion in 1988 and aggregate stock buybacks were $ 50 billion in that year. (In fact, if you go back to the early part of the 1980s, buybacks were just a pittance... an unusual occurrence even at large, cash-rich companies). During the 1990s, buybacks increased dramatically and in 1999, cash returned in buybacks exceeded cash paid out in dividends, in the aggregate. The trend continued uninterrupted through 2008, with 2007 representing a high water mark for buybacks. The market collapse and economic fears that followed induced companies to hold back on buybacks in 2009 but it was clearly just a pause, not a stop, as the return to buybacks in 2010 indicates.

So, what has caused this  movement away from dividends in the last two decades? It cannot be that dividends are taxed more heavily than capital gains: Note that dividends have been taxed at much higher rates than capital gains going back to the early decades of the last century. In fact, in 1979, the highest marginal tax rate on dividends was 70%, while it was only 28% on capital gains. The changes in the tax laws in the last three decades have reduced the tax disadvantage of dividends - in fact, they have both been taxed at 15% since 2003 - and cannot therefore be a rationale for the surge in buybacks. It also cannot be attributed to companies thinking that their stock prices were too low, since these buyback surge occurred during the bull markets of the 1990s and 2004-2007, not during down markets.

There are several possible explanations.
a. Management compensation: The first is the shift towards using options in management compensation alters managerial incentives on the dividends vs. buybacks choice. When you pay a dividend, your stock will drop on the ex-dividend day whereas a buyback should not have the same effect (I will talk about the price effect of buybacks in my next post). As an investor, you may not care because you get a dividend to compensate for the price drop. As a manager with options, you do care, since your option value will decrease with the stock price.
Testable hypothesis: Companies that reward their managers with big option grants or tie compensation to price per share should buy back more stock than companies that have more traditional compensation packages (bonuses tied to profits, for instance).
b. Uncertainty about earnings: The second is that dividends are sticky: once you initiate or increase a dividend, you are expected to keep paying that dividend. Buybacks are flexible: companies can buy back stock in one year without creating expectations about future years. Companies that are uncertain about future earnings will therefore be more likely to buy back stock than pay dividends. It is my contention that deregulation (of telecommunications, airlines and a host of other businesses) in conjunction with globalization (and the concurrent loss of secure local markets) has resulted in less predictability in earnings across the board.
Testable hypothesis: Companies in sectors with more unstable earnings should return a larger portion of cash in stock buybacks (and less in dividends) than otherwise similar companies (in terms of cash flow) in sectors with more predictable earnings.
c. Changing investor profiles: A more debatable reason is that the expansion of hedge funds and private equity have changed investor profiles in the stock market. These investors tend to be focused on price appreciation (rather than dividends) and often are unwilling to wait for their cash.
Testable hypothesis: Companies that have activist institutional investors or are held by hedge funds/private equity holdings should be more likely to buy back stock.
d. The Dilution Delusion:   A stock buyback reduces the number of shares outstanding and generally increases earnings per share. Applying the current PE ratio to the higher earnings per share should result in a stock price. If this logic holds, stock buybacks are magic bullets that companies can use to push their stock price up. There is a fatal flaw in this reasoning, which I will examine in my next post.
Testable hypothesis: The more focused a company becomes on earnings per share, the greater the likelihood that the company will buy back stock.

I don't see any reason to believe that these shifts will be reversed in the near future. In fact, I will go further. I think that you will see companies across the globe shift to buybacks or at least to more flexible dividend policies (tied to earnings).  My next three posts will revolve around the buyback question.  In the first, I will take a closer look at the alluring (but untrue) argument that a buyback is always good for stock prices. In the second, I will look at the consequences of the shift towards buybacks for traditional investment rules and valuation models that have been built around conventional dividends. In the last one, I will argue that dividends should not be abandoned, but that it is time we rethink how companies set and change dividends.



How much cash is too much? Looking at Apple

In the midst of lots of news about Apple - Steve Jobs taking a leave of absence and a 78% surge in profits reported today - I saw this news story in the Wall Street Journal. The gist of the story is that a portfolio manager who has about $700 million in Apple's stock feels that it should pay out some or all of its $ 50 billion cash balance to investors. I do not know the portfolio manager mentioned in the article, Mr. Bonavico, and I hope that he was misquoted because what he is quoted as saying borders on corporate finance malpractice.

Here is what Mr. Bonavico is purported to have said:"...they (Apple) are leaving money on the table by having such a large cash balance well below their cost of capital. The cash is earning near zero." That is an absurd comparison. Apple's cost of capital is close to 9% but that is for its operating investments in software, hardware and its iTunes store. Cash is invested in near-riskless, liquid investments and the appropriate benchmark (or discount rate) to compare it to  is therefore what you would make on riskless, liquid investment. The three-month T.Bill rate currently is yielding 0.16% and that is all that cash has to make to break even (or to be a zero net present value investment). Cash is not a good or a bad investment. It is a neutral one.

Does that imply that all companies should be allowed to hold on to as much cash as they want to? Not at all. Clearly, some companies accumulate too much cash and their investors would be better off, if that cash were returned to them. The question of how much cash is too much cash is  a debate worth having.  To resolve this debate, though, you have to start off with a clear sense of how or why cash balances affect equity investors in a company. No investor in a company is ever hurt by cash being invested in low return, riskless assets (commercial paper, treasury bills). What investors should worry about is what the company may do with the cash: take bad investments or overpay with acquisitions. I would rather that the cash earn 0.16% in T.Bills than be invested in projects earning 6%, if the cost of capital for those projects is 9%. To make a judgment on whether to attach a "stupidity discount" to cash, investors should look at a company's track record. They should discount cash balances in the hands of companies that have a history of over reacting, poor investments and bad acquisitions. They should not discount cash balances in the hands of companies where managers are selective in their investments and have earned high returns (on both projects and for their investors). In fact, over the last decade, there have been several studies that have looked at how the market prices cash balances and the results support this proposition.

In the case of Apple, a company that has seen its market cap rise almost thirty-fold over the last decade while generating a return on invested capital that exceeds 30%, this debate to me is a no-brainer. Do you trust Apple's managers with your cash? In fact, the real question should be if you don't trust Apple's managers with your cash, what company would you trust with your cash? As an Apple investor (albeit with a lot less than $ 700 million invested) since 1999, I have no complaints and here are the three scenarios relating to cash that I can see unfolding:

a. Do no harm scenario: In this scenario, which is the one that Apple has practiced for the last decade, it invests, when it feels that it has a good product (iPod, iPhone, iPad etc.) to promote and holds on to cash when it does not. Continuing with this scenario does not hurt me, as long as they keep the hits coming. I don't get dividends, but who needs them when you get that price appreciation?
b. Dream scenario: In this one, Apple finds a way to invest its entire cash balance of $ 50 billion right now and manages to earn a 30% return on capital on this investment. While this would clearly jump start and increase value, it does not strike me as viable. A company, even one as good as Apple, just cannot create new products and investments out of thin air and then staff them successfully.
c. Nightmare scenario: In this one, Apple decides that the return on cash (less than 1%) is too low and decides to take operating investments or acquisitions that generate returns that are higher than 1% but lower than the cost of capital. This would be devastating for value. If Apple goes on an extended buying spree, acquiring companies at outrageous premiums, I would join Mr. Bonavico in demanding my cash back.
d. Listen to Mr. Bonavico scenario: In this one, Apple returns $ 50 billion in dividends immediately. As an investor, I will get a big check in the mail (for dividends) on which I will have to pay taxes, but the stock price will decline by roughly the dividend. In fact, there is a very real chance that a big payout could be viewed by the market as a negative signal of future prospects and that the stock price could drop by more. (If the alternative is a stock buyback, the same problems exist though they will manifest themselves in a different way)

I have an extended paper on the value of cash and cross holdings (another widely misunderstood asset) that you can access at:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=841485
Have a go at it!



Herding behavior: Why, so what and what if?

A news story from yesterday's Wall Street Journal on hedge funds and their herding behavior provides a good starting point for this discussion. In summary, the article notes the following:
(1) Hedge funds seem to buy and sell the same stocks, at the same time, and track each other's investment strategies.
(2) The correlation across hedge funds has increased over time. Hedge fund managers copy each other more than they used to.
(3) Hedge funds collectively are under performing the S&P 500 by more and more each year; for 2010, hedge funds generated 10.4% in returns and the S&P 500 earned 15%. On this point, you can take issue, arguing that hedge funds (or at least some of them) are less risky than the market and that the hedge funds may not lag the market on a risk/return basis. However, there is no denying that even on that dimension, hedge fund performance has deteriorated over time. I am not surprised by any of these findings, since they are consistent with existing research.

Why is there herding behavior?
We see herding in all aspects of human behavior, not just in finance. We tend to wear what other people wear, eat where other people eat and congregate in places that attract the biggest crowds. Herding may be more researched in finance than in other areas, but it is not unique to finance. Here are some reasons why herding is common.
a. Evolution instinct: It is not hyperbole to note that we have survived as a species by following the crowd. A cave person, when confronted with a crowd of cave people running in the opposite direction, would have been well advise to turn tail and run with them. Odds are that they were being chased by a mammoth. That instinct is still deeply embedded in our psyches. Faced with a wave of panic selling or buying in markets, it is very difficult to not join in.
b. Safety in numbers: Remember when you were a child, doing something stupid with a group of your friends. Odds are that when queried about your behavior, you used the standard excuse, "that they were all doing it". Put in analytical terms, a portfolio manager or CFO who makes a mistake is more likely to escape the consequences, if others make the same mistake, but will be punished if he or she is wrong alone. Think of all those bank equity research analysts who had buy recommendations on Lehman in 2007, who are still equity research analysts...
c. Information:  Assume that you are in a city you have never been in before and that you are looking for a restaurant to eat dinner at. Watching where the locals eat does give you information; you want to avoid the empty restaurants, because they are empty for a reason.
d.  Absence of competitive edge: It is easier to stand alone, if you know something that others do not or have a unique skill that gives you a leg up on the competition. The hedge fund story is revealing. Note that the herding behavior has increased as the hedge fund business has grown and collective performance has suffered. Much as we like to attribute superior skills to hedge fund managers, the herding behavior suggests that the average hedge fund manager has no competitive edge to speak off and seems to know it.

What are the consequences of herding?
If herding is a fact of life in both portfolio management and corporate finance, here are the consequences.  
In portfolio management: The bunching up of buying and selling on the same stocks will increase correlation over time in stocks (serial correlation), as an up day on a stock will attract more buyers in the near term, resulting in more up days. This will make momentum strategies more lucrative, at least in the short term. It will also make pricing bubbles and corrections more extreme and the latter will lay waste to the momentum strategies that looked so good before the correction. That "random walk" down Wall Street just became a lot more like a drunk walking down the street, overshooting in both directions.
Corporate finance:  If CFOs indulge in herd behavior, corporate financial practice will reveal "me-too" characteristics. In terms of financial policy, companies will try to set dividends and debt policy to be as close to their peer group as possible. If you are in a sector where everyone borrows money and pays dividends, you too will do so (even if you cannot afford to pay dividends or carry debt). An acquisition or buyback by one company is a sector should set off a wave of acquisitions and buybacks by other companies in the same sector. Not surprisingly, mistakes, when they occur, will be sector wide (like those telecomm companies that borrowed too much money in the late 1990s) or even market wide.

Can you take advantage of herding and if so, how?
 There are two strategies that you can adopt in a world where herding is the rule, rather than the exception:
a. The Yogi Bear strategy: The movie that just came out was disastrously bad, but Yogi Bear was "smarter than the average bear". To adopt the Yogi Bear strategy, you have to be smarter than the average investor. Essentially, you play the momentum game, reaping profits from herd behavior, but you get out just in time, before the correction hits. You get all of the upside of herd behavior and none of the downside. I had an extended post on momentum investing a while back, where I noted that while I don't think I can pull this off, there are others who can.
b. The Yoda strategy: Every investment sage will tell you that you should not be part of the herd and that you can make more money as a contrarian. Easier said than done. To succeed as an idiosyncratic investor, here is what you need:
a. A competitive edge: There is no point going against the crowd, if you have little to offer that is unique or different. It is a point that I have made several times before, but you need to bring something to the table before you bet against the crowd.  In Yoda's words: 
"You will find only what you bring in."
b. Self confidence: You have to believe in yourself. Without a core investment philosophy, it is difficult to hold on in the face of peer group pressure. As Yoda would say: “Do … or do not. There is no try.”
c. A patient client base: If you are investing for yourself, you have to answer only to yourself. If you are investing for others, you need investors who trust you to be right in the long term.




The Facebook Valuation!

One of the biggest stories of the last week was Goldman's $ 500 million investment in Facebook for approximately 1% of the company. Extrapolating from the transaction, we obtain an implied value of $ 50 billion for Facebook, a number that has been making the rounds in news stories over the last few days. There are three questions that emerge from this news story: (a) With private businesses, can you extrapolate from a single transaction amount to an overall value? (b) Why would a company worth billions choose to stay private, when it clearly has the option to go public? (c) How would you value a share in a non-listed, non-traded company (as opposed to a publicly traded company)?

a. Can you extrapolate from a single transaction amount to an overall value?
Sure, as long as the transaction is an arms length one and all you are getting in return for your investment is a share of the company's equity. If, as is common, there are side benefits or side costs that go with the transaction, extrapolation will yielding a misleading estimate of value. In the case of the Goldman transaction, there are plenty of reasons to be skeptical. In addition to getting a piece of Facebook, Goldman also gets the following benefits:
a. Investment opportunities for Goldman's clients: As part of the deal, Goldman will be raising $1.5 billion from its clients to invest in Facebook. While this may seem to be a favor that Goldman is doing for Facebook, the reality is that Facebook is a hot company to invest in and this will allow eager investors an exclusive entree into the company.
b. A front seat for the Facebook IPO: If at some point in time, Facebook decides to go public, Goldman is likely to be the lead underwriter and reap a big share of the commission.
c. Private wealth management services to Facebook's potential billionaires and millionaires: When Facebook goes public, Mark Zuckerberg and a number of other executives will have the capacity to sell their shares in the market. While I do not expect a wholesale cashing out of equity positions immediately after the IPO, it is likely to happen over time, at which point these very wealthy individuals will need some private banking help and Goldman will be there to provide that help.
The profits and fees from these added businesses could account for a significant chunk of the $ 500 million that Goldman paid in this transaction. Exactly how much will depend on the likelihood of an IPO and the fee structure for the transaction. If, for instance, the present value of the expected fees from these side benefits is $ 200 million, the implied value for Facebook will be $ 30 billion, rather than $ 50 billion.
One more note of caution. Strange though this may sound, I would trust a market price derived from a consensus of a thousands of buyers and sellers to get the value right more than I trust the price from a single transaction, even if the buyer and seller are supremely sophisticated.


b. Why would a company worth billions choose to stay private, when it clearly has the option to go public?
Facebook's reluctance to go public may seem surprising. After all, the conventional wisdom has always been that companies like Facebook should get a more favorable response from offering shares in the public market place than from private offerings to venture capitalists and large investors. Here are some reasons, rational or otherwise, for why Facebook may be holding back:
i. Extending the tease: Looking at the favorable publicity that Facebook has got in the last week from the Goldman deal, it does not look like waiting to go public is hurting Facebook, at least for the moment. In fact, it may be making Facebook an even more desirable investment to those who cannot invest in it right now.
ii. "Proprietary" information: While I don't think that this is a big factor for Facebook, there are some companies that choose to stay private because they are afraid of revealing proprietary information about their products/services to the general market. Instead, they can provide the information, with sufficient restrictions on disclosure, to a few wealthy investors who can then invest in the company.
iii. Founder idiosyncracies: If the founder and majority stockholder in a company decides that he does not want the company to go public, the company will not go public. In the case of Facebook, it is entirely possible that Mark Zuckerberg has decided that he does not want to take the company public and he does not seem the kind of person who can be dissuaded easily.
iv. Regulatory and information disclosure concerns:  From Sarbanes-Oxley to SEC restrictions, public companies are constrained in ways that private businesses are not.
v. No valuation scrutiny: As a publicly traded company, no matter how well regarded it may be, the market valuation will be questioned by skeptical investors. Scaling value to earnings or book value, investors will argue that the company are over priced, relative to other companies in the market. (Take a look at Apple, Google and Netflix, all big winners over the last year, and you will see this phenomenon at play). Facebook gets to have the best of both worlds, again at least for the moment. We get glimpses of its immense value, each time a transaction is made, and no real way to examine whether the value makes sense, since we do not have access to much of the information we need.
In summary, Facebook is in a unique position. It has the profile to raise capital from wealthy investors are favorable terms and is getting many of the benefits of being a publicly traded company without any of the costs. Could that change? Absolutely. If there is bad news (or even rumored bad news) about the company and some or even a few investors have trouble exiting the company, the estimated value could melt down quickly.

(c) How would you value a share in a private company (as opposed to a public company)?
Let's assume that you are one of those lucky investors that has a chance to invest in Facebook. How would you go about valuing the company?
i. Financial data: You have to get your hands on some operating numbers. All you have right now is rumor: Facebook supposedly will generate $ 2 billion in revenues this year and there is no word on how much earnings they will have. You cannot value a company based upon information that is this threadbare and you will need fuller financial statements.
ii. Future projections: Once you have the information, you have to make projections for the future, valuing  Facebook just the way you would value any young, high growth publicly traded company. I have a paper on the topic. Normally, with private businesses, you will discount the value for lack of liquidity but I don't think this is a concern with Facebook shares, even if privately held.
iii. Ownership protections: I don't know about you but I just finished watching Social Network, the movie, and I am not sure that I feel secure that my ownership rights will be protected by the controlling stockholders at Facebook. I would need to make sure that there are enough protections in place for existing stockholders in the event of new capital being raised or an IPO.

So, is Facebook worth $ 50 billion? Based upon current revenues of $ 2 billion, it is richly priced; 25 times revenues and god only knows how many times earnings. The justifications that I hear from analysts for the high valuation are:
(a) An unprecedented platform: The 500 million users provide a platform that could generate much higher revenues and earnings in the future, but a lot of things of things have to go right for this to work out. I am not a big user of Facebook, but my gut feeling is that an overt commercialization of the space will make it less attractive to many users. So, it has to be subtle and creative commercialization... while fending off competition. (Remind me again what happened to Myspace, another hot place to be not so long ago).
(b) Goldman knows best: Smart investors (like Goldman) think its worth $ 50 billion. So, it must be worth $ 50 billion. This line of reasoning is so absurd that it is not worth pursuing. If you think that Goldman does not make big valuation mistakes, you are wrong. What Goldman does well is cut its losses, if it does make mistakes.  You and I will not have that option.
(c) The Big Story: To those who use the big story justification, everyone will be on a social network in the future, and you need to pay a premium to be part of the movement. Having heard variants of the big story before used to justify other bubbles (dot com, telecomm, PCs), I don't buy this. I think the market may be right about the macro story but is being hopelessly over optimistic about the micro pieces. In other words, we may all be parts of social networks a decade from now, but can all of these social networking platforms (Facebook, Twitter, Groupon...)  be profitable? My guess is that there will be a few big winners and lots of losers, before the final story is written. (Remember that the market was right in 1998 about dot-com retailing being the wave of the future but most dot-com retailers never made it through to nirvana. Amazon did and it is worth almost $ 80 billion, but it is the exception.)



Buffett and Black-Scholes

As always, I am playing with fire when I critique Warren Buffett, but he does indulge in hyperbole (I hope that is all it is..) when he strays from his preferred habitat. In fact, my previous post on him evoked some strong responses. In the last Berkshire Hathaway report, he is quoted as saying “Both Charlie and I believe that Black-Scholes produces wildly inappropriate values when applied to long-dated options… Academics’ current practice of teaching Black-Scholes as revealed truth needs re-examination. For that matter, so does the academic’s inclination to dwell on the valuation of options. You can be highly successful as an investor without having the slightest ability to value an option”.

Let's take apart this statement:
a. "Both Charlie and I": I presume that Charlie here stands for Charlie Munger, the other fount of wisdom from Omaha. I guess this is supposed to add to the intimidation factor. If Charlie Munger agrees with Warren Buffett, what right-minded person would disagree, right? Charlie Munger has a way with words (I especially love this quote: "If the only tool you have is a hammer, everything starts to look like a nail.") But so do Yogi Berra and Lady Gaga, and I am not listening to investment advice from either one..

b. "Black-Scholes produces wildly inappropriate values when appled to long-dated options": So, the Black-Scholes that Mr. Buffett must be referencing must be the original Black-Scholes, with no dividend  or dilution adjustments to value European options? And what exactly are these long dated options that are being valued? Warrants or management options? Since US companies are light users of the former, I would assume that it is the latter, which are not traded. If they are not traded, two questions:

i. How would Mr. Buffett know that they are wildly inappropriate? Because the values he got from these options were higher than Mr. Buffett's gut said that they should be worth? Perhaps, he should take a look at LEAPs (long term call and put options) traded on US stocks on the exchanges. As the value guru, he may think that all of these options are being over valued. If so, I would welcome his intervention in these markets.

ii. What exactly did Mr. Buffett do with the Black-Scholes model? The Black-Scholes model is only as good as its inputs. With long term options, the variance that  should be used in the model is a long term variance (which may be well below the current level) and if the options are management options, you should be correcting for dilution and illiquidity. Since FASB has required companies to value management options and expense them for the last three years, this is a well researched area of finance. With the adjustments, the Black Scholes delivers reasonable values for options.

Here is the bottom line. The Black Scholes under values deep out of the money options (because of its assumption that prices move continuously) and over values options that are illiquid. To compensate, we can either modify the Black Scholes or use a binomial option pricing model, both of which deliver much better estimates of option value than any individual's gut...

c. "Academic’s inclination to dwell on the valuation of options": I love this one! Where does Warren Buffett's academic live? Is he a Phd student that Buffett and Munger trapped in the 1970s and put in a hut in Omaha, poring over old Journals of Finance (preferably from the 1960s)?  That may explain Buffett's fixation with the CAPM and the Black Scholes. There are some academics and many practitioners who dwell on the valuation of options, but there is a reason for that.  It is their job is to assess the value of listed options, warrants or convertibles, and if that is their job, they have to just dwell on the valuation of options. I am an academic (in Buffett's sense of the word) but option valuation is an after thought to me, not a central part of either corporate finance and valuation..

d. "Academics’ current practice of teaching Black-Scholes as revealed truth needs re-examination: I would be interested in what constitutes "current" practice to Mr. Munger and Mr. Buffett. Furthermore, what are these nasty academics doing? Are they telling their students to value options using the Black-Scholes model, to buy under valued options and sell over valued options?

e. "You can be highly successful as an investor without having the slightest ability to value an option": Here is the only statement that I completely agree with. Absolutely, but only if you stay away from option laden investments (which includes companies like Cisco which have a significant management option overhang, oil companies with undeveloped reserves like Petrobras, pharmaceutical companies with potential blockbuster drugs making their way through the pipeline).

I am sorry if you find me to be disrespectful for not treating Warren Buffett as a minor deity, whose every word is gospel.  It is clear that all of the praise that he receives from his followers has gone to his head. He sound absurd when he talks about derivatives and seems to think that he is a macro forecaster (which actually cuts against everything he stood for two decades ago). I will pay him the ultimate compliment (or insult) by taking every macro suggestion that he makes and doing the opposite.




Equity Risk Premiums: The 2011 Edition

As many of you who have been readers of my posts know, I have a bit of fixation on the equity risk premium and have had several posts on the topic. The equity risk premium is what investors charge over and above what they can make on a riskfree investment to invest in equities, as a class. The reason for the fixation is simple. The equity risk premium is a central number in both corporate finance and valuation. In corporate finance, it determines the costs of equity and capital for firms, and by extension, their investment policies. It also drives the choice between debt and equity and determines whether the company should be accumulating cash or returning it to stockholders. In valuation, it is a key input to the value of any company.

The message that I have tried to deliver is that this number is too important to be be viewed as a constant or outsourced to someone else. Thus, the defense that is offered by many investment banks, consulting firms and corporations that the equity risk premium that they use comes from a reputable source (Ibbotson, Duff and Phelps or Credit Suisse) fails the credibility test. If you run a business or have to value it, you have to take ownership of this number.

A confession, though, is a good place to start this discussion. I used to think that equity risk premiums in developed markets were fairly stable numbers and that mean reversion (assuming that things move back to a normal or at least average level) was a safe assumption. That is.. until September 2008. I got a wake-up call between September 2008 and December 2008 about the dangers in this assumption as equity risk premiums in developed markets exploded.. by my estimate, the equity risk premium in the S&P 500 almost doubled in two months. I wrote a paper on equity risk premiums in the midst of that crisis in November 2008 and the response indicated that quite a few other people were just as concerned as I was about the lack of attention that practitioners paid to what the equity risk premium was and what it was measuring.

Gratified by the response to that first attempt, I have returned to the well two times and done updates of the equity risk premium paper at the start of 2009 and 2010. Since we are into 2011, I just finished my latest update on equity risk premiums and you can get it here:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1769064

It is awfully an long paper (about 94 pages) and I apologize in advance. Some of the verbosity can be attributed to verbal diarrhea, an occupational hazard for someone who loves writing and likes hearing himself talk. Some of the length, though, is due to the fact that this is a widely researched topic, examined from many different angles, and I felt the urge to present a full picture.

Here, though, are my summary thoughts/ findings:
1. The equity risk premium is neither a mathematical number nor is it a statistical number. Instead, it is a reflection of what investors are feeling in their gut: if investors feel more worried about the future, the equity risk premium will rise. After the last week (Feb 20-24, 2011) in the Middle East (Egypt in turmoil, Libya on the edge, the House of Saud wondering whether the bells will be tolling for them), equity risk premiums have probably risen across the globe.

2. Pragmatically, though, there are only three ways of estimating the equity risk premiums:
a. You can survey investors, portfolio managers, CFOs or even academics to get a sense of what they think is a reasonable value for the equity risk premium. As I note in the paper, these survey premiums right now indicate that people seem pretty sanguine about equity risk and the risk premiums have dropped from what they were two years ago. The actual values range from just above 3% (from CFOs) to just under 4% (portfolio managers).

b. You can look at the past and look at the actual premiums earned by stocks over riskless investments in the past. I do this as well, using the long historical database that we have in the US, and estimate that stocks have earned an average premium of 4.31% over treasury bonds between 1928 and 2010. That is very close to the 4.29% that I reported as the historical premium last year, using 1928-2009 data. However, there are two caveats. Even with this long time period, the standard error in the estimate is 2.38%; applying the standard plus or minus two standard errors to the 4.31%, we would conclude that the true risk premium can be zero or greater than 9%. Second, the historical premium number itself can change depending upon your choice of riskfree rate (T.Bills or T.Bonds), time period (1928-2010, 1960-2010, 2001-2010) and averaging approach (arithmetic average or geometric average). Needless to say, I don't trust historical risk premiums.

c. You can try to estimate a forward-looking premium, by looking at what people are paying for stocks today and estimating expected cash flows in the future. On January 1, 2011, using the S&P 500 level of approximately 1258 and expected cash flows for the future, you can back out a required return on 8.49% for stocks in the index. Netting out the treasury bond rate of 3.29% on January 1, 2011, yields an "implied" equity risk premium of 5.20% for that day. While estimating future growth rates can be hazardous, I trust implied premiums more than historical premiums. Talking about updating the numbers, I estimated the equity risk premium today (Feb 24, 2011) using the level of the index at close of trading today (1306.10) and the treasury bond rate at the close of trading (3.45%) to be 4.98%.  That is up from 4.82% a week ago... I guess Libya is having an impact. By the time you read this post, that number may be dated. So, give it your best shot:
http://www.stern.nyu.edu/~adamodar/pc/implprem/ERPupdated.xls
Those of you who follow me on Twitter (#AswathDamodaran) get my monthly updates on the equity risk premium, at least for the US.

d. Estimating equity risk premiums in emerging markets is more difficult to do, partly because the historical data is thinner and less reliable. Implied premiums are more difficult to estimate because of the absence of information on cash flows and growth rates. Notwithstanding these limitations, I have laid out three ways in which equity risk premiums can be estimated in emerging markets and my biases about these approaches. Looking at the big picture, though, it is astonishing how much equity risk premiums in "big" emerging markets (India, China, Brazil) have declined over the last decade, a huge contributor to the surge in equity prices in those markets.

e. Risk premiums for the most part move together across different markets, geographically and across asset classes. As the equity risk premium has changed in the US, so have the default spreads on bonds and risk premiums in real estate. When risk premiums do not move together, all too often it is an indication of a bubble in one market or a mispricing in the other.

3. The big question, of course, is which of these equity risk premium estimates is the right one to use in corporate finance and valuation. My answer is nuanced, which may surprise some of you, because I don't take kindly to nuance:
a. If your job is to be market neutral, i.e., assess the value of a company, given where the market is today, you should use today's implied equity risk premium. On February 24, 2011, this would have meant using 4.98% in a mature equity maret. Using any other premium would introduce your market views into the valuation.
b. If you are a long term value investor and don't have to answer to market metrics in the short term, you are lucky. You can then take market views into your valuation by using what you think is a better long term estimate of the equity risk premium.
c. If you are a CFO and are concerned about long term value, you can take the same point of view as the long term value investor and estimate a "normalized" equity risk premium.
d. If you are a macro strategist, you can look at implied equity risk premiums in different market to make your judgment on where you want to invest your money. As a general rule, you want more of your money invested in markets with high "risk premiums" and less invested in markets with 'low" risk premiums.

Bottom line: The equity risk premium is too important a number to be outsourced. Investors, managers and central banks need to keep their eyes on risk premiums in different markets.http://www.stern.nyu.edu/~adamodar/pc/implprem/ERPupdated.xl



Merck and Pfizer: Thoughts on investing as a patriotic duty and market efficiency

We have an interesting long-term experiment in the making in the pharmaceutical business, as two of the largest players - Pfizer and Merck announced their plans for the future. Pfizer was the first up, announcing its plans to buy back stock and rein in R&D. Pfizer has been an active acquirer over the last few years, buying Wyeth for $68 billion in 2009, and this announcement seems to at least implicitly suggest at least a pause in, and perhaps an abandonment of,  that strategy.

Merck responded with a very different vision of its future, suggesting that it would be investing more in R&D and would not be returning cash (at least in the near term). Given that Merck spent $41 billion buying Schering Plough in 2009 and is still showing signs of indigestion from that acquisition, it is not clear whether this announcement is an indication that they have abandoned the "big acquisition" strategy for a return to basics.

The immediate reaction from the market was positive to Pfizer's announcement (an increase of 5-7% in the stock price) and negative to Merck's announcement (a drop of 2-5%). The reason these stories reverberate is because they also coincide with a push by the Obama administration to get US firms, which have been sitting on large cash balances, to do their patriotic duty and invest that cash, with R&D being singled out as a good place for the investment. So, here are some open questions:

1. Is investing in R&D and capital investments the patriotic thing to do?
Pushing companies to invest their cash, whether it be in R&D or in factories, is not always good for the economy and using patriotism as the argument for doing so strikes me as wrong on three levels.
  • The very fact that you have to use the patriotism card suggests to me that you have lost the economic argument. (It is akin to the "strategic" card that some managers pull when they want to push through an investment or acquisition that makes no economic sense.) Through the centuries, political leaders have called on their people to give up economic and political rights in the cause of the "greater good ". There are times where the argument reverberates. FDR and Churchill's pleas for shared sacrifice during the Second World War were responded to, because people (and by extension, corporations) recognized that losing the war would catastrophic to their own interests. And you cannot attribute the success to the persuasive powers of the leaders. After all, Winston Churchill lost his prime ministership and the British parliament in 1945, when the fear of war passed. In most periods, though, the argument falls flat because people detect the emptiness behind the sloganeering.
  • Is it patriotic for companies to build factories and invest in R&D, if the economic rationale for doing so is not there? Sure, if you define short term job creation as patriotic. After that initial glow, though, how do you sustain these uneconomic investments? You either provide taxpayer subsidies in perpetuity or the investments shut down: the former are not tenable with our budget deficits and with the latter, the layoffs return with a vengeance as the investment craters.
  • Even if you believe that it is appropriate to draw on patriotism as a rationale for economic decisions, it is one thing to ask it of individuals and another of corporations. A corporation is a legal entity, owned by stockholders. With globalization, the investors in many publicly traded US companies are Europeans, Asians and Latin Americans, just as investors in many companies in those countries are US citizens. Why should a Brazilian stockholder in Merck or Pfizer have to pay an economic price for either company to do its patriotic duty and invest in US jobs?
Bottom line: If you want to induce companies to invest their money, try to create an economic environment where such investments make sense. That does not mean creating special tax breaks for these investments (that is just another way of taxpayers subsidizing bad investments). It would imply reducing macroeconomic uncertainty and putting place policies that increase overall growth. If in spite of all these efforts, investments still don't make sufficient returns, the most patriotic thing for companies to do is to not invest the money but instead to give cash back to stockholders who will find better places to invest.

2. What does the market reaction to these announcements tell us?
I am always leery about reading too much into how the market reacts to individual firm announcements. After all, we have a sample of two in this case. But I can predict the two polar opposite reactions that the Merck/Pfizer news story will elicit.

At one extreme will be those who belong to the "don't trust markets because they are short term" group. To them, the fact that market reacted negatively to Merck, a firm belonging virtuously (any firm that invests in R&D is endowed with this label) and positively to Pfizer, a firm catering to the greediest among us (since only greedy investors want to cash out on investments) will be viewed as proof that markets are short term and not to be trusted. I would have more sympathy for their arguments if the market reaction was knee jerk, always negative for R&D (or other investment announcements) and always positive for stock buybacks. But that is not what the evidence indicates. On average, stock markets react positively to investment announcements, whether they be in R&D or more conventional capital expenditures, as evidenced by the figure below.

However, this chart is not a blanket endorsement of R&D or investment being good. In fact, stock prices go down at some firms that announce investment plans, as they did at Merck.

Is the market being unfair to Merck by reacting so negatively to the announcement that it would increase R&D? I don't think so and Merck's recent history is one reason that the market is skeptical. The firm has invested tens of billions in R&D over the last 20 years but they have not much commercial success to show for the investment. More significantly, they did spend $41 billion to buy Schering Plough just two years ago, an action that makes little sense if Merck felt confidence in their internal R&D's value creating ability. Finally, investors are also aware that the health care business is changing in fundamental ways and many of these changes will not be friendly to the bottom line at pharmaceutical companies.

At the other, there will be firm believers in market efficiency who will point to the market reaction as evidence of the foresight and wisdom of markets. I am not willing to go that far, based on the limited evidence. After all, there are investors who react to every stock buyback as good news, at least initially.

3. Which of these firms took the "right" action?
While the initial market reaction favors Pfizer, I think that it will take time to make the final judgment. I will be looking at three developments to draw my conclusions:

a. Market follow through: Investors get a chance to reassess their initial reaction as markets settle down and fundamentals reassert their dominance. If six months from now, Pfizer has been able to sustain its gains, I will feel more confident that it did the right thing to begin with. Conversely, if six months from now, Merck's stock price has reversed direction and risen, I will be less worried about the R&D being misspent.
b. Economic payoff: With Pfizer, I expect to see the "lesser" investment in R&D to be redirected to areas with higher payoff (and higher return on capital). With Merck, it would be too much to ask that their new R&D investment start paying off in the near term, but I would like to see some of the billions that they have spent on R&D in the last decade show up as blockbuster drugs in the pipeline. In other words, I am looking for evidence that Merck's decision to invest in R&D was based upon real promise that they were seeing in their labs and not just hope. (One item that makes feel a little better about Merck is that their pipeline is finally starting to show some promise)
c. Internal consistency: Perhaps, the worst thing that either firm can do now is take other actions that are inconsistent with their current actions, in terms of future direction. With Pfizer, these inconsistent actions would take the form of expensive acquisitions and new stock issues to fund these acquisitions, actions that don't jell with more frugal, mature, cash returning company it is portraying itself to be. With Merck too, a return to large acquisitions would contradict the return to R&D roots story that they are pushing.

Put succintly, as an investor, both firms are on probation, as far as I am concerned. Merck has a steeper hill to climb, because they are fighting their recent history and a health care business that has fundamentally changed, but Pfizer is not out of the woods either...



Dividend Policy for the 21st century

This is the fourth of a series of posts that I have on dividend policy, starting with the one noting the shift from dividends to stock buybacks, moving on to examining whether buybacks are good news for stockholders and then looking at the consequences for investment strategies of the shift. In this post, I would like to examine how companies should think about dividends in a globalized economy, with relatively few safe havens.

The best way to describe dividend policy at most US and European companies is that dividends are sticky. Put differently, the dividend per share this year at most companies will be set at either last year's level or will be a little bit more. Cutting dividends is viewed as an action of last resort, when all else has been tried and failed. If you combine the reluctance to cut dividends with their stickiness, it is no wonder that dividend changes lag earnings changes. In fact, a  study, by John Lintner in 1956, of how US companies set dividends came to almost exactly the same conclusions, showing how little dividend policy has changed over the decades. This policy, in turn, can be traced back to the origins of stock markets: stocks were sold to investors as bonds with price appreciation, and the larger and more stable the dividends, the better the stock was considered to be. Growth was viewed as icing on the cake.

But does this policy make sense? After all, what differentiates debt from equity is that debt generates fixed (and contractual) claims on the cash flows, whereas equity gets whatever is left over (a residual claim). Companies that lock themselves into fixed dividends are in effect turning their equity into quasi bonds and taking away the primary benefit of using equity: its flexibility. Playing devil's advocate, though, there are two reasons given in defense of this established policy. The first is that it commits managers to returning cash to stockholders, who can then decide where to invest that cash. To the extent that you (as a stockholder) don't trust managers in companies to invest your cash, this is a good thing. The second is that dividends can be used as a signal by companies: firms with good growth prospects can increase dividends to indicate their confidence in future prospects. There are real costs to this policy, though. The first is that companies, fearing the consequences of cutting dividends, will be conservative about paying dividends, tending to set them well below cash flows. The second is that companies that get locked into unsustainable dividends will continue to do so and end up in much worse trouble.

As globalization and competition increase uncertainty about future earnings, sticking with "fixed dividends" will result in firms paying less  in dividends (and the trend lines bear this out) and retaining more cash to cover future shortfalls. So, what are the options? Two variations are already in play:
a. Dividends + Stock Buybacks: This is the policy that US companies have adopted for much of the last two decades. While buybacks provide more flexibility to companies, the downside is that they may give them too much flexibility to managers. Thus, managers who prefer to sit on large cash balances will continue to do so.
b. Regular Dividends + Special Dividends: In countries where stock buybacks are either uncommon or restricted, companies supplement regular dividends (which are sticky) with special dividends in periods of high cash flows.
In effect, these two choices preserve the "fixed dividend " policy and supplement it with additional cash returns.

There are more revolutionary alternatives that firms should consider:
a. Fixed payout ratio: In much of Latin America, firms have sticky payout ratios (rather than sticky dividends). Thus, a firm will pay out 35% of its net income as dividends each period, resulting in dividends that vary with earnings. On the plus side, this allows firms to suspend dividends during periods of negative earnings, with little fanfare and signaling consequence. On the minus side, the problem with linking dividends to net income is that the earnings are not cash flows; a firm can have positive net income and negative cash flows, especially if it has significant reinvestment needs.
b. Residual cash flow payout: A simple modification of the fixed payout ratio would be to tie dividends to residual cash flows, computed after reinvestment needs have been met.
Residual Cash flow (FCFE) = Net Income + Depreciation - Capital Expenditures - Change in non-cash working capital
In fact, you can bring in net debt repayments that have to be made into this computation as well. In valuation terms, the dividend would then be set at a fixed percentage of the free cash flow to equity, with the percentage varying across companies. Thus, a company with stable and predictable cash flows may set dividends at 90% of free cash flow to equity, whereas one with uncertain cash flows and reinvestment needs may set it at 65% of free cash flow to equity. This approach preserves the commitment feature of conventional dividends without the inflexibility.
c. Contingent Dividends: The earnings (and cash flows) at some companies are more a function of movements in a macro variable (say oil prices or interest rates) than firm-specific actions. Thus, an oil company will see its cash flows surge if oil prices hit $100 a barrel and drop off if they hit $ 40 a barrel. Rather than force this company to set a fixed dividend, which it may worry about sustaining if oil prices drop, dividends paid can be partially or fully tied to movements in oil prices. This allows the firm to pre-commit to returning cash flows to stockholders (as is the case with conventional dividends) without putting their financial health in jeopardy.

To illustrate how these different policies would affect the dividends that investors receive, I have used Proctor & Gamble and the time period from 2001 to 2010:

Between 2001 and 2010, P&G paid out 41.65% of their net income in dividends. If you add in stock buybacks, they returned 110% of their earnings to stockholders and 120% of their cash flow to equity; they borrowed more money to fund their business. While the prudence of increasing leverage can be debated, that is not the purpose of this post. Instead, the chart notes the volatility in cash flows to stockholders created by the stock buyback policy (note in particular the jump in 2006). P&G could have returned the same aggregate cash flows to equity investors by paying a fixed payout ratio (110% of net income each year) or by returning 120% of their FCFE each year.

Investors who are used to receiving a fixed dividend check in the mail will undoubtedly be disappointed. However, if your primary motivation in buying stock is earning a fixed dividend, would you not be better off buying a bond instead? Ironically, forcing companies to pay a fixed dollar dividend can result in fewer companies paying dividends and those that do paying less in dividends. Perhaps, it is time for a reset on dividend policy.



The unemployment rate: A look at the sampling question.

The unemployment numbers for the United States came out yesterday and they seemed internally inconsistent. Payrolls increased by only 36,000 (a significant disappointment, since payrolls need to increase by 200,000 or more to make a dent in unemployment) but the unemployment rate dropped from 9.4% to 9%. The news, though, gives me a chance to talk about one of my favorite topics: sampling, statistics and standard error.

Staying on the unemployment numbers, it is worth examining how they are computed. The best source is the Bureau of Labor Statistics (BLS), which provides details on how it computes the numbers. What makes the unemployment numbers interesting is that the two numbers (payrolls and unemployment rate) are based upon different samples.
Unemployment rate: Here is the description of how the BLS computes this number:
http://www.bls.gov/cps/cps_htgm.htm
As the BLS points out, it uses a sample of 60,000 households, translating into about 110,000 individuals, to estimate the number of employed and unemployed people in the nation and computes the rate based upon that sample. It uses interviewers to classify these individuals into three groups -those that are employed, those that are unemployed and those that are not part of the work force (they are not employed but are not looking for work either).
Unemployment rate = Unemployed / (Employed + Unemployed)
Those who are not looking for work don't get counted.
Payroll: The BLS describes how it computes payroll numbers here:
http://www.bls.gov/bls/empsitquickguide.htm
This a survey of 140,000 businesses, with roughly 440,000 work sites, with adjustments for new businesses starting up and businesses exiting.
(Kudos to the BLS for transparency. They do an excellent job describing what they do as well as how and why they do it.)

If the last month, if the survey is to be believed, almost a half a million people decided to leave the workforce, shrinking the denominator. Thus, the abrupt drop in the unemployment rate. Since few people believe that this big a change could have occurred in January, we are seeing questions being raised and answers offered:

1. Is the sample size large enough?
Absolutely. As samples goes, these are both huge samples. To provide a contrast, the typical sample size for the polls that we see around presidential elections is 1000-2000.

2. Is there sampling bias?
This is a concern with any test based upon a sample. If the sample is not representative of the population, the results cannot be generalized. Thus, if the sample of households used by the Labor department has a disproportionate number of college graduates or people from the Mountain States or people between the ages of 45-60, the results will be skewed. Unless I see evidence to the contrary, I will continue to believe that the Labor department has unbiased and competent statisticians on its staff to ensure that there is no sampling bias.


3. How much sampling noise is there?
Even with a large sample size and no sampling bias, the results from a sample will have a standard error, i.e., a range on the estimated number. That standard error will be a function of the volatility in the underlying data. In periods like the last two and a half years, where the labor market has been in tumult, there is every reason to believe that the unemployment rate is being estimated with more error than it was in more stable time periods. There can be other sources for the noise as well. One culprit being pointed to is the weather, with some economists claiming that the terrible weather has affected employment statistics in some sectors (such as construction). This may explain the payroll data and the employed/unemployed numbers. Unless it also had an impact on data gathering as well, I don't see how this explains the surge in the number of people who have left the employment pool.

4. What post-sampling adjustments are being made to the number that may affect the reported number?
The Labor department does not report the raw numbers that it gets from its survey.
* It makes seasonal adjustments to reflect the "normal" ups and downs in employment. In December, for instance, it adjusts the employment rate to reflect the increase in part-time jobs before Christmas; thus, an increase of 100,000 jobs on the raw data might be seasonally adjusted to become an increase of only 20,000 jobs in the report. To the extent that the seasonal adjustments are incorrect or imprecise, they can cause the unemployment rate to be volatile.
* The other number that the Labor department reports is revisions to previous months' estimates. Presumably, some of the respondents being interviewed provide information that leads to a reassessment of both employment data (into employed, unemployed and not in the work force) and payroll data in prior months.

5. Can I trust the results from the sample?
Any estimate that comes from a sample has to be viewed as such: an estimate and not a fact. I believe that the employment picture is improving but it is doing so slowly. I would not be surprised to see the number of payroll jobs increase by a lot more in February but see the unemployment rate go up with it.

As a general rule, these are the questions you should ask about most assertions that you see made about economics, health and general culture. As access to data improves and the number of data-snoopers multiplies, we are bombarded every day with more, and often contradictory, findings: workers are becoming more productive (or is it less productive?).. drink more wine for good health (or is it stop drinking all together?)..  Take a deep breath and resolve to do the following on the next statistic or study that you encounter:

1. Check for bias in the source of the study. A study by a gun-control group that guns increase violence should be viewed with just as much skepticism as a study by the NRA that improving access to guns makes you safer.
2. Do not over react to any single statistic (or study). It may just reflect statistical noise. The problem will be magnified if you have small samples and are measuring a variable that is volatile or difficult to measure.
3. Look for confirmation in independent studies or assessments. With unemployment, for instance, the government does take multiple shots at getting it right. You have the unemployment claims that are estimated every Thursday, the payroll numbers and the unemployment rates. You also have estimates from private sources: ADP estimates the number of jobs created each month by private businesses and reports it just before the government reports the unemployment rate. I will feel more sanguine about US employment when I see all the numbers start moving in the same direction.
4. Statistical significance does not always equate to real world significance. There are a lot of findings that are statistically significant that matter very little in the real world. This is especially so with large sample studies, where small changes in a variable can be statistically significant.

I know it is asking too much of reporters and researchers to be transparent: report sample sizes, standard errors and any information that may reflect your bias. On my part, I will try to do better on this dimension. However, as consumers, we need to be more skeptical about data and wary about generalizations.



The Shift to Buybacks: Implications for investors

A couple of posts ago, I noted the shift from dividends to stock buybacks at US corporations, a shift that is already starting to have ripple effects in other markets. In 2010, about 60% of the cash returned by S&P 500 companies came from stock buybacks, whereas only 40% took the form of dividends. Since so much of investment lore is built around dividends, there are consequences for investors of all types:

a. The dividend player: In the earliest days of equity markets, the advice given to investors was simple. Find a stock that pays a "big" dividend, and growth then is pure icing on the cake; the dividends will generate cash income while you hold the stock and the growth will provide for price appreciation. Over the decades, there are many investment strategies that have built around this premise, from the "Dow Dogs" (investing in the stocks with the highest dividend yields on the Dow 30) to more sophisticated variants. The academic research has been supportive, as I noted in an earlier post, with high dividend yield stocks generating excess returns, after adjusting for risk.

At first sight, the shift to buybacks may seem like bad news for investors focused on dividends, but I think it actually strengthens their hand. It is true that there are fewer "big" dividend payers than there used to be, but if you buy into the earnings stability argument (that the reason for the shift to buybacks is because companies feel less secure about future earnings), those big dividend payers who remain must feel even more confident about their future earnings potential than the dividend payers of the past. Put in more abstract terms, if increasing dividends was a positive signal in the past (when it was the only option for returning cash), it should be even more so now (when it would be far easier to just buy back stock).

So, what are the caveats? First, the universe of stocks that you can invest in going to be smaller and there may be entire sectors (technology, for instance), where you will find few or no stocks to invest in. Second, watch out for the impostors. These are the companies with unstable earnings that have no business paying large dividends but do so because they want to take advantage of a large and loyal investor base that likes dividends.
Bottom line: Focus on stocks that pay large dividends and treat buybacks as noise that you either weight very little or not at all in your investment decision. Screen for stocks that have the earnings to sustain dividends and offer some growth potential, and eliminate companies that have unsustainable dividends (they pay dividends with borrowed money or by selling assets).

b. The "cash" player: There are many investors who want near term cash flows from their investments, but are not particularly attached to dividends. These investors should consider stock buybacks as cash payback, when assessing stocks, since they can always tender a portion of their shares in each buyback. These investors should be adjusting measures like dividend yield and dividend payout, commonly used by "dividend' based investors, to include stock buybacks. In fact, all of these measures can be computed with what I call augmented dividends = dividends + stock buybacks:
Augmented Dividends = Dividends + Stock Buybacks
Augmented Dividend yield = Augmented Dividends/ Market Capitalization
Augmented Dividend payout = Augmented Dividends/ Earnings
Since buybacks are volatile, you should use a normalized or average buyback per year, in computing the augmented dividend.

While this strategy does widen the universe of stocks that you can invest in, it is also more risky than a pure dividend strategy. You cannot count on buybacks; in 2009, for instance, the dividends paid by US companies dropped by 10% in the aggregate but stock buybacks dropped by almost 80%.  As I noted in an earlier post, there is a significant sub-section of companies that make themselves less valuable and perhaps even put themselves at risk of distress by buying back stock.
Bottom line: Focus on companies that buy back stock for the right reasons - because they are under levered and have few investment opportunities. Stay away from over levered companies that buy back stock with even more borrowed money.

c. The growth player: There are investors who have little interest or need for near term cash but are much more focused on long term growth and price appreciation. For these investors, buybacks are a mixed blessing. On the minus side, at some growth companies, the announcement of a buyback is a signal that the days of heady growth are over and that the company is approaching a more mature status. That would be a signal to sell. On the plus side, the use of buybacks may allow some mature companies to become growth investments. How? A growth investor who holds on to his shares will get price appreciation as other investors tender their shares.
Bottom line: Look for mature companies where buybacks offer the most price appreciation potential. In general, these will be companies that are perceived to have few growth opportunities and have significant debt capacity. At growth companies, reassess prospects for the future on the announcement of a buyback. The price bounce after a buyback may offer the perfect exit strategy.


No matter what type of investor you are, you need to be aware of when and how much companies are buying back. Unfortunately, both conventional print media (Wall Street Journal, Financial Times) and data services (Yahoo! Finance, Morningstar etc.) seem to pay little heed to buybacks. While it is possible to extract the raw data from the statement of cash flows, I think that adding an augmented dividend number would be a step in the right direction.



Breach of Trust: Bank Valuation after the banking crisis

Until the banking crisis of 2008, investors had made a Faustian bargain, when it came to valuing and investing in banks. Banks were opaque in their public disclosures and investors often had little information on either the risk of the securities held or the default probabilities of loan portfolios. However, investors were willing to accept this opacity and view banks as "safe" investments for two reasons:
  1. Banks were regulated in their risk taking: In effect, we were assuming that bank regulators would bring enough scrutiny to the process to prevent banks from taking "rash" risks. (We also assumed that the regulatory authorities had access to far more information that we did and would act accordingly.)
  2. Assets (and equity capital) were marked to market: The notion of marking to market was adopted much more quickly in financial service firms than at other sectors. Our distrust of accounting notwithstanding, we assumed that the book values for banks actually were good reflections of market value.

How did this faith in the regulatory overlay get reflected in valuation/investing?
  • In intrinsic valuation, banks remained the last holdout for the use of the dividend discount model. Unlike other companies, where our distrust in managers paying out what they could afford to had led us to move on to free cash flows, we retained the faith that bank managers, constrained by the need to meet regulatory capital constraints on one hand and "dividend seeking" investors on the other, would pay out what they could afford to in dividends. (In effect, banks that paid too much in dividends would be punished by the regulators and those that paid too little in dividends would be punished by investors.) 
  • In relative valuation, the book value of equity in a bank was given more weight than in other sectors, because it was marked to market and subject to regulatory capital rules. Thus, price to book ratios (with returns on equity as companion variables) were widely used in analysis: a bank with a low price to book ratio and a high return on equity was viewed as a bargain. Worse still, risk averse investors were asked to buy the highest dividend yield banks and assured that these yields were secure.
So, what's changed? First, our faith in both bankers and regulators has been shaken, perhaps to a point of no return. We can no longer assume that having regulatory rules on risk taking will result in sensible risk taking at individual banks. There can be, as there are in other sectors, very risky banks, risky banks, safe banks and very safe banks, as a consequence. Second, the erratic and often ill-thought out dividend policies adopted by banks since the crisis indicates that bank managers, at many banks, use dividends as a blunt weapon. How else can you explain banks with precarious capital ratios that continue to pay and increase dividends, while raising fresh capital in preferred stock at the same time? In fact, it is a sign of the times that the Fed  stepped in to stop a major money center bank from paying dividends, as it did with Bank of America a couple of weeks ago.

So, what do we do now? In intrinsic valuation, we have two choices.
1. One is to use a modified version of the dividend discount model, where we estimate future dividends based upon expected growth and the return on equity that we foresee for a bank, rather than the actual dividends in the last period. Thus, if a bank is expected to grow at 8% and has a return on equity of 10%, it an afford to pay out only 20% of its earnings as dividends:
Payout ratio = 1 - Expected growth rate/ Return on equity
Thus, we can bring in both the quality of a bank's investments and expected changes in regulatory capital rules into the valuation. Increases in regulatory capital requirements will reduce the return on equity and by extension, the capacity to pay dividends.
2. The other and more complicated route requires knowledge of regulatory capital requirements and involves the following steps. You first estimate the growth in the asset base of the bank (growth in loans, for instance). You then follow up by estimating how much regulatory capital will be required to sustain the asset base - that will depend upon the risk in the asset base and the regulatory capital ratio that the bank wants to maintain. (Note that this ratio will not necessarily be at the regulatory minimum since conservative banks will maintain a buffer.) Changes in regulatory capital from period to period than take on the role that capital expenditures do in a more conventional firm and can be used to compute free cash flows to equity:
FCFE for a bank = Net Income - Change in Regulatory capital required for future growth
These FCFE are potential dividends and can be discounted to arrive at fair value. In fact the cost of equity for a bank can then be tied to its regulatory capital buffer: banks that build in a bigger buffer will be safer and have a lower cost of equity whereas banks that are more aggressive in both their asset holdings and regulatory capital policies will have higher costs of equity.

In relative valuation, I think that the use of price to book ratios, in conjunction with return on equity, still makes sense, but risk now has to be treated as a third dimension. The risk itself can be measured using a variety of measures: regulatory capital ratios (higher ratios are safer), losses on bad loans (higher is riskier) or holdings of toxic securities (higher is riskier). A bargain bank will then be one that trades at a low price to book ratio, has a high return on equity and is well capitalized. I expand on both notions in this paper that I wrote a couple of years ago on valuing banks (which subsequently became a chapter in one of my books):
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1798578

I think that there are broader policy implications.
  1. More transparency in financial statements: Since banks have broken their side of the bargain with investors, we need to respond by removing the opacity from the financial statements of banks. Banks should be forced to provide far more detail about the riskiness of their security holdings and the default risk in the loans that they make. Much more information needs to be provided about regulatory capital requirements and the policies that banks adopt on regulatory capital should be more transparent.
  2. Regulatory capital has to be common equity: Banks that are under capitalized should be required to issue common stock, and face up to their fears of dilution. We need to scrap the notion that preferred stock (a tax-inefficient mismash) or convoluted hybrids (such as these) will be treated as equity, since it exposes us to game playing and worse.

I am not ready to give up on investing in banks. In fact, I am sure that some banks are great bargains and the payoff to finding these, in this time of greater uncertainty, is higher than ever before. But I will be more careful in my assessments of banks and not take numbers for given, just because they have been rubber stamped by regulators and appraised by accountants. That is more a promise to myself than to you!



Catastrophe and consequences for value

The airwaves have been inundated with news about natural disasters in Japan and their aftermath. Without minimizing the human impact - the thousands who have lost their lives and belongings - and the dangers of a nuclear meltdown, I want to focus on the impact of catastrophes, natural or man-made, on markets and asset values. While each disaster is different, here are some common themes that emerge after the disaster:

a. Our definition of "long time periods" is woefully inadequate: After the quake, which measured 8.9 on the Richter scale and ranked as one of the five strongest in recorded history, it was noted that nothing of this magnitude had been seen in Japan over the last 300 years. Since much of the regulation (of construction and nuclear power plants) had been structured based upon past history, they proved inadequate for the quake. As I look at how much of what we do in corporate finance and valuation is based upon time periods of 80-100 years (if we are lucky) and 10-20 years (if we are not), I wonder how much we are missing as a consequence of our dependence on the past.
 b. Experts are always "surprised" and are exceptionally good at ex-post rationalization: I am not that knowledgeable about earthquakes, but as I watched earthquake experts on the news in the days following the quake, I was struck by how much they reminded me of financial experts after the banking crisis in 2008 in their messages. First, for the most part, they admitted to be surprised by both the magnitude and the location of the quake (just as banking experts were surprised by the magnitude of and players in the sub-prime crisis). Second, they waxed eloquent about how uncertain they were about  long term consequences.... which leaves me wondering why we call them experts in the first place.
c. The doomsayers will have their day in the sun:  In the aftermath of every crisis, there will be people who emerge from the woodwork to say "I told you so". They will be feted as celebrities and treated as oracles, at least for a while. My response is less positive. After all, I have walked by the crazy preacher in Times Square almost every weekday, for close to 25 years, and he has warned me every single time that I have passed him that the end of the world was coming... He did sound prescient on September 12, 2001, but he was bound to, sooner or later. That is the reaction I have to those who preach doom and gloom all the time. They will be right at times but I will not attribute that success to wisdom but to accident....
d. Managing catastrophic risk exposure is much more difficult than managing continuous risk exposure: As companies and investors with Japanese risk exposure struggled with the aftermath of the disaster, I was reminded again of how much more difficult it is to manage and deal with discontinuous risk than continuous risk, especially if that risk occurs infrequently and has large economic consequences. In fact, this is the reason that I argued that companies that think that operating in authoritarian, stable regimes is less risky than operating in democratic chaos are mistaken. It is also the reason why managing exchange rate risk in a floating rate currency is much easier than managing that risk in a fixed rate currency.

I am not a deep thinker and am more interested in the prosaic than in the profound,  but I would like to address two questions that I have been asked in the last two weeks:

i. Are the markets reacting appropriately to the news?
While my instincts, based upon everything I know about behavioral finance, would lead me to say that markets  overreact to crises, I am not convinced by the analysis that I have read that make this argument with the Japanese tsunami. While much of the commentary has noted that the market value lost (in the Nikkei) has been disproportionally large, relative to the cost of of the damage, the definition of cost (as damage to existing assets) seems crimped.

As I see it, there are three levels of cost from any catastrophe:
a. Damage to existing assets: This is measured, either in terms of book value (or what was originally spent to build or acquire these assets) or replacement cost (to replace the damaged assets).
b. Loss of earnings power: The true value lost in a catastrophe is not the original cost, replacement cost or book value of the assets destroyed but the present value of cash flows lost in future periods as a result of the loss. Thus, when a factory with a book value or replacement cost of $50 million collapses, the value lost is the present value of the expected cash flows that would have been generated by the factory. If the firm was generating returns that exceeded its cost of capital, the value from the foregone cash flows will exceed $ 50 million.
c. Psychic damage: Catastrophes create psychic damage by reminding investors not only of their own mortality but of the fragility of the assumptions that they make to justify value. After all, in discounted cash flow valuations, we assume that cash flows  continue in perpetuity for most companies and that big chunks of value (especially for growth companies) come from expectations of excess returns from investments that firms will make in the future. To the extent that catastrophes shake this faith that investors have in the future, they can create significant damage to the value of growth assets.


The change in market value after a catastrophe will reflect these costs to varying degrees.
  • For mature businesses that generate little in terms of excess returns, the loss in value will approximate just the damage to existing assets (since the present value of cash flows should be close or equal to the book value). 
  • For mature businesses that generate returns on their investments that exceed the cost of capital, the value loss will be higher than the replacement cost or book value of existing assets and be more reflective of the lost cash flows. 
  • For growth firms, the loss in value can be extensive (as expectations of future growth get downgraded) even though they may suffer the least losses to existing assets.
If you are a contrarian or value investor, who believes that the psychic damage is transitory, there is an investment strategy that emerges from the rubble. It is not to invest in the entire market (all Japanese stocks) or in companies that have dropped the most in price (because some  may be mature companies like Tokyo Electric Power that have suffered significant loss of earning power), but to pick those companies where the price drop is more the result of the psychic reaction than the economic costs. (Multinationals like Honda, Toyota and Fuji that are Japanese in origin but have both their revenues and operations spread over the world would be a good place to start looking.) The risk, of course, is that the psychic damage is long term and not easily reversed.

ii. How do you incorporate the risk that catastrophes can occur in the future into valuation models?
If we define catastrophes as low-probability, high-impact events that affect most companies in an economy, there are three ways in which we can incorporate those events into value:
a. Adjust cash flows for an expected insurance cost: The simplest mechanism for building in the potential for catastrophes is to estimate the cost of insuring against catastrophes and building that cost into the expected cash flows. This, in turn, will lower the cash flows and value of every asset. It may be difficult to do for two reasons. The first is that some catastrophes may be uninsurable and getting an estimate of the insurance cost is not easy. The second is that even if there are insurers willing to provide coverage, a large enough catastrophe may render them incapable of backing up their promises (by making them insolvent). Note also that insurance covers only the first of the three levels of costs - damage to existing assets - and provides little protection against the other two levels - loss of expected cash flows and loss in growth asset value.
b. Use a higher risk premium: When buying risky assets, investors attach a risk premium to their required returns- an equity risk premium in the equity market and default spreads in the bond market. Since catastrophes affect entire markets, one way in which investors can build their likelihood (and consequent damage) into value is by charging higher risk premiums. As a consequence, the potential for catastrophe will have a much larger effect on risky, high growth firms than on safer,  mature companies. (The higher risk premium will push up costs of capital for all firms, but growth firms will be more affected since they get more of their value from cash flows way into the future.) To me, this seems to be the most viable option, especially when faced with risks that occur rarely, have large effects and are difficult to quantify in cash flow terms. I had an extended post on this a few months ago.
c. Allow for a higher probability of truncation risk: As I noted earlier, we value companies assuming cash flows in perpetuity (or at least for very long time periods), and catastrophes can put firms at risk of default or distress. When valuing companies (especially those with significant debt or other obligations), we should not only be more cautious about long term assumptions but also explicitly build into value, the likelihood that the firm will not survive.
 



A tide in the affairs of men...

In my last post, I noted how difficult it is to separate luck from skill in  both investment and corporate finance.  While I remain leery of stock picking success stories (and believe me when I say I hear dozens each week), I continue to admire successful businesses of all stripes, from the bagel shop in my town that manages to sell out every day to Facebook in the social media world.

It is not that luck does not play a role in business success. In fact, most successful individuals and businesses can point to a stroke of good luck that got them started.  Microsoft was lucky that IBM allowed it to write the code that made the first personal computers work and Apple was lucky that music companies were too bullheaded to deviate from their traditional sales model of bundling a dozen songs on an album and forcing people to buy the entire package. It is what great companies do with that initial lucky break that set them apart: when they get lucky, they take that success and build on it. Most other businesses, however, view good luck as a windfall, report higher earnings for the year, but have little to show for it in the long term.

In fact, this was the reason I wrote my book on strategic risk taking. If the essence of risk taking is that you are going to be right some of the time and wrong the rest of the time, here is what I see separating good risk takers from bad ones. When good risk taking organizations get lucky and see upside from risk taking, they find ways to build on that upside. When they are confronted with unpleasant surprises, they manage to minimize their losses and move on. In option terminology, successful risk takers create their own call options to augment upside risk and put options to minimize downside risk. Of course, I am not the first to recognize this. Here is one of my favorite quotes from Shakespeare:
There is a tide in the affairs of men.
Which, taken at the flood, leads on to fortune;
Omitted, all the voyage of their life
Is bound in shallows and in miseries.
On such a full sea are we now afloat,
And we must take the current when it serves,
Or lose our ventures.

Brutus had a splendid grasp of risk taking (though I don't quite know where to put the stabbing of Julius Caesar in the risk taking scale).

Put in less lofty terms, each of us will be blessed with good luck in our investment and business endeavors at some point in time. What we do with that luck will determine whether it leaves a lasting mark or not. In the same vein, each of us will also be unlucky at some point in time and how prepared we are for that contingency will determine whether it will bring us down or just dent us.



Luck versus skill: How can you tell?

A hedge fund manager doubles her investors' money over the course of a year.. A company's stock increases four fold over the course of six months.... these are not unusual news stories but they give rise to one of those enduring questions in finance: Was it luck or skill? The answer of course is critical. If it was "luck", we should not be giving the hedge fund manager 2% of our wealth and 20% of the profits. If it was skill, the company's managers deserve not just a huge thank you but commensurate financial rewards.

As always in finance, there are two extreme outlooks. At one end, there are those who view any superior performance as evidence of skill and extended superior performance as almost super natural. At the other end, there are those who who contend that it is all "luck" and that portfolio managers have any "discernible skill". As an illustration, Fama and French have a damning article on active portfolio management, where they note that all of the excess returns in practice can be explained by randomness:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1356021
In their assessment, all "superior performance" in portfolio management  can be attributed to luck. Here is a more recent paper by Andrew Mauboussin and Sam Arbesman that argues that there is some evidence of differential skill:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1664031
Needless to say, this is an issue where researchers have disagreed and continue to do so.

You may disagree with the broadness of the Fama/French conclusions (and I do), but they do point out how difficult it to differentiate lucky winners from skillful winners. To understand why, it is best to look at an arena where the differentiation between luck and skill is easier: sports. Even those who don't like Sachin Tendulkar, Lionel Messi, Tiger Woods or Kobe Bryant have to admit that they have skills the rest of us don't possess and that their success cannot be attributed to luck.  So, why is it so easy to separate skill from luck in sports and not so in finance? Separating luck from skill is easiest when:

a. Success is clearly defined: In basketball, you either make a basket or you do not. In cricket, you are out or you are not. In golf, you make par or you do not. In soccer, you score a goal or you do not.  An "almost a basket" or "almost par" can be a chatting point with a friend but does not count.

b. It is difficult to have a successful outcome with just luck: I will make a confession. I cannot shoot par on a golf course, make a three pointer in basketball or score a goal in soccer, even with luck.  I am awed when I see people do these things, since I know it requires skills that I do not have.

c. Number of trials: Professional sports players get hundreds of chances to show their wares, and luck very quickly drops to the wayside. You may make one three-pointer in the gym, with sheer luck, but if you were asked to shoot a few hundred three pointers, your limitations would be clear to all. There is no way that luck can explain the hundreds of sub-par rounds that Tiger Woods had (when he was a golfer and not a celebrity), the runs that Sachin scored for India, the points (and championships) for Kobe and the goals that Messi has scored for Argentina (and Barcelona) over time.

Looking at finance through these lens, it is easy to see why it is so difficult to separate luck from skill:

a. Success is not clearly defined: Is a portfolio manager who makes money for his investors a success? What about one who beats the S&P 500 each year? Is a company that delivers returns that outstrip the rest of the sector a success a "good" company? The very fact that we have to think about our answers to these questions tells you something about "success" in finance. To be successful, you have to beat your benchmark, after controlling for risk. However, since risk is a subjective measure, it is entirely possible for a portfolio manager to be classified as a success by one evaluator and not by another. With hedge funds and private equity managers, it becomes even more so, since the net risk exposure is often tough to measure.


b. It is easier being successful with just luck in finance:  I would not bet my house that my portfolio selections will deliver higher returns in the next year than those of my neighbor, who picks stocks based on astrological signs and has the financial sense of a dodo, or of my 11-year old son, who has never looked at the Wall Street Journal. As I note in my valuation class, there is no justice in the investing world. You can do everything right (collect the data, analyze it carefully, make reasoned judgments) and go bankrupt... and you can be absolutely cavalier in your investment judgments and make millions.

c. Too few trials: Can you be lucky once? Sure! How about 4 times in a row? Yes.. How about 15 years in a row? Not as easy, but with hundreds of people trying, a few will.... One problem that we face in portfolio management and corporate finance is that we get to observe outcomes too infrequently, making it difficult to separate luck from skill.

I don't mean to leave you in limbo. After all, most of us want to separate luck from skill in finance. So, here are the things that I would look for in a "skillful" portfolio manager or a CEO:

a. Consistency: As an investor, I don't want to just see that you beat the market, on average, but that you beat it consistently for an extended period. I am more likely to attribute your success to skill, if you beat the market by 2-3% each year for 15 years than if you beat the market by an average of 2-3%, with more variability and poor years intermixed, over that period.

b. Transparency: I tend to mistrust success, when that success is based on portfolio managers self-appraising the values of the properties and investments in their portfolios. A hedge fund may claim it made a 30% return last year, but if that return was based on appraised values for non-traded assets, did it really make 30%? If your success is based on skill and not luck, you should have as open a process as possible for measuring returns and risk and allow investors to observe that process.

c. Awareness: If you beat the market, you are pulling off a difficult feat, since there are literally millions of investors attempting to to do the same thing. If it is not luck that is causing the superior performance, you have to be able to point to something that you are bringing to the table that others are not - better information, better analytical tools, a longer time horizon or a very different tax status. If you don't know why you are beating the market, rest assured that you will not be beating the market for very long..... In my experience, the most skillful investors tend to not only be the most self aware (of their strengths and limitations) but also have no qualms about letting you know what their investment philosophy is. (Note that you can be secretive about investment strategies but you give away little by sharing an investment philosophy).

d. Humility: This is my subjective input to the process. In my years in the market, I have discovered that it is the lucky investors (with no skill) who are most hot headed and arrogant about their skills, and that skillful investors recognize how much luck can affect their final returns.

Here is my bottom line for a skillful portfolio manager or CEO: I am looking for a person who has been able to deliver performance that beats the competition consistently over many years, can tell you why he or she can pull this off and is willing to concede that luck could explain the whole phenomena....

Update: A couple of you have drawn my attention to Mike Mauboussin's excellent and extended discussion of the topic.
www.lmcm.com/pdf/UntanglingSkillandLuck.pdf
Mike is one of my favorite thinkers in finance - he is always original and manages to think across disciplines - and I don't know how I missed this piece but he says what I was trying to say much better than I ever could, and in much more depth. Do read it!



Behavioral Economics: Thoughts on Value and Price

I must confess that I was a skeptic on behavioral finance until a few years ago. At that point, the amount of information that had been accumulated on the "irrational" behavior of investors became so overwhelming that I faced one of two choices. I could ignore reality and live in the clean, rational world of classical economics or I could face up to facts and think about how investment and corporate finance decisions should be made in the messy world that we live in. After struggling with the conflict, I think I am making some progress. In an earlier post  on the third edition of my corporate finance book, I noted my attempts to incorporate the findings from behavioral finance into every aspect of corporate finance from how to create effective boards of directors to capital budgeting and capital structure decisions.

Reconciling behavioral finance with my view of the world has been tougher in my other area of interest: valuation. Every semester that I teach the valuation class, using the tools of the trade (discounted cash flow models, relative valuation), I am asked how I would incorporate the findings from behavioral finance into valuation. Here is my reaction. I don't think intrinsic valuation approaches will change much, if at all, as a result of behavioral economics. The expected cash flows are still the expected cash flows and  the required return still has to reflect the perceived risk in the investment.

So, what does change? Remember that to make money of your valuations, not only do you have to be able to value assets but the price has to move towards that value. Behavioral economics provides us with interesting insights on three dimensions:

a. Why do different analysts arrive at different estimates of value for the same company?  When you value a company, you are one of many doing so, often drawing on the same information as other investors, and often using the same models. So why do different analysts arrive at different estimates of value?  By looking at the interaction between psychology and valuation, behavioral economics yields interesting insights into why the values that we arrive at are different (and by extension, why some of us are buyers and others are sellers) and the systematic errors (over valuation or under valuation) that we make as a consequence.

b. Why does price differs from value? In the classical world, the price can deviate from value because investors make mistakes or because the price may reflect information that the analyst may not have or vice versa. With behavioral economics, we are learning that even if investors may behave in ways (refusing to sell losers, wanting to be part of the crowd, being over confident and misassessing probabilities) that cause prices to diverge from value by significant amounts.

c. When will they converge? Behavioral economics may provide us with clues about how quickly convergence between price and value will happen and why the speed may vary across assets. That would be incredibly useful to an investor. Thus, we may be able to answer a question that has historically eluded us: If I buy a cheap stock today (and I am right about it being cheap), how long do I have to wait before my bet pays off?

As investors, it behooves us to not only become conversant with the findings in behavioral finance but to also recognize when following instinct can damage portfolios. Meir Statman, one of my favorite behavioral economists, has written a great book on how investors can overcome their base urges and make better decisions:
http://www.amazon.com/What-Investors-Really-Want-Financial/dp/0071741658/ref=ntt_at_ep_dpi_1
I hope you get a chance to read it. There is much work to be done, but the foundations are being laid.




Alternatives to the CAPM: Wrapping up

Even as we agree to disagree about the usefulness or lack of the same of CAPM betas, let us reach consensus on a fundamental fact. To ignore risk in investments is foolhardy and not all investments are equally risky. Thus, no matter what investment strategy you adopt, you have to develop your own devices for measuring and controlling for risk. In making your choice, consider the following:

a. Explicit versus implicit: I know plenty of analysts who steer away from discounted cash flow valuation and use relative valuation (multiples and comparable firms) because they are uncomfortable with measuring risk explicitly. However, what they fail to recognize is that they are implicitly making a risk adjustment. How? When you compare PE ratios across banks and suggest that the bank with lowest PE ratio is cheapest, you are implicitly assuming that banks are all equally risky. Similarly, when you tell me to buy a technology firm because it trades at a PEG ratio lower than the PEG ratio for the technology sector, you are assuming that the firm has the same risk as other companies in the sector. The danger with implicit assumptions is that you can be lulled into a false sense of complacency, even as circumstances change. After all, does it make sense to assume that Citigroup and Wells Fargo, both large money center banks, are equally risky? Or that Adobe and Microsoft, both software firms, have the same risk exposure?


b. Quantitative versus qualitative: I am constantly accused of being too number oriented and not looking at qualitative factors enough. Perhaps, but I think the true test of whether you can do valuation is whether you can take the stories that you hear about companies and convert them into numbers for the future. Thus, if your story is that a company has loyal customers, I would expect to see the evidence in stable revenues and lots of repeat customers; as a result, the cash flows for the company will be higher and less risky. After all, at the end of the process, your dividends are not paid with qualitative dollars but with quantitative ones.

c. Simple versus complicated: Another mantra that I push is that less is more and to keep things simple. In fact, one reason that I stay with the CAPM is that it is a simple model at its core and I am reluctant to abandon it for more complex models, until I am given convincing evidence that these models work better.

So, find your own way of adjusting for risk in valuation but refine it and question it constantly. The best feedback you get will be from your investment mistakes, since they give you indicators of the risks you missed on your original assessment. As for me, I remain wedded to the fundamental principle that value is affected by risk but not to any risk and return model, which to mean just remains a means to an end.

The series on alternatives to the CAPM:
Alternatives to the CAPM: Part 1: Relative Risk Measures
Alternatives to the CAPM: Part 2: Proxy Models
Alternatives to the CAPM: Part 3: Connecting cost of equity to cost of debt
Alternatives to the CAPM: Part 4: Market-implied costs of equity
Alternatives to the CAPM: Part 5: Risk adjusting the cash flows
Alternatives to the CAPM: Wrapping up




Alternatives to the CAPM: Part 5. Risk Adjusting the cash flows

In the last four posts, I laid our alternatives to the CAPM beta, but all of them were structured around adjusting the discount rate for risk. Having made this pitch many times in the past, I know that there are some of you who wonder why I don't risk adjust the cash flows instead of risk adjusting the discount rate. The answer to that question, though, depends on what you mean by risk adjusting the cash flows. For the most part, here is what the proponents of this approach seem to mean. They will bring in the possibility of bad scenarios (and the outcomes from these scenarios) into the expected cash flows and thus risk adjust them. As I will argue below, that is not risk adjustment.

It is true that there are two ways in which you can adjust discounted cash flow value for risk. One is to estimate expected cash flows across all scenarios, essentially multiplying the probability of each scenario by the likelihood of that scenario unfolding, and then to discount those expected cash flows using a risk adjusted discount rate. The other is to take the expected cash flows and replace them with "certainty equivalent" cash flows and discounting those certainty equivalent cash flows at the riskfree rate.

But what are certainty equivalent cash flows? To illustrate, let me provide a simple example. Assume that you have an investment, where there are two scenarios: a good scenario, where you make $ 80 instantly and a bad one, where you lose $ 20 instantly. Assume also that the likelihood of each scenario occurring is 50%. The expected cash flow on this investment is $30 (0.50*$80 + 0.50*- $20). A risk neutral investor would be willing to pay $ 30 for this investment but a risk averse investor would not. He would pay less than $ 30, with how much less depending upon how risk averse he was. The amount he would be willing to pay would be the certainty equivalent cash flow.

Applying this concept to more complicated investments is generally difficult because there are essentially a very large number of scenarios and estimating cash flows under each one is difficult to do. Once the expected cash flow is computed, converting it into a certainty equivalent is just as complicated. There is one practical solution, which is to take the expected cash flow and discount it back at just the risk premium component of your discount rate. Thus, if your expected cash flow in one year is $ 100 million, and your risk adjusted discount rate is 9% (with the risk free rate of 4%), the certainty equivalent for this cash flow would be:
Risk premium component of discount rate = (1.09/1.04)-1 = 4.81%
Certainty equivalent cash flow in year 1 = $ 100/ 1.0481 = $95.41
Value today = Certainty equivalent CF/ (1 + riskfree rate) = $95.41/1.04 = $91.74
Note, though, that you would get exactly the same answer using the risk adjusted discount rate approach:
Value today = Expected CF/ (1 + risk adjusted discount rate) = 100/1.09 = $91.74
Put differently, unless you have a nifty way of adjusting expected cash flows for risk that does not use risk premiums that you have already computed for your discount rates, there is nothing gained in this exercise.

There is two practical approaches to certainty equivalent cash flows that I have seen used by some value investors. In the first, you consider only those cash flows from a business that are "safe" and that you can count on, when you do valuation. If you do so, and you are correct in your assessment, you don't have to risk adjust the cash flows. The next time you are told that Buffett does not risk adjust his valuations, take a look at whether this is in fact what he is doing. The second variant is an interesting twist on dividends and a throw back to Ben Graham. To the extent that companies are reluctant to cut dividends, once they initiate them, it can be argued that the dividends paid by a company reflects its view of how much of its earnings are certain. Thus, a firm that is very uncertain about future earnings may pay only 20% of its earnings as dividends whereas one that is more certain will 80% of its earnings. An investor who buys stocks, based upon their dividends, thus has less need to worry about risk adjusting those numbers.

Bottom line. There are no short cuts in risk adjustment. It is no easier (and often more difficult) to adjust expected cash flows for risk than it is to adjust discount rates for risk. If you do use one of the short cuts - counting only safe cash flows or just dividends - recognize when these approaches will fail you (as they inevitably will) and protect yourself against those consequences.

The series on alternatives to the CAPM
Alternatives to the CAPM: Part 1: Relative Risk Measures
Alternatives to the CAPM: Part 2: Proxy Models
Alternatives to the CAPM: Part 3: Connecting cost of equity to cost of debt
Alternatives to the CAPM: Part 4: Market-implied costs of equity
Alternatives to the CAPM: Part 5: Risk adjusting the cash flows
Alternatives to the CAPM: Wrapping up




Alternatives to the CAPM: Part 4: Market-Implied cost of equity

As you can see from each of the alternatives laid out in the previous three parts, there are assumptions and models underlying each alternative that can make users uncomfortable. So, what if you want to estimate a model-free cost of equity? There is a choice, but it comes with a catch.

To see the choice, assume that you have a stock that has an expected annual dividend of $3/share next year, with growth at 4% a year and that the stock trades at $60. Using a very simple dividend discount model, you can back out the cost of equity for this company from the existing stock price:
Value of stock  = Dividends next year / (Cost of equity - growth rate)
$ 60  = $3.00/ (Cost of equity -4%)
Cost of equity = 9%
The mechanics of computing implied cost of equity become messier as you go from dividends to estimated cash flows and from stable growth models to high growth models, but the principle remains the same. You can use the current stock price and solve for the cost of equity. For those of you who use Excel, the goal seek function or solver work very well at doing this job, even in the most complicated valuations.

This cost of equity is a market-implied cost of equity. If you are in corporate finance and need a cost of equity to use in your investment decisions, it would suffice. If you were required to value this company, though, using this cost of equity to value the stock would be pointless since you would arrive at a value of $ 60 and the not-surprising conclusion that the stock is fairly priced.

So, what point is there to computing an implied cost of equity? I see three possibilities.
  1. One is to use a conventional cost of equity in the valuation and to compare the market-implied cost of equity to the conventional one to see how much "margin for error" you have in your estimate. Thus, if you find your stock to be undervalued, with an 8% cost of equity, but the implied cost of equity is 8.5%, you may very well decide not to buy the stock because your margin for error is too narrow; with an implied cost of equity of 14%, you may be more comfortable buying the stock. Think of it as a marriage of discounted cash flow valuation with a margin of safety. 
  2. The second is to compute a market-implied cost of equity for an entire sector sector and to use this cost as the cost of equity for all companies in that sector. Thus, I could compute the implied cost of equity for all banks of 9%, using an index of banking stocks and expected aggregate dividends on that index.  I could then use that 9% cost of equity for any bank that I had to value. This, in effect, brings discounted cash flow valuation closer to relative valuation; after all, when we compare price to book ratios across banks, we are assuming that they all have the same risk (and costs of equity).
  3. The third is to compute the market-implied cost of equity for the same company each period for a number of periods and to use that average as the cost of equity when valuing the company now. You are, in effect, assuming that the market prices your stock correctly over time but can be wrong in any given time period.
I use traditional models of risk and return to estimate costs of equity in valuation but I use market-implied costs of equity extensively. As those of you who track my equity risk premium estimates and posts know, I compute an implied equity risk premium for the S&P 500 every month, using exactly the approach described above (though I augment dividends with buybacks). When I value individual companies, I do compare my estimates of cost of equity with the market-implied estimates. Finally, when I am concerned that the beta for a firm is not reflecting its underlying risk, because the sector itself has changed, I compute a market-implied cost of equity for the sector. For instance, after the banking crisis in 2008, I felt that using the beta for a bank or even a sector-average beta to estimate the cost of equity made no sense, since much of the data used in the estimates reflected pre-crisis returns. Consequently, I used the S&P banking index to back out an implied cost of equity (which yielded an estimate almost 4% higher than the CAPM estimate) and used it in my valuations.

The series on alternatives to the CAPM
Alternatives to the CAPM: Part 1: Relative Risk Measures
Alternatives to the CAPM: Part 2: Proxy Models
Alternatives to the CAPM: Part 3: Connecting cost of equity to cost of debt
Alternatives to the CAPM: Part 4: Market-implied costs of equity
Alternatives to the CAPM: Part 5: Risk adjusting the cash flows
Alternatives to the CAPM: Wrapping up




Alternatives to the CAPM: Part 3: Connecting cost of debt to cost of equity

Analysts have generally had an easier time estimating the cost of debt than the cost of equity, for any given firm, for a simple reason. When banks lend money to a firm, the cost of debt is explicit at least at the time of borrowing and takes the form of an interest rate. While it is true that this stated interest rate may not be a good measure of cost of debt later in the loan life, the cost of debt for firms with publicly traded bonds outstanding can be computed as the yield to maturity (an observable and updated number) on those bonds.

Armed with this insight, there are some who suggest that the cost of equity for a firm can be estimated, relative to its cost of debt. Their intuition goes as follows. If the pre-tax cost of debt for a firm is 8% its cost of equity should be higher. But how much higher? One approach that has been developed is to estimate the standard deviation in bond and stock returns for a company; both numbers should be available if both instruments are traded. The cost of equity then can be written as follows:
Cost of equity = Cost of debt (Standard deviation of equity/ Standard deviation of bond)
Thus, in the example above, if the standard deviation in stock prices is 30% and the standard deviation in bond prices is only 20%, the cost of equity will be 12%.
Cost of equity = 8% (30/20) = 12%
In fact, an alternative to using historical standard deviations is to use implied standard deviations, assuming that there are options outstanding on the stock, the bond or on both.

While this approach seems appealing, it is both dangerous and has very limited use. Note that it works only for publicly companies that have significant debt outstanding in the form of corporate bonds. Since these firms are generally large market cap companies, with long histories, they also tend to be companies where estimating the cost of capital using conventional approaches is easiest. This approach cannot be used for large market companies like Apple and Google that have no debt outstanding or for any company that has only bank debt (since it is not traded and has no standard deviation). There is also the underlying problem that the risk of investing in equity (where you get residual cash flows, and the uncertainty is about the magnitude of these cash flows) is very different from the risk of investing in the company's bonds (where the risk is that you will not get promised payments - the upside is limited and the downside is high) and the ratio of their standard deviations may be a poor indication of risk, at least for individual companies. It also assumes that all of the risk in equity is relevant, even though a large portion of that risk may disappear in portfolios. Consequently, you will overstate the cost of equity for firms where the bulk of the risk is firm-specific and not market risk.

Notwithstanding these limitations, this approach can still be used as a check on costs of equity estimated using other approaches, especially for companies that have significant debt outstanding. Since the claims of equity investors can be met only after lenders' claims have been met, it is logical that the cost of equity should be higher than the pre-tax cost of debt, with the difference increasing with the proportion of cash flows being used to service debt payments. Using a simple proxy for this proportion - interest coverage ratio (operating income/ interest expense), for instance, I would hypothesize that the cost of equity will rise, relative to the cost of debt, as the interest coverage ratio decreases. Incidentally, this is the same rationale that we use to adjust betas for financial leverage, with beta increasing as the debt to equity ratio increases.

The series on alternatives to the CAPM
Alternatives to the CAPM: Part 1: Relative Risk Measures
Alternatives to the CAPM: Part 2: Proxy Models
Alternatives to the CAPM: Part 3: Connecting cost of equity to cost of debt
Alternatives to the CAPM: Part 4: Market-implied costs of equity
Alternatives to the CAPM: Part 5: Risk adjusting the cash flows
Alternatives to the CAPM: Wrapping up



Alternatives to the CAPM: Part 2: Proxy Models

The conventional models for risk and return in finance (CAPM, arbitrage pricing model and even multi-factor models) start by making assumptions about how investors behave and how markets work to derive models that measure risk and link those measures to expected returns. While these models have the advantage of a foundation in economic theory, they seem to fall short in explaining differences in returns across investments. The reasons for the failure of these models run the gamut: the assumptions made about markets are unrealistic (no transactions costs, perfect information) and investors don't behave rationally (and behavioral finance research provides ample evidence of this).

With proxy models, we essentially give up on building risk and return models from economic theory. Instead, we start with how investments are priced by markets and relate returns earned to observable variables. Rather than talk in abstractions, consider the work done by Fama and French in the early 1990s. Examining returns earned by individual stocks from 1962 to 1990, they concluded that CAPM betas did not explain much of the variation in these returns. They then took a different tack and  looking for company-specific variables that did a better job of explaining return differences and pinpointed two variables - the market capitalization of a firm and its price to book ratio (the ratio of market cap to accounting book value for equity). Specifically, they concluded that small market cap stocks earned much higher annual returns than large market cap stocks and that low price to book ratio stocks earned much higher annual returns than stocks that traded at high price to book ratios. Rather than view this as evidence of market inefficiency (which is what prior studies that had found the same phenomena had), they argued if these stocks earned higher returns over long time periods, they must be riskier than stocks that earned lower returns. In effect, market capitalization and price to book ratios were better proxies for risk, according to their reasoning, than betas. In fact, they regressed returns on stocks against the market capitalization of a company and its price to book ratio to arrive at the following regression for US stocks;
Expected Monthly Return = 1.77% - 0.11 (ln(Market Capitalization in millions) + 0.35 (ln (Book/Price))
In a pure proxy model, you could plug the market capitalization and book to market ratio for any company into this regression to get expected monthly returns.

In the two decades since the Fama-French paper brought proxy models to the fore, researchers have probed the data (which has become more detailed and voluminous over time) to find better and additional proxies for risk. Some of the proxies are highlighted below:
a. Earnings Momentum: Equity research analysts will find vindication in research that seems to indicate that companies that have reported stronger than expected earnings growth in the past earn higher returns than the rest of the market.
b. Price Momentum: Chartists will smile when they read this, but researchers have concluded that price momentum carries over into future periods. Thus, the expected returns will be higher for stocks that have outperformed markets in recent time periods and lower for stocks that have lagged.
c. Liquidity: In a nod to real world costs, there seems to be clear evidence that stocks that are less liquid (lower trading volume, higher bid-ask spreads) earn higher returns than more liquid stocks. In fact, I have a paper on liquidity, where I explore the estimation of a liquidity beta and liquidity risk premium to adjust expected returns for less liquid companies.

While the use of pure proxy models by practitioners is rare, they have adapted the findings for these models into their day-to-day use. IMany analysts have melded the CAPM with proxy models to create composite or melded models. For instance, many analysts who value small companies derive expected returns for these companies by adding a "small cap premium" to the CAPM expected return:
Expected return = Riskfree rate + Market Beta * Equity Risk Premium + Small Cap Premium
The threshold for small capitalization varies across time but is generally set at the bottom decile of publicly traded companies and the small cap premium itself is estimated by looking at the historical premium earned by small cap stocks over the market. (In my 2011 paper on equity risk premiums, I estimate that companies in the bottom market cap decile earned 4.82% more than the overall market between 1928 and 2010.) Thus, the expected return (cost of equity) for a small cap company, with a beta of 1.20 would be:
Expected return = 3.5% + 1.2 (5%) + 4.82% = 14.32%
(I have used a riskfree rate of 3.5% and a mature market premium of 5% in my estimation)
Using the Fama-French findings, the CAPM has been expanded to include market capitalization and price to book ratios as additional variables, with the expected return stated as:
Expected return = Riskfree rate + Market Beta * Equity Risk Premium + Size beta * Small cap risk premium + Book to Market beta * Book to Market premium
The size factor and the book to market betas are estimated by regressing a stock's returns against the size premium and book to market premiums over time; this is analogous to the way we get the market beta, by regressing stock returns against overall market returns.

While the use of proxy and melded models offers a way of adjusting expected returns to reflect market reality, there are three dangers in using these models.
a. Data mining: As the amount of data that we have on companies increases and becomes more accessible, it is inevitable that we will find more variables that are related to returns. It is also likely that most of these variables are not proxies for risk and that the correlation is a function of the time period that we look at. In effect, proxy models are statistical models and not economic models. Thus, there is no easy way to separate the variables that matter from those that do not.
b. Standard error: Since proxy models come from looking at historical data, they carry all of the burden of the noise in the data . Stock returns are extremely volatile over time, and any historical premia that we compute (for market capitalization or any other variable) are going to have significant standard errors. For instance, the small cap premium of 4.82% between 1928 and 2010 has a standard error of 2.02%; put simply, the true premium may be less than 1% or higher than 7%. The standard errors on the size and book to market betas in the three factor Fama-French model are so large that using them in practice creates almost as much noise as it adds in precision.
c. Pricing error or Risk proxy: For decades, value investors have argued that you should invest in stocks with low PE ratios that trade at low multiples of book value and have high dividend yields, pointing to the fact that you will earn higher returns by doing so. (In fact, a scan of Ben Graham's screens from security analysis for cheap companies unearths most of the proxies that you see in use today.)  Proxy models incorporate all of these variables into the expected return and thus render these assets to be fairly priced. Using the circular logic of these models, markets are always efficient because any inefficiency that exists is just another risk proxy that needs to get built into the model.

I have never used the Fama-French model or added a small cap premium to a CAPM model in intrinsic valuation. If I believe that small cap stocks are riskier than large stocks, I have an obligation to think of fundamental or economic reasons why and build those into my risk and return model or into the parameters of the model. Adding a small cap premium strikes me as not only a sloppy (and high error) way of adjusting expected returns but an abdication of the mission in intrinsic valuation, which is to build up your numbers from fundamentals. I do think that it makes sense to adjust your expected returns for liquidity, and I think our capacity to do so is improving as we get access to more data on liquidity and better models for incorporating that data.

The series on alternatives to the CAPM
Alternatives to the CAPM: Part 1: Relative Risk Measures
Alternatives to the CAPM: Part 2: Proxy Models
Alternatives to the CAPM: Part 3: Connecting cost of equity to cost of debt
Alternatives to the CAPM: Part 4: Market-implied costs of equity
Alternatives to the CAPM: Part 5: Risk adjusting the cash flows
Alternatives to the CAPM: Wrapping up





Alternatives to the CAPM: Part 1: Relative Risk Measures

The Capital Asset Pricing Model (CAPM) is almost fifty years old and it still evokes strong responses, especially from practitioners. In academia, the CAPM lives on primarily in the archives of old journals and most researchers have moved on to newer asset pricing models.  To practitioners, it represents everything that is wrong with financial theory, and beta is the cudgel that is used to beat up academics, no matter what the topic. I have never been shy about arguing the following:
a. The CAPM is a flawed model for risk and return among many flawed models.
b. The estimates of expected return that we get from the CAPM can be significantly improved if we use more information and remember basic statistics along the way. (I argue for using sector betas rather than a single regression beta.)
c. The expected returns we get from the CAPM (discount rates in valuation and corporate finance) are a small piece of overall corporate finance and valuation. In fact, removing the CAPM from my tool box will in no way paralyze me in my estimation of value.

Notwithstanding this, I understand the discomfort that people feel with the CAPM at several levels. First, by starting with the premise that risk is symmetric - the upside and downside are balanced - it already seems to concede the fight to beat the market. After all, a good investment should have more upside than downside; value investors in particular build their investment strategies around the ethos of minimizing downside risk while expanding upside potential. Second, the model's dependence upon past market prices to get a measure of risk (betas after all come from regressions) should make anyone wary: after all, markets are often volatile for no good fundamental reason. Third, the CAPM's focus on breaking down risk into diversifiable and undiversifiable risk, with only the latter being relevant for beta does not convince some, who believe that the distinction is meaningless or should not be made.

Consequently, both academics and practitioners have been on the lookout for better ways of measuring risk and estimating expected returns. In this post, which will be the first of a few, I want to look at alternatives to the CAPM that stay with its core set-up, where the risk of an investment is measured relative to the average risk investment and expected returns are derived accordingly:
E(Return) = Riskfree Rate + Beta of investment (Expected Risk Premium for all risky investments)
Note that in this set up, the riskfree rate and expected risk premium are the same for all investments in a market and that beta alone carries the burden of measuring risk. The fact that betas are scaled around one provides for a simple intuitive hook: an investment with a beta of 1.2 is 1.2 times more risky than the average investment in the market. I have extended papers on how best to estimate the riskfree rate and expected equity risk premium.

I. Multi Beta Models
Contrary to conventional wisdom, which views theorists as cult followers of beta, the criticism of the CAPM in academia has been around for as long as the model itself. While the initial critiques just argued that CAPM betas did not do very well in explaining past returns, we did see two alternatives emerge by the late 1970s.
- The Arbitrage Pricing Model, which stays true to conventional portfolio theory, but allows for multiple (though unidentified) sources of market risk, with betas estimated against each one.
- The Multifactor model, which uses historical data to relate stock returns to specific macro economic variables (the level of interest rates, the slope of the yield curve, growth rate in the GDP) and estimates betas for individual companies against these macro factors.
Both models represent extensions of the CAPM, with multiple betas replacing a single market beta, with risk premiums to go with each one.
Pluses: Do better than the CAPM in explaining past return differences across investments.
Minuses: For forward looking estimates (which is what we usually need in corporate finance and valuation), the improvement over the CAPM is debatable.
Bottom line: If you don't like the CAPM because of its complexity and its assumptions about markets, you will like multi beta models even less.

II. Market Price based Models
The CAPM beta can be written as follows:
CAPM Beta = Correlation between stock and market * Standard deviation in returns of stock/ Standard deviation in returns of market
The instability in this estimate comes from the correlation input, which can be volatile and change dramatically from period to period. One alternative suggested by some is to dispense with the correlation entirely and to estimate the relative risk of a stock by dividing its standard deviation by the average (or median) standard deviation across all stocks. For instance, the median annualized standard deviation across all US stocks between 2008 and 2010 was 57.01%. The relative standard deviation scores for two firms - Apple and 3M - can be computed using their annualized standard deviations over the same period: Apple's standard deviation was 42.66% and 3M's standard deviation was 25.17%.
Apple's relative standard deviation = 42.66%/ 57.01% = 0.75
3M's relative standard deviation = 25.17%/57.01% = 0.44
These take the place of the CAPM betas and get used with the riskfree rate and equity risk premium to get expected returns.
Pluses: Standard deviations are easier to compute and more stable than correlations (and betas)
Minuses: No real economic rationale behind the model. Treats all risk as equivalent, whether it can be diversified away or not.
Bottom line: For those who want relative risk measures that look closer to what they would intuitively expect, it is an alternative. For those who do not like market based measures, it is more of the same.

III. Accounting information based Models
For those who are inherently suspicious of any market based measure, there is always accounting information that can be used to come up with a measure of risk. In particular, firms that have low debt ratios, high dividends, stable and growing accounting earnings and large cash holdings should be less risky to equity investors than firms without these characteristics. While the intuition is impeccable, converting it into an expected return can be problematic, but here are some choices:
a. Pick one accounting ratio and create scaled risk measures around that ratio. Thus, the median book debt to capital ratio for US companies at the start of 2011 was 51%. The book debt to capital ratio for 3M at that time 30.91%, yielding a relative risk measure of 0.61 for the company. The perils of this approach should be clear when applied to Apple, since the firm has no debt outstanding, yielding a relative risk of zero (which is an absurd result).
b. Compute an accounting beta: Rather than estimate a beta from market prices, an accounting beta is estimated from accounting numbers. One simple approach is to relate changes in accounting earnings at a firm to accounting earnings for the entire market. Firms that have more stable earnings than the rest of the market or whose earnings movements have nothing to do with the rest of the market will have low accounting betas. An extended version of this approach would be to estimate the accounting beta as a function of multiple accounting variables including dividend payout ratios, debt ratios, cash balances and earnings stability for the entire market. Plugging in the values for an individual company into this regression will yield an accounting beta for the firm. While this approach looks promising, here are some cautionary notes: accounting numbers are smoothed out and can hide risk and are estimated at most four times a year (as opposed to market numbers which get minute by minute updates).
Pluses: The risk is related to a company's fundamentals, which seems more in keeping with an intrinsic valuation view of the world.
Minuses: Accounting numbers can be deceptive and the estimates can have significant errors associated with them.
Bottom line: If you truly do not trust market prices, use accounting data to construct your risk measures.

The reason for the CAPM's endurance as a model is simple. It provides a way of estimating the required returns and costs of equity for individual companies at low cost, by requiring only one input: a market beta. For those who like that aspect of the model, but don't like the baggage that comes with the model, relative standard deviations and accounting betas provide an alternative. For those who like the theoretical underpinnings of the model but do not like the poor estimates that it yields, the arbitrage and multifactor models should appeal. For those who contest the very basis of the approach, I will look at alternatives in the next few posts.

The series on alternatives to the CAPM
Alternatives to the CAPM: Part 1: Relative Risk Measures
Alternatives to the CAPM: Part 2: Proxy Models
Alternatives to the CAPM: Part 3: Connecting cost of equity to cost of debt
Alternatives to the CAPM: Part 4: Market-implied costs of equity
Alternatives to the CAPM: Part 5: Risk adjusting the cash flows
Alternatives to the CAPM: Wrapping up





Margin of Safety: An alternative risk assessment tool?

I have lost count of the number of times I have been taken to task for not mentioning "margin of safety" in my valuation and investment books. In general, the critique is usually couched thus: "Instead of using beta or some other portfolio theory risk measure, why don't you look at the margin of safety?". While I see the intuitive value of paying heed to the "margin of safety",  I don't see the two as alternative measures of risk. In fact, I think that risk measures in valuation and margin of safety play very different roles in investing.

I know that "margin of safety" has a long history in value investing. While the term may have been in use prior to 1934, Graham and Dodd brought it into the value investing vernacular, when they used it in the first edition of "Security Analysis". Put simply, they argued that investors should buy stocks that trade at significant discounts on value and developed screens that would yield these stocks. In fact, many of Graham's screens in investment analysis (low PE, stocks that trade at a discount on net working capital) are attempts to put the margin of safety into practice.

In the years since, there have been value investors who have woven the margin on safety (MOS) into their valuation strategies. In fact, here is how I understand how a savvy value investor uses MOS. The first step in the process requires screening for companies that meets good company criteria: solid management, good product and sustainable competitive advantage; this is often done qualitatively but can be quantifiable. The second step in the process is the estimation of intrinsic value, but value investors are all over the map on how they do this: some use discounted cash flow, some use relative valuation and some look at book value. The third step in the process is to compare the price to the intrinsic value and that is where the MOS comes in: with a margin of safety of 40%, you would only buy an asset if its price was more than 40% below its intrinsic value.

The term returned to center stage a few years ago, when Seth Klarman, a value investing legend, wrote a book using the term as the title, published in 1991. In the book, though, Seth summarizes the margin of safety as "buying assets at a significant discount to underlying business value, and giving preference to tangible assets over intangibles".  Seth is a brilliant thinker (I love the letters he writes to investors..)  and the book has original and interesting ways of looking at risk. I learned a great deal about the ethos of value investing but it did not alter the fundamental ways in which I approached estimating intrinsic value, only the ways in which I used that value.

The basic idea behind MOS is an unexceptional one. In fact, would any investor (growth, value or a technical analyst) disagree with the notion that you would like buy an asset at a significant discount on estimated value? Even the most daring growth investor would buy into the notion, though she may disagree about what to incorporate into intrinsic value. To integrate MOS into the investment process, we need to recognize its place in the process and its limitations.

1. Stage of the investment process: Note that the MOS is used by investors at the very last stage of the investment process, once you have screened for good companies and estimated intrinsic value. Thinking about MOS while screening for companies or estimating intrinsic value is a distraction, not a help.
Proposition 1: MOS comes into play at the end of the investment process, not at the beginning.

2. MOS is only as good as your estimate of intrinsic value: This should go without saying but the MOS is heavily dependent on getting good and unbiased estimates of the intrinsic value. Put a different way, if you consistently over estimate intrinsic value by 100% ore greater, having a 40% margin for error will not protect you against bad investment choices.

That is perhaps the reason why I have never understood why MOS is offered as an alternative to the standard risk and return measures used in intrinsic valuation (beta or betas). Beta is not an investment choice tool but an input (and not even the key one) into a discounted cash flow model. In other words, there is no reason why I cannot use beta to estimate intrinsic value and then use MOS to determine whether I buy the investment. If you don't like beta as your measure of risk, I completely understand, but how does using MOS provide an alternative? You still need to come up with a different way of incorporating risk into your analysis and estimating intrinsic value. (Perhaps, you would like me to use the risk free rate as my discount rate in discounted cash flow valuation and use MOS as my risk adjustment measure... That's an interesting choice and worth talking about ... I know that Buffett claims to do something similar, but he discounts only the cash flows that he believes he can count on, making his cash flows risk adjusted cash flows.)

I know.. I know... There are those who argue that you don't need to do discounted cash flow valuation to estimate intrinsic value and that there are alternatives. True, but they come with their own baggage. One is to use relative valuation: assume that the multiple (PE or EV/EBITDA) at which the sector is trading at can be used to estimate the intrinsic value for your company. The upside of this approach is that it is simple and does not require an explicit risk adjustment. The downside is that you make implicit assumptions about risk and growth when you use a sector average multiple... The other is to use book value, in stated or modified form, as the intrinsic value. Not a bad way of doing things, if you trust accountants to get these numbers right...
Proposition 2: MOS does not substitute for risk assessment and intrinsic valuation, but augments them.

3. Need a measure of error in intrinsic value estimate: If you are going to use a MOS, it cannot be a constant. Intuitively, you would expect it to vary across investments and across time. Why? The reason we build in margins for error is because we are uncertain about our own estimates of intrinsic value, but that uncertainty is not the same for all stocks. Thus, I would feel perfectly comfortable buying stock in Con Ed, a regulated utility where I feel secure about my estimates of cash flows, growth and risk, with a 20% margin of safety, whereas I would need a 40% margin of safety, before buying Google or Apple, where I face more uncertainty. In a similar vein, I would have demanded a much larger margin of safety in November 2008, when macro economic uncertainty was substantial, than today, for the same stock.

While this may seem completely subjective, it does not have to be so. If we can bring probabilistic approaches (simulations, scenario analysis) to play in intrinsic valuation, we can not only estimate intrinsic value but also the standard error in the estimates.
Proposition 3: The MOS cannot and should not be a fixed number, but should be reflective of the uncertainty in the assessment of intrinsic value.

4. There is a cost to having a larger margin of safety: Adding MOS to the investment process adds a constraint and every constraint creates a cost. What, you may wonder, is the cost of investing only in stocks that have a margin on safety of 40% or higher? Borrowing from statistics, there are two types of errors in investing: type 1 errors, where you invest in over valued stocks thinking that they are cheap and type 2 errors, where you don't invest in under valued stocks because of concerns that they might be over valued. Adding MOS to the screening process and increasing the MOS reduces your chance of type 1 errors but increases the possibility of type 2 errors. For individual investors or small portfolio managers, the cost of type 2 errors may be small because there are so many listed stocks and they have relatively little money to invest. However, as fund size increases, the costs of type 2 errors will also go up. I know quite of few larger mutual fund managers, who claim to be value investors , who cannot find enough stocks that meet their MOS criteria and hold larger and larger amounts of the fund in cash.

It gets worse, when a MOS is overlaid on top of a conservative estimate of intrinsic value. While the investments that make it through both tests may be great, there may be very few or no investments that meet these criteria. I would love to find a company with growing earnings, no debt, trading for less than the cash balance on the balance sheet. I would also like to play shortstop for the Yankees and slam dunk a basketball and I have no chance of doing any of those and I would waste my time and resources trying to do so.
Proposition 4: Being too conservative can be damaging to your long term investment prospects.

So, let's call a truce. Rather than making intrinsic valuation techniques (such as DCF) the enemy and portraying portfolio theory as the black science, value investors who want to use MOS should consider incorporating useful information from both to refine MOS as an investment technique. After all, we have a shared objective. We want to generate better returns on our investments than the proverbial monkey with a dartboard... or the Vanguard 500 Index fund...



Dual share structure: The Google model spreads

Google rewrote the book for initial public offerings in two ways. One is that they bypassed the traditional investment banking syndicate for an auction (which is a good development) and the other is that they were unapologetic about the fact that they had two classes of shares and that the founders would hold on to the shares with the disproportionately large voting rights. While shares with different voting rights are par for the course in many parts of the world (Latin America, for instance), their use in the United States was limited to a few sectors; publishing and media companies such as the New York Times and the Washington Post have used the structure to allow the founding families to control these companies, with relatively small percentages of the overall equity.

Two factors played a role in containing dual class shares: the first was that, for decades, the New York Stock Exchange barred shares with different voting rights from getting listed on the exchange and the second was the fear of an adverse reaction from investors. Google was unfazed by either concern. It listed on the NASDAQ and institutional investors were so eager to hold the stock that they seemed to overlook the voting share structure (or at least not price it in).

So, what's the big deal with voting rights? Voting rights matter because they allow stockholders to have a say in who runs the company and how it is run. It is true that most stockholders don't use these rights and prefer to vote with their feet, but the voting power does come into use, especially at badly managed companies, where a challenge is mounted on management either from within (activist stockholders) or from without (hostile acquisitions). The argument I have heard from institutional investors for their benign neglect of different voting share classes at Google is that the company is well managed and that control is therefore worth little or nothing. There is a kernel of truth to their statement: the expected value of control (and voting rights) is greater in badly managed companies than in well managed ones. However, if you are an investor for the long term, you have to worry about whether managers who are perceived as good managers today could be perceived otherwise in a few years. (A decade ago, Cisco would have been ranked among the best managed companies in the world. Today, its management is under assault after ten years of bad acquisitions and under performance).

How does this play out in valuation? Once you have valued the aggregate equity in a company, you have to estimate the value of equity per share. When shares all have the same voting & dividend rights, you can divide by the total number of shares outstanding. When they don't, though, you may have to allocate the equity value differently to different share classes. Generally speaking, voting shares should trade at a premium over non-voting shares, but that premium should be larger in poorly managed firms than in well-managed firms. How much larger? I have a paper on the topic that does try to come up with a specific premium for voting shares.

The trigger for this post was the Linkedin valuation that I did yesterday. I valued the equity of the company at approximately $ 2 billion, but I was unforgivably sloppy about getting the per share value. I used the 43.31 million shares that Yahoo! Finance listed as shares outstanding and I should have known better. Checking the prospectus for Linkedin, here is what I see:
* 7.8 million class A shares (all of the shares offered in the IPO are class A shares)
* 86.7 million class B shares (which have ten times the voting rights of class A shares)
Dividing the value of equity by 94.5 million shares yields a value per share of $21.51/share, but even that may be an over estimate. If we assume that the voting shares trade at a premium of 5% over the non-voting shares (the 5% is the average premium for voting over non-voting shares in US companies), the value per share for the non-voting shares drops $ 20.57:
Value per non-voting share = $2,033 million (7.8 + 1.05*86.7) = $20.57
Reading the prospectus, though, things get worse. Linked in notes that it has options outstanding on roughly 17 million shares, with exercise prices ranging from $6 to $23. Needless to say, all those options are deep in-the-money now and while I don't have information on vesting, it behooves us to act as if these options will be exercised. Using an average exercise price of $15, the value per share drops further to about $20.

Bottom line: Getting from value of equity to value per share gets progressively more difficult as you add shares with different voting rights and outstanding options to the mix. 



Valuing young growth companies: A postscript on Linkedin

So, that was quite an opening for Linkedin.. The stock opened in the mid-80s, almost double the offer price. I know that some of you have used the model that I attached to my last post to value Linkedin on your own and that was exactly my point. None of us has a crystal ball that shows us the future and your estimates are as good as mine.

However, since we are on the topic of young growth companies, here is what I see in the base year numbers for Linkedin, as contrasted with Skype:
a. Linkedin is at an earlier stage in the life cycle that Skype. It revenue growth is more explosive (100% growth last year: Revenues grew from $120 million in 2009 to $243 million in 2010) than Skype's revenue growth in 2010 (20%).
b. Linkedin is already profitable. It reported pre-tax operating income of about $20 million in 2010. In contrast, Skype is still losing money.

Now, here's where the subjective component comes into play in the forecasts:
a. Revenue growth: You may disagree with me on this one but I see a smaller potential market for Linkedin than I do for Skype. While at least in theory, Skype could compete for the much larger wireless telecom market, Linkedin has a narrower focus. To provide perspective, Yahoo's total revenues in 2010 were $ 6 billion and I have a tough time seeing Linkedin generate revenues as large, even ten years from now.
My projection: 50% compounded revenue growth for the next 5 years, scaling down to 3.5% in stable growth. Revenues in 2021 will be about $ 5 billion.

b. Operating margins: I see margins falling somewhere in the middle of the range for companies in this space: Google at the top end and Yahoo towards the bottom. Competition in this space is much fiercer and the barriers to entry seem small.
My projection: Pre-tax operating margin of 15% in 2021, rising from the current margin of 8.23%.

c. Survival: The company has little debt ($2 million), enough cash on the balance sheet ($92 million) with more coming in from the IPO.
My projection: I am going to assume that there is a 100% chance that the firm will survive, though I am not sure how successful it will be.

The valuation, with these inputs, yields a value per share of $47 and I think that that number is at the upper end of the spectrum. So, the original offer price of $43 does not sound unreasonable... As for the current price in the mid-80s, I am glad I don't have it in my portfolio. (Update: It gets worse. There are two classes of shares outstanding and if you incorporate both, the value per share that I estimate drops into the twenties.. I have updated the spreadsheet as well..)

As with the Skype valuation, here is my Linkedin spreadsheet. Make your own best estimates.... and good luck...





Is Skype worth $8.5 billion? An exercise in valuing young, growth companies

Last week, Microsoft announced that it would buy Skype for $8.5 billion. The reaction was fast, furious and very predictable. First, there was the search for reasons for the deal and technology mavens listed a few. Second, there was the reaction from investors and analysts, which was generally not very positive. Third, it was noted that Bill Gates, the face of Microsoft for so long, was strongly in favor of the deal (thus providing cover for Steve Ballmer).

Ultimately, though, the discussion of the deal was lacking in one key respect: Is Skype worth $8.5 billion to Microsoft? A few of the analysts noted that the price paid was roughly ten times Skype's revenues in 2010, an undoubtedly rich price, but by itself proving nothing. After all, if you had been able to buy into Google at ten times revenues in 2003, you would be rich now. A great deal of attention was paid to whether Skype was the right company for Microsoft to buy and the strategic/synergistic fit of the two companies.  It has always been my contention with acquisitions that it is not the strategic fit or synergistic stories that make the difference between a good deal and a bad one, but whether you buy a company at the right price. Put in more direct terms, buying a company that is a poor strategic fit at a low price is vastly preferable to buying a company that fits like a glove at the wrong price.

So, let's get back to valuation basics. What is the value of Skype? The question is rendered more difficult to answer because Skype is a private business and we know little about the insides of the financial statements. It is widely reported, though, that Skype had operating losses of $7 million on revenues of $ 860 million in 2010. Taking those numbers as a base, I tried to value Skype, making what I thought were very optimistic assumptions:
- Continued revenue growth of 20% (which was what they had last year) for the next 5 years and a gradual tapering down of growth to 3% in ten years.
- A surge in pre-tax operating margins to 30% over the next ten years; this margin is at the very upper end of the technology spectrum (where companies like Google reside).
- A decline in the cost of capital from 12% now (reflecting the uncertainty associated with young, growth businesses) to a cost of capital of a mature company in ten years
With those assumptions, I estimated a value of $ 3.8 billion for Skype. It is entirely possible, however, that I am wrong on my key assumptions - revenue growth rates and target margins. In fact, changing those base inputs gives me the following table:

Is it possible that Skype is worth more than $8.5 billion? Sure, if you can deliver revenue growth higher than 35% and a pre-tax operating margin of 30%. Is it probable? I don't think so.

The value drivers for Skype - revenue growth, target pre-tax operating margin and survival - are generally the constants you worry about with young, growth companies. In the Little Book of Valuation, in the chapter on valuing young growth companies, I argue that these value drivers also should give you indicators of value plays in young, growth companies. Thus, when investing in a young, growth company (Tesla Motors, Linkedin, Facebook etc.), here are some of the indicators you would look at:
a. Size of potential market: Since high revenue growth is easier to pull off, when the market is large, you want to invest in companies that are entering large potential markets rather than narrower, specialized markets.
b. Competitive barriers: For margins to improve over time, you need space to grow and protection from intense competition. This can come from patents (for a young, biotechnology company), a technological advantage, a brand name or the sheer ineptitude of established competitors.
c. Survival skills: Survival boils down to two types of resources: financial and personnel. Young, growth companies with access to capital, little or no debt and large cash balances have a much better chance of surviving than companies without those characteristics. In addition, companies that are dependent on a key person or personnel with no back-up are much more at risk than companies that have a good bench.
So, take your favorite young, growth company for a qualitative spin around this track and see if it passes the tests.

You can download the spreadsheet that I used for the valuation of Skype and play with the revenue growth and operating margin numbers. You can also use the spreadsheet to value any other young, growth company. As you do these valuations, recognize that uncertainty is the name of the game and that you are making estimates for the future. You will be wrong, but so will everyone else, and at least you are trying.



The Little Book of Valuation

I don't like to use this blog as a publicity front, but my newest book just hit the bookstores. It is part of Wiley's Little Book series and it is titled "The Little Book of Valuation". My motivation for writing the book was simple. While I have three books on valuation - Investment Valuation, Damodaran on Valuation and The Dark Side of Valuation", they are all written for valuation practitioners. They are dense, not easy to read and require work to put into practice. I have always wanted to write a book for investors, many of seem to believe that valuation is far too complex for them to handle. That view makes them easy prey for valuation experts and analysts, who use a mixture of bombast, buzz words and numbers to intimidate.

As I started to write the book, I set myself two objectives. The first was to not short change readers, by assuming that they were not skilled enough to do valuation. I think valuation is fundamentally simple but that we choose to layer complexities on it. So, I wanted to provide investors with the tools to do a full fledged valuation of any type of company - young or old, mature or growth, cyclical or commodity. The second was to cut through the details of valuation models and identify the value drivers for any company. Even in the most complex valuation models, the value of a stock is determined by one or two key inputs. Knowing what those inputs are and how to estimate them is 90% of valuation. More importantly, if you know the drivers of value, you can create investment strategies that are built around those drivers, even if you choose not to do a full-fledged valuation. If you get a chance to take a look at the book, you will notice that the chapters are structured around different types of companies and that each chapter is centered around identifying the "value drivers" for that type of company and the "value plays" that emerge from these drivers.

Since I did write the book, I cannot give you an unbiased assessment of how well I did in accomplishing my objectives. I hope you do get a chance to browse through the book and I really hope that you not only find it useful but an easy read. If you are interested in getting the book, here is the Amazon link:
http://www.amazon.com/Little-Book-Valuation-Company-Profit/dp/1118004779/ref=ntt_at_ep_dpt_1
To support the book, I have put together spreadsheets and other material in a website for the book. You can visit it by clicking here.



From revenues to earnings: Operating, financing and capital expenses....

A few days ago, Groupon filed an S-1 statement with the Securities Exchange Commission, officially signaling its intent to do an initial public offering.
http://blogs.wsj.com/deals/2011/06/02/groupon-ipo-its-here/
I do know that there are valuation questions that will come up with the IPO but talking about them will lead me to repeat earlier points that I made about the Linkedin and Skype valuations: the value will depend upon revenue growth and potential operating margins. Instead, I want to focus on a claim that Groupon has made, that has opened up the company for some ridicule in the financial press. In 2010, Groupon generated revenues of $713 million and reported an operating loss of $420 million (see the S-1 filing link below):
http://www.sec.gov/Archives/edgar/data/1490281/000104746911005613/a2203913zs-1.htm
Pretty bad, right? But here's where it gets interesting. In the same S-1, Groupon claims that it will make money in 2011 using a different measure of operating income (which is calls Adjusted CSOI: Consolidated Segment Operating Income). I am already suspicious, because the term carries two pieces that make me nervous - the word "adjusted" and a new acronym for earning. But what is Adjusted CSOI? According to Groupon, it is the income before expensing to acquire new subscribers is taken into account and since this expense amounted to about a third of overall operating expenses in 2010, removing it does wonders to profitability. It is this claim that has raised the ire of financial journalists and of some investors and their argument is encapsulated well in this blog post on Forbes:
http://blogs.forbes.com/ericsavitz/2011/06/02/deja-vu-groupons-bubble-1-0-approach-to-accounting
Is Groupon breaking new ground in measuring profitability or is this playing with the accounting rules?

To answer this question, we need to go back to accounting first principles (which are often ignored by accounting rule writers, but that is a different story). In an ideal accounting world, the expenses incurred by a firm would be broken down into three groups:
a. Operating expenses: These are expenses incurred to generate revenues only in the current period; there are no spillover benefits into future periods. Thus, the cost of labor and material incurred in making a widget will be part of operating expenses.
b. Financial expenses: These are expenses associated with the use of borrowed money in the business. Thus, interest expenses on bank loans would be included here as should lease expenses.
c. Capital expenses: These are expenses that generate benefits over multiple years. Classic examples would be the cost of building a factory or buying long-lived equipment.
Assuming that you can classify expenses cleanly into these groups, here is how they play out in the financial statements. Operating expenses get netted out of revenues to get to operating income, financial expenses get netted out of operating income to get to taxable income and taxes get netted out of taxable income to get to net income. Capital expenses do not affect income in the year in which they are made but have two effects: the first is that they show up as assets on the balance sheet at the end of the year that they are incurred and then get amortized or depreciated over their useful life. The amortization or depreciation is also shown as an expense to get to operating income:
Revenues
- Operating Expenses
- Depreciation/Amortization of Capital Expenses
= Operating Income
- Financial (interest) expenses
= Taxable Income
- Taxes
= Net Income

So, here is the best possible spin on what Groupon is doing. The cost of acquiring new customers presumably creates benefits over many years, since once a customer is acquired, he or she continues to use Groupon for years (I told you that I was taking the best possible spin here). Using this rationale, you could conceivably argue that acquisition costs are capital expenses and should not be netted out to get to the operating income. However, here is why I am skeptical about whether this is being done to get a better measure of income (which would be noble) or for window dressing (which is not):
a. Back up the claim that customers, once acquired, stay on for a while: If you are going to capitalize acquisition costs, the onus is on you to show proof that acquired customers stay as customers (and actually buy products for many years). With strong competition from other online coupon based companies (like LivingSocial), it is entirely possible that customers once acquired, are fickle and move on... If that is the case, the acquisition cost has a very short amortizable life and begins to look more like an operating expense.
b. If you are capitalizing acquisition costs, carry it through to its logical limit: This would require amortizing previous year's acquisition costs (which would in turn require an answer to (a), since the amortization will be over the customer life with the company). In other words, you cannot just remove acquisition costs (as Groupon has done) from your income statement, but you would have to replace that cost with an amortization cost.
c. Recognize that all of this reclassifying of expenses does not change your cash flow status: The bottom line is that Groupon has negative cash flows and those negative cash flows will get more negative over time, since the company will have to keep spending the money to acquire customers (to get the growth rate it would need to justify a $20 billion value...).

Note that none of this is breaking ground. I have been making this point about R&D expenses at technology firms and advertising expenses at brand name companies for years. In fact, I have a paper on how we need to take a fresh look at companies with intangible assets:
http://pages.stern.nyu.edu/~adamodar/pdfiles/papers/intangibles.pdf
This is also a chapter in my book, The Dark Side of Valuation (2nd edition, Wiley)
If you want to try your hand out at capitalizing acquisition (or brand name advertising or R&D) costs, try this spreadsheet.

The bottom line, though, is that from a valuation perspective, reclassifying acquisition costs is a mixed blessing. For growing companies like Groupon, it can make the earnings look more positive, but it will also increase the capital invested at these companies (because the acquisition costs will be capitalized). It can alter perspectives on whether the company is actually profitable and creating value: the key profitability number in the long term is not the operating margin but the return on invested capital and Groupon has just admitted that it invests a lot more capital than people realize in what it spends to acquire customers.

The other adjustments that Groupon makes to operating income that are more dubious. It is absurd to add back stock-based compensation (it is an operating expense...)  and we are taking the company at its word, when it breaks its marketing costs down into acquisition costs and regular marketing costs. What Groupon is doing is also part of a trend that I find disturbing, where analysts adopt half-baked approaches to dealing with costs like R&D and marketing by adding them back to EBITDA, leading to a proliferation of measures like EBITDAR (Earnings before interest, taxes, depreciation and R&D) and EBITDAM (Earnings before interest, taxes, depreciation and marketing). While this approach deals with a serious accounting problem (where capital expenses are being treated as operating expenses in some companies and thus skewing not just earnings but book values), it does so at a surface level. After all, if we are going to treat R&D and customer acquisition costs as capital expenditures, we should follow up by asking the key questions: How effective are they? Are they creating or destroying value?

Postscript: I forgot to mention that I hope that the tax authorities don't buy into Groupon's argument. If they did, acquisition costs would no longer be tax deductible; only the amortization would. As is often said, be careful what you wish for. You may get it.




There is an app for that....

I have a healthy respect for technology. While I don't see it as the cure for any of our problems in valuation, it has made life a lot easier in terms of mechanics. I still remember trying to value companies in the mid-eighties, where data had to be collected by hand (in libraries) and computers were primitive (I started with Visicalc on a Kaypro and it was just a glorified hand calculator, with limited features). I have tried to stay on top of evolving trends, though I have never been cutting edge on any dimension.

As I watch my kids and colleagues increasingly abandon their computers for their smartphones and iPads, I have wondered whether I could make this transition. Thanks to Anant Sundaram, my good friend, who teaches valuation at Dartmouth College, the first step has been taken. Together, we developed a valuation app for the iPad that allows you to value a stock or a business. A confession is in order. Neither Anant nor I have the technological capability to write apps: it is a lot more complicated than it looks. We owe aa great deal to Xiandong Ren, a graduate of the Computer Science department at Dartmouth College, who schooled us on the basics and wrote the code for the app. Initially, we wanted to give the app the moniker of "iValue" but as is common in this space, some one else beat us to that name by a few weeks. So, we used our fall back name for the app: uValue and it is now available on the Apple iTunes store:
http://itunes.apple.com/us/app/uvalue/id440046276

uValue is a valuation app, with surprising versatility (or at least, we think so). There are three basic models - a conventional cost of capital DCF model, an Adjusted Present Value (APV) model and a dividend discount model. For the cost of capital and APV models, we have detailed versions, where you are given full control over all of the input levers, and simple versions, where we set many of the input levers to safe defaults. In the near future, we hope to add a relative valuation (multiples and comparables) module as well as a financial tools module. Embedded in the app is a short book on valuation (called the uValue Companion) that leads you through the basics of which model to use in a specific context and the fundamentals of that model as well as data sets on industry averages on key input variables (margins, returns, betas, cost of capital etc.).

While we cannot be objective about the app's capabilities, here is what we see as its pluses and minuses right now. On the minus side:
a. The app is available only for the iPad right now. The output is too intensive for a Smartphone screen and we just don't have the capacity or energy or time (right now) to write the code to allow it work on Android pads.
b. It is a young app. We have already been alerted to a couple of errors in the app (the simple APV has a glitch in the expected bankruptcy cost component, for instance) that we will fix in the next update (in the next couple of weeks). This website for the app will keep you updated on errors as you find them (and we fix them):
http://uvalueapp.com
c. It does incorporate our "points of view" on DCF valuation, which may not map on to your points of view on the same. Just to make you feel better, even Anant and I have differences on individual components (like what to use for the equity risk premium) and have been open in laying them out in the app.

On the plus slide, we have tried the app out on all kinds of companies: young, growth companies (like Linkedin), mature companies, money losing companies, commodity companies, financial service companies, and it seems to work for all of them. Best of all, check out the price for the app. You will see why we feel absolutely secure in our "money back" guarantee...   



Thoughts on intrinsic value

I know this post will strike some of you as splitting hairs and an abstraction but it is a topic that fascinates me. A few weeks ago, I got an email asking a very simple question: How do you estimate the "intrinsic" value of gold? This, of course, raised two key questions:
a. What is intrinsic value?
b. Does every asset have an intrinsic value?

On the first question, here is my definition of intrinsic value. It is the value that you would attach to an asset, based upon its fundamentals: cash flows, expected growth and risk. The essence of intrinsic value is that you can estimate it in a vacuum for a specific asset, without any information on how the market is pricing other assets (though it does certainly help to have that information). At its core, if you stay true to principles, a discounted cash flow model is an intrinsic valuation model, because you are valuing an asset based upon its expected cash flows, adjusted for risk. Even a book value approach is an intrinsic valuation approach, where you are assuming that the accountant's estimate of what fixed and current assets are worth is the true value of a business.

This definition then answers the second question. Only assets that are expected to generate cash flows can have intrinsic values. Thus, a bond (coupons), a stock (dividends), a business (operating cash flows) or commercial real estate (net rental income) all have intrinsic values, though computing those values can be easier for some assets than others. At the other extreme, fine art and baseball cards do not have intrinsic value, since they generate no cash flows (though they may generate a more amorphous utility for their owners) and value, in a sense, is in entirely in the eye of the beholder. Residential real estate is closer to the latter than the former and estimating the intrinsic value of your house is an exercise in futility.

So, how do people value assets where intrinsic value cannot be estimated? They look at what other people are paying for similar or comparable assets: i.e., they use relative valuation. Thus, an auction house sets a value for your Picasso, based on what other Picassos have sold for in the recent past, adjusted for differences (which is where the experts come in). The realtor sets the price for residential real estate, based on what other residences in the neighborhood have sold for, adjusted for differences again. In fact, let's face it: this is the way even assets that have intrinsic value are evaluated for the most part. Thus, the investment banker who takes Groupon public may go through the process of providing a discounted cash flow model to back up the valuation, but the pricing of the IPO will be determined largely by the euphoric reception that Linkedin got a few weeks ago.

I don't intend this to come across as snobbish, but I think we need to clarify terms. Most people who claim to be valuation specialists, experts or appraisers are really pricing specialists, experts and appraisers. In other words, what separates them in terms of skills is in how good they are in finding comparable assets and adjusting for differences across assets. In fact, I have a counter question, when I am asked the question of what the value of a business or stock is: Do you want a value for your business or a price for your business? The answers can be very different.

In closing, though, let me try to answer the question that triggered this post: what is the "intrinsic value" of gold? In my view, gold does not have an intrinsic value but it does have a relative value. For centuries, gold (because of its durability and relative scarcity) has been an alternative to financial assets (that are tied to paper currency). Unlike the gold standard days, where the linkage between paper currency and gold was explicit, the value of paper currency rests entirely on trust in central banks and governments. As a consequence, the price of gold has varied inversely with the degree of trust that we have in these authorities. Though not a perfect indicator, gold prices have surged when a subset of investors have lost that faith, i.e., they fear that the currency is being debased (inflation) or systematic government failures. What makes this monent in economic history disquieting is that we are getting discordant signals from the market: the low interest rates on treasuries (US, German and Japanese) suggests that investors think expected inflation will be low in the future whereas higher prices for precious metals (gold, silver) give support to the argument that investors (or at least a subset of them) believe the opposite. One of these two groups will be wrong and I would not want to be in that group, when there is a final reckoning.



A Sovereign Ratings Downgrade for the US? End of the world or bump in the road?

It is a sign of the times that a blog such as mine,  dedicated to micro questions (on corporate finance and valuation), is bogged down on the macro question of sovereign default and its consequences. But there is no getting around the fact that corporations and investors will spend the next week focused on the circus in Washington DC and not on their core businesses. So, let's ask the key questions: What is it that investors fear will happen next week? And what if those fears become reality?

1. Default: Perception versus Reality
The US will not default next week or in the near future, even if there is no debt ceiling legislation passed by August 2. However, the damage has already have been done. The perception that an entity will not default is built not only on the resources controlled by the entity but on the faith that it will always find a way to use these resources to pay its bondholders. Once investors begin debating whether a borrower will default, the faith has been shaken and like Humpty Dumpty, it cannot be put together again.
Bottom line: Investors now perceive the US government as being capable of defaulting on their debt. That will not change, no matter what happens over the next week.

2. Sovereign Ratings and Default
I don't envy the ratings agency that is the first to downgrade the United States, since I am sure that abuse will be heaped on it.  But the critics miss a key point. Ratings agencies have more in common with politicians than you may realize: specifically, they are more likely to be followers than leaders. Investors have already starting building in a "default spread" (to cover the likelihood of default) into market prices. While backing this spread out of the treasury bond rate may be difficult to do, it is visible in the Credit Default Swap (CDS) market, where the price for insuring against default on the US treasury has risen over the last few months:


There does seem to be a disconnect between the two markets, with the T.Bond rate decreasing as the default spread in the CDS market rises; you would expect the two to move together. There are a couple of interpretations. The first is that these markets attract different investors, with the nervous nellies (and default risk speculators) going into the CDS market and the oblivious rest holding treasury bonds. The second (and more likely explanation) is that there is information in both markets: the CDS market, for all its faults, is signaling that the default risk in the US Treasury has risen (by about 0.25% over the year) and the the treasury bond market is indicating slower economic growth (and thus lower real interest rates) in the future.
Bottom line: The market has already downgraded the implicit sovereign rating for the United States. An explicit ratings downgrade will still have an effect on bond prices/rates but it will not be a surprise when it does happen.

3. What next?
So, let's assume that the worst comes to pass. Deadlock persists in the DC or is resolved in an unsatisfactory plan. Standard & Poors and/or Moody's downgrades the United States from AAA to AA. Then what?
a. Treasury bond rate: The expectation among many experts is that a downgrade will lead to a surge in treasury bond rates. Given my earlier assertion that a downgrade, if it does occur, will not be a complete surprise to many investors, I don't anticipate a surge in the treasury bond rate, or at least a sustainable one. To make my case, let me break down the treasury bond rate into three components:
 T. Bond rate = Expected Inflation + Expected riskfree real interest rate + Expected default spread
If the treasury bond rate already includes a default spread, the day of the downgrade will be ugly for the bond market, with high volatility and big losses for impulsive traders, but I would not be surprised to see treasury bond rates return to pre-downgrade levels within a few weeks. If the ratings change is truly a complete surprise, then the treasury bond market will reflect substantial losses to bondholders on the day of the ratings change.
Bottom line: My expectation is that the treasury bond rate will rise on the downgrade day but not by as much as experts seem to think.

b. Riskfree rate: If the treasury bond rate does have a default spread component, there is a longer term consequence. For decades, when valuing companies in US dollars, we have used the treasury bond rate as the riskfree rate. That practice will no longer hold and the riskfree rate in US dollars will have to be estimated:
Riskfree rate in US dollars = Treasury bond rate - Default spread for the US government
Thus, if the sovereign rating for the US drops to AA+ (with a default spread of 0.25%) and the treasury bond rate is 3.25%, the risk free rate in US dollars will be 3%:
Risk free rate = 3.25% - 0.25% = 3%
A few months ago I posted on a paper that I wrote last year titled "What if nothing is risk free?", a question that no longer sounds hypothetical, but I examine practical ways in which risk free rates can be estimated when sovereign issuers have default risk.
Bottom line: The US treasury bond rate will no longer be the risk free rate in US dollars.

c. Equity Risk Premium:  I have always argued that the equity risk premium will increase as country risk increases. Using the US equity risk premium as my base for a mature equity market, I have augmented it by adding a country risk premium, which is a function of the country default spread, obtained from either the rating or the CDS market. A downgrade of the US will cause two changes: a rethinking of what comprises a mature market premium and the adding of a country risk premium for the US. The net effect will be a higher equity risk premium for the US. In fact, using the default spread of 0.25% as the basis, the equity risk premium for the US will rise about 0.38%.
One measure that will capture the effects of increased country risk is the implied equity risk premium that I compute for the S&P 500 at the start of every month. That number has risen over the course of this year from 5.20% at the start of the year to 5.72% at the start of July. I will do my August update in a few days and it will be interesting to see how this number shifts over the rest of the year.
Bottom line: As with the treasury bond rate, if markets have already priced in the higher default risk, the equity risk premium for the US will not jump substantially. If the downgrade is a complete surprise, there will be carnage in equity markets as the equity risk premium will jump,

d. Costs of equity/capital for US firms: Even if risk free rates don't rise significantly, the costs of equity and capital for US firms will increase because of rising equity risk premiums (for cost of equity) and the increase in the cost of debt for all firms (which will now bear some of the burden of sovereign default risk). One simple way to adjust the cost of debt is to add the sovereign default spread to the cost of debt for all firms; thus, with a 0.25% default spread for the US, the pre-tax cost of debt for a US company will rise by 0.25%.

To make this less abstract, let's compare the cost of capital for an average risk firm (Beta =1, Rating = BBB, Debt ratio = 30%) before and after a sovereign downgrade for the US. I have assumed for simplicity that the downgrade is a complete surprise and that the downgrade is to a AA+ and computed the effect on the cost of capital below:

The cost of capital increases by 0.31%, which may not seem like much but will have a substantial effect on value.  Given my reasoning earlier, though, I don't think that the increase will be this high, since some or much of the change has already been priced in. You may disagree with the base assumptions and you can change them for yourself in the spreadsheet that I used. Note also that the effect will vary across companies and be much higher for riskier firms, with higher betas and lower bond ratings.


Be prepared for some anomalies. It is possible that a few US corporations may have smaller default spreads than the US government. Let's face it. If you were a bondholder buying bonds, you may feel a lot more secure buying bonds issued by Exxon Mobil than by the US government.

d. Valuation and stock prices: Holding all else constant, higher costs of equity/capital will lower stock prices. An increase of 0.31% in the cost of capital, estimated in the section above, would decrease the value of a mature firm by approximately 5%. (The spreadsheet makes this estimate as well...) What could accelerate this decline, though, is the perception that the sovereign default risk will percolate into fiscal/monetary policy (i.e., the Federal Reserve will become more cautious about pumping in more money into the system and the government has to rein in spending/borrowing) leading to a further slowing down in economic growth and lower earnings. To the extent that the sovereign rating for the US is now in play (and could change), it will add to the volatility in stock prices.

Summing up. To act as if all of this drama will unfold on the date of the downgrade is giving far too much power and weight to the ratings agencies. This process has been going on for months (if not longer) and it is unclear how much the stock and bond markets have already incorporated into prices. A ratings downgrade, if it does occur, will not be a surprise and it is not the cause of economic malaise but a symptom of unresolved economic problems: a government that spends far more than it takes in and has been doing so for a while, households that save too little and borrow too much and a loss of the competitive advantages that the US once enjoyed over the rest of the world. But here is the depressing follow up. Even if there is a debt-ceiling deal by August 2 and the ratings agencies don't downgrade the US, these underlying problems will remain and have to be dealt with, sooner rather than later. 



Stay Private vs Going Public: Changing landscape

For much of the last century, as public equity markets have grown, the choice for owners of private businesses that had growth potential was a simple one. Stay private, with limited access to equity capital or go public? In making the decision, the owner weighed the pluses and minuses of a public offering. On the plus side, liquidity increases and you have access to far more capital, generally at a lower cost, since the investors buying your equity tend to be more diversified (and thus willing to overlook a portion of the risk in your company). On the minus side, you risk loss of control (if not right away, but at some point in time in the future; remember the cautionary tale of Steve Jobs and Steve Wozniak being forced out of Apple in the 1980s) and you also have far more stringent corporate governance rules (think Sarbanes-Oxley) and information disclosure requirements. The venture capital market eased the transition, by allowing small firms that were not ready to go public to raise equity from private investors, albeit at a higher cost than they would pay in public markets.

To capture how the diversification status of the potential equity investor affects the cost of equity, I developed a scaled measure of beta a couple of decades ago, with the beta changing as a function of the diversification status:

Thus, a company with a market beta of 0.8 (to a diversified investor) can have a total beta of 2.4 (to a completely undiversified owner) and 1.6 (to a partially diversified venture capitalist). I have a data set that summarizes my estimates of market and total betas by sector for US companies that you can take a look at, if you are interested.

In the last few years, there have been two developments that have muddied the waters and changed the dynamics of whether and when firms go public. The first is the development of a private share market, where shares of private business can be traded by their owners, granting private businesses many of the advantages that they would have as public companies without much of the information disclosure/monitoring requirements that come with being public. Facebook is perhaps the most prominent example of a private business that has access to as much capital as almost any public company through this market. The second is the insidious route adopted by some non-US (primarily Chinese) private businesses that have bought small publicly traded US companies and used these companies as shell vehicles to gain access to public equity.

In both cases, equity owners of these businesses are badly served, since they own portions of private businesses without the right to access information or influence management (that they at least in theory have with public companies). In know that the obvious fix to both these problems is to regulate these options, either by extending public company scrutiny to firms in the private share market or by barring trading in the market. However, the people who buy equity in Facebook in the private share market or a Chinese shell company are doing so voluntarily. Presumably, they are pricing in their concerns (or lack thereof) into what they pay and deserve to get whatever upside (or downside) they get from their investments. I will not envy them their returns but I will certainly not shed any tears for their losses, either. So, Facebook equity investors, I hope you make money on your investments.. but with Mark Zuckerberg as your lead partner, you should perhaps consult the Winkelvoss twins on how well your interests will be served.



Default and Bankruptcy: Black, white and shades of grey

The talk of default is all around us, as we watch Greece and Italy struggle with impending disaster and the fight over debt limits in the United States fills the airwaves. But what is default? What are the consequences? And given a choice, when is default the best option?

Let's start with the most basic question. What is default? Most people would view it as the failure to meet an obligated interest or principal payment. That may technically be true, but it does not capture the shades of grey that characterize default. In fact, the ratings agencies seem to have thrown the Greek situation into tumult by viewing the country as being in default, notwithstanding the legislative approval of the
http://online.wsj.com/article/SB10001424052702304760604576424961088825954.html?mod=WSJ_hp_LEFTWhatsNewsCollection
The ratings agencies have a solid argument here, since default cannot be defined narrowly as failing to make an obligated debt payment. It has to be defined more broadly as lenders accepting a drop in value in their positions, in return for letting the borrower escape technical default; this could include loosening debt covenants or restructuring the debt to the borrower's advantage, without being compensated adequately for these changes. Thus,  if lenders let borrowers sell secured assets to raise cash, delay later payments, borrow more money on already secured assets, or lend them more money at below-market rates, they are accepting a reduction in value of their loans, in return for on-time payments. I will let you make the judgment on whether Greece is in default, but this story is telling:
http://www.globalnews.ca/French+banks+readying+plan+help+Greece+rolling+over+cent+debt/5012495/story.html
In effect, French banks are re-lending money to Greece at the rates that they set when Greece was viewed as a much healthier borrower. That is the equivalent of lending at below market rates and no amount of dancing around the truth will change that basic fact.

Why would lenders go along with this charade? In other words, why would lenders choose implicit default over explicit default? One reason is psychological. Explicit default casts as much light on lenders as it does on borrowers, since it reflects on the lenders' failure to assess credit risk adequately at the time of the original borrowing. Classifying a loan as being in default makes it impossible to deny that failure, while implicit default allows them to delay that recognition. The other is financial. Once a loan is classified in default, the rules on what follows are also more clear cut. Lenders have to write down the values of their loans to reflect the fact that default has occurred. This will have negative consequences for lending banks, which will take a hit to their regulatory capital holdings, and it will also lead to immediate losses for other investors who hold non-traded Greek debt in their portfolios. With implicit default, the rules are hazier and lenders can use the discretion built into the rules to put the best possible spin on the consequences. But implicit default has its own costs for lenders. By putting off the day of reckoning, it allows them to continue with the practices that led to the problems in the first place. In fact, if the price of implicit default is that lenders have to bring in fresh funds to cover past mistakes, it will make the eventual blow-up much bigger. (The best analogy that I can think off is the experience of Japanese banks in the early 1990s. Rather than accept the fact that the real estate loans that they had made during the boom years of the eighties were in default, they chose the path of implicit default, thus letting the problems fester and grow for another decade)

What about borrowers? Is implicit default better than explicit default for them? While there may be more shame and immediate cost associated with the latter, it is sometimes better to default, accept failure and move on to making the fundamental changes that need to be made. With implicit default, both borrowers and lenders remain locked into a dance, where fundamental changes are delayed or deferred. It remains an open question whether Greece is better off with its austerity package (and implicit default) or whether it would have better served by defaulting on its debt (even though that may mean exiting the European Union and giving up on the Euro). I know that there are many economists and investors who view the latter as a doomsday option, noting that default by Greece would have led to default by Spain, Italy, Ireland an Portugal. Well, guess what? Greece managed to avoid explicit default but that did not stop Italy from moving into the danger zone this week. Greece's actions may have bought some time for the EU to fix its problem states, but unless the fundamentals change, it has not changed the underlying dynamics that created these problems in the first place.

Postscript: The very first comment brought up a point that I should have addressed in my post, i.e., whether Greece's actions constitute a credit event in the Credit Default Swap market. That is not an academic question. If it is classified as a credit event, the sellers of the CDS are liable to cover potential damages. If not, life goes on... For the moment, it does not look like it meets the credit event criteria, but this post does a much better job than I ever could discussing the issue:
http://seekingalpha.com/article/274195-greek-cds-restructuring-credit-event-and-repudiation
It also raises an interesting problem with default. When different entities define default differently, there will be more game playing around default... 



Buffett and Bank of America: Playing Poker with Patsies...

Warren Buffet is famously quoted as saying, "If you have been playing poker for half an hour and you still don't know who the patsy is, you're the patsy". Today, we got a glimpse of Buffett playing poker with Bank of America, and at least from my perspective, it seems clear who the patsy in this game is... it is either Bank of America's stockholders or the rest of us who attribute mystical properties (and uncommon ethics) to the Oracle from Omaha...

So, let's recap what happened. It has been a rough few months for Bank of America stock, prior to today. The stock price had halved between November and yesterday:
Macro factors (the Euro crisis and the S&P downgrade) did play a role in the price decline but the company had itself to blame as well.  It reported a loss of $8.8 billion for the second quarter of 2011, reflecting payments to settle legal claims related to troubled mortgages.While the stock price decline suggested that the market was increasingly pessimistic about the company's future profitability, the company itself indicated that it was sufficiently capitalized to make it through these travails. Earlier this month, the company announced that it would lay off 3500 employees and cut costs, but evoked little positive response from the market.

Today, we woke up to the news story that Warren Buffett, white knight extraordinaire, had ridden to the rescue of Bank of America. 
Here were the terms of the deal:
- Buffett invests $ 5 billion in preferred stock, with a 6% cumulative dividend, redeemable by the company at a 5% premium on face value.
- If Bank of America is unable to pay the preferred dividend, not only do the dividends cumulate but they do so at 8% per annum and the bank is restricted from paying dividends or buying back stock, in the meantime.
- Buffett get options to buy 700 million shares in BofA at $7.14/share, exercisable any time over the next 10 years.

Let's see what Buffett gets out of the deal. Valuing the options with a strike price of $7.14, even using yesterday's low price of $6.40/share, an annualized standard deviation of 50% in the stock price (significantly lower than the 3-year historical standard deviation of 79% and the implied standard deviation in excess of 100% from the option market)  and a ten-year maturity, I estimate a value of $4.30/option or an overall value of approximately $ 3 billion (700*4.30) for the options. (I know.. I know..  Buffett does not like using the Black-Scholes model for long term options...Perhaps, he sold Bank of America's managers on the idea of using the famous Buffett-Munger long term option value model to derive a value of zero for these options...) Netting the $ 3 billion value of the options out of the $ 5 billion investment in the preferred stock makes it a $ 2 billion investment, on which $ 300 million is being paid in dividends. That works out to an effective dividend yield of 15% on the investment. By exercising his veto power over dividends and stock buybacks, Buffett can ensure that he is always the first person to be paid after debt holders in the firm. To cap it off, Berkshire Hathaway will be able to exclude 70% of the dividends received from Bank of America in computing taxable income (this is the rule with inter-company dividends), when paying taxes next year.   That is an incredibly sweet deal! 

What did Bank of America get out of this deal? Let's look at what it did not get first:
  1. It did not get Tier 1 capital (the most stringent measure of bank capital), which includes only common equity, and thus does not get any stronger on that dimension. (Update: I have been getting mixed responses on this issue from those who are well versed in bank regulatory capital rules, some saying that I am right and others that I am wrong. The fact that it is cumulative preferred stock, according to some, makes it ineligible for Tier 1 capital, whereas others note that Citi was allowed in 2008 to count cumulative preferred as Tier 1. Here is one article that seems to provide clarity  on the topic. My final response. Whether this passes the regulatory rule requirement or not, it does not pass the common sense rule for Tier 1 capital. If financing results in a commitment of $ 300 million each year that you have to meet, or roll over, it cannot be true Tier 1 capital, no matter what the rules say... )
  2. It gets no tax deductions, since preferred dividends are not tax deductible. So, the $ 300 million in dividends will have to be paid out of after-tax income.
  3. It risks losing flexibility on dividend policy and stock buybacks, as a consequence of the restrictions imposed on this deal.
The only conceivable benefit I see accruing from this transaction to the company is that Buffett has provided some cover for the managers of Bank of America to make two arguments: that the bank is not in immediate financial trouble and that it is, in fact, a well managed bank. I, for one, am not willing to accept Buffett's investment (or his words) as proof of either, and the way the deal is structured is not consistent with any of the arguments I have been hearing all day (from those who think it is good for Bank of America stockholders).
  • First, let us assume that the bank is not in financial trouble and that the market has run away with its fears over the last few months. But, why would a bank that is not on the verge of collapse agree to raising capital at an after-tax rate of 15% and give up power over its dividend and buyback policy? And given the extremely generous terms offered to Buffett on this deal, how can this action be viewed as an indicator of good management? 
  • Playing devil's advocate, let's look at the other possibility, which is that the bank has been hiding its problems and is in far worse shape than the rest of us think. If so, perhaps the terms of the deal make sense to Buffett (high risk/high return), but the deal still does not make sense to Bank of America. If the bank is in that much trouble, it should be raising tier 1 capital, and adding $ 300 million in preferred dividends to its required payments each year makes no sense. And, if it is in fact the case that the bank is in a lot more trouble that we thought, how can Buffett in good conscience then claim that BofA is a "strong, well-led company"?
Either the terms of deal are way too favorable to Mr. Buffett or he is not being forthright in his description of the company... In either case, this does not pass the smell test.

I know that there are some who are comparing Buffett's deal with Bank of America to his earlier deal with Goldman Sachs. But there is a key difference. The Goldman deal was entered into at the depths of the banking crisis, and in a period where liquidity had dried up, Buffett was providing capital. Even in that case, you could argue that Goldman Sachs paid a hefty price for taking money from Buffett to shore up their standing... Perhaps, this has become Buffett's competitive advantage. Rather than buy and hold under valued companies, which is what he used to do, he focuses on companies that have lost credibility and he sells them his credibility at a hefty price.  I know that Buffett has accumulated a great deal of trust with investors over the decades, but even his stock will run dry at some point in time, especially if he keeps dissembling after each intervention about the company, its management and his own motives.

In summary, is this deal good for Buffett? Absolutely, and I don't begrudge him any money he makes on this deal or the fact that the tax law may work in his favor. Does the deal make sense to Bank of America's stockholders? I don't think so, notwithstanding some of the cheerleading you are hearing from some equity research analysts and the market's positive reaction. Is Bank of America a "strong, well-led" company? Only if you have a very perverse definition of strong and well-led... 



Trapped Cash: Measurement and Consequences

It is an open secret that US companies have accumulated huge cash balances over the last two years. In fact, there were a few mentions that Apple's cash balance of $76 billion gave it more cash than the US treasury a few weeks ago, and I did a post on a while back on whether Apple had too much cash. While this "sitting on cash story" is an interesting one, there is a sub-story that we need to pay attention to and that may affect how we value companies. Not all of cash balances are equally benign. In fact, a significant portion of the cash balance, at some companies, may be "trapped" and thus not easily accessible, either for investments or paying dividends.

What is trapped cash?
Trapped cash refers to the portion of a company's cash that is held a company that is held in fully-owned foreign subsidiaries or units of the company. Note that there is nothing illegal or even unusual about this phenomenon. All multinationals generate revenue, earnings and cash flows in foreign markets, and those cash flows are held (at least temporarily) in those markets. As US companies generate larger proportions of their revenues overseas, the cash flows they generate from foreign markets has also increased.

Why is it trapped?
There are four reasons why cash may be trapped in foreign subsidiaries:
a. Operating reasons: To the extent that there are significant growth opportunities in foreign markets (especially in Asia), the cash is being held in abeyance to cover investment needs in these markets. 
b. Foreign restrictions: In some markets, the country in question has put significant restrictions on remittances from that country back to the United States. To be fair, these restrictions are sometimes tied to incentives or favorable tax treatment offered to the company for investing in the country.
c. US tax laws: Income generated by US companies in foreign countries is first taxed by those countries, when it is earned. However, it is not subject to US taxes until it is remitted back to the United States, with foreign taxes paid allowed as a credit. Thus, if a US company generates $ 1 billion in taxes in China, it will pay the Chinese corporate tax rate of 25% on this income. When that income is remitted back to the US, the income will be taxed at the US corporate tax rate of 35%, with the $250 million in Chinese taxes paid already as an offset. The net tax paid to the US government at the time of remittance will therefore be $100 million. By letting the cash accumulate in the foreign subsidiary, the company will be able to delay paying taxes to the US government. Since the US has one of the highest marginal corporate tax rates in the world, cash accumulation in foreign subsidiaries is a given, with the accumulation being greatest in countries that have marginal corporate tax rates much lower than the United States.
d. Accounting: Adding to the tax law is a GAAP accounting requirement that US companies with foreign income recognize the US taxes that they would have to pay on that income, in the period in which the foreign income is generated (rather than wait for remittance). There is, however, an exception. If the company makes the assertion that it never intends to bring the cash back home, it does not have to recognize US taxes. Not surprisingly, many US companies make this assertion to reduce taxes paid on income statements (and increase after-tax income).
Thus, there is both a cash flow and a reported earnings rationale for holding cash in foreign subsidiaries and the cost of remittance will increase over time, as the foreign cash balance increases.

How big is the trapped cash balance?
There are estimates floating around the blogosphere that put the total trapped cash well in excess of a trillion; a JP Morgan Chase analyst report estimated that 519 US multinationals alone accounted for about $1.4 trillion in trapped cash. The truth is that no one has a precise estimate because US companies are not required to reveal how much of their cash is held in foreign subsidiaries. There are three ways of estimating the amount of trapped cash:
a. Public reports: While companies are not required to break out their trapped cash, some companies do so voluntarily. For instance, Apple in its most recent 10K explicitly broke out the portion of its cash balance that was held overseas; it specified that more than $30 billion was invested overseas (Update: It is estimated that $41 billion of Apple's cash balance of $76 billion in mid-2011 is invested in foreign units). You could extrapolate from the numbers reported by these companies to the rest of the market. Thus, if 55% of the cash balances at companies that report foreign cash balances explicitly is trapped cash, you could assume that a similar proportion applies to companies that are not explicit. The danger, of course, is that companies that are not explicit about their cash holdings may be very different in their behavior than firm that are.
b. Operating exposure: Companies do report what proportion of their revenues and operating income is generated in foreign markets, In 2010, for instance, S&P estimated that 46.3% of revenues of the S&P 500 companies were generated overseas. One could argue that 46.3% of the cash balances of these companies are trapped, though that requires heroic assumptions about earnings and cash remittances at these companies.
c. Effective tax rates: If we assume that companies that trap cash in foreign subsidiaries also adopt the consistent accounting rule (of asserting that they do not plan to bring that cash back to the US), the effective tax rate of a company should provide some information on its cash trapping practices: the more cash that is being trapped in foreign subsidiaries, the lower the effective tax rate for the company should be.
No matter how you measure the magnitude of the trapped cash, we know that it is a very large number. How? Well, companies are spending millions of dollars lobbying Congress to change the tax laws on remittances and they would not be doing this, if there were not billions at stake.

So, what if cash is trapped?
Now, to the billion dollar question. Why does it matter whether cash is trapped or not? Put in more general terms, does this trapped cash have any consequences for corporate finance, valuation and the general well-being of US companies? I think it does and here are some reasons why:
a. Trapped cash may be wasting cash: In most valuations, we treat cash as a neutral asset, i.e., we value a dollar of cash at a dollar and add the cash balance on to the value of operating assets to arrive at firm value. However, cash is a neutral asset only if it earns a fair market return, given the risk and liquidity of the investment. Investments in treasury bills and commercial paper may earn a low rate, but a fair rate, of return and are thus neutral investments. Cash trapped in some emerging markets may not be as easily invested in fair market return investments. In fact, it is possible that the closest selection to a liquid, risk less investment is a bank deposit delivering interest income much lower than justified. That cash will have to be discounted and the value of the firm will decrease as a consequence.
b. Trapped cash may create financial constraints (and costs): It is possible that a company that has significant portions of its cash trapped in other markets may have to raise new financing (debt or equity) to carry out transactions or worse still, not take good investments because it does not have the capital available to do so. Thus, you may have the oddity of a company like Google with $20 billion in a cash balance issuing $ 3 billion in bonds to make an investment. The value of the firm will be reduced by the transactions costs associated with the new financing (if new financing is raised) or the value lost by turning down good investments (if investments are rejected).
c. Trapped cash may induce "bad" investment decisions: Companies with significant trapped cash may jump at the chance of using that cash, even if the investments taken offer sub-par returns. The defense will be that they have nothing better to do with the cash. This is the rationale that was offered by some for Microsoft's acquisition of Skype, a Luxembourg based company that allowed Microsoft to use up $8.5 billion of its trapped cash. I have argued earlier that Microsoft over paid for Skype. The fact that they were able to use trapped cash is small consolation and does not alter the value destructive aspects of that transaction.

How can this cash be released?
If you accept the premise that trapped cash can be value destructive, at least for some companies, then the question becomes one of how best to "untrap" this cash. Here are the options:
a. The punitive solution: The tax law can be changed to require that all income generated by US-based corporations will be taxed at the US tax rate, when the income is generated, even if it is in foreign subsidiaries. While this solution may be appealing to those angry at corporations, it will be counter productive and may very well backfire. In particular, note that a multi-national does not need to be US-based and it is conceivable that many multi-nationals will chose to switch their incorporation to a more benign tax regime rather than pay billions more in taxes each year.
b. The benign solution: The tax law can be changed to eliminate the "differential tax" (reflecting the difference between the US corporate tax rate and the foreign corporate tax rate) when income is remitted back to the United States. That will eliminate both the tax and the accounting rationales for trapped cash but will be a tough sell politically.
c. The bad solution: The worst solution to adopt is one that provides the illusion of being punitive without the tax revenues to go with the punishment. That is effectively what we have right now, where remitted income is subject to a differential tax but where every decade or so, we have a tax holiday where companies are allowed to bring trapped cash home without paying the differential tax. 
What do I see happening? I think that there will be a tax holiday, either explicitly or implicitly allowing companies to bring trapped cash home without the differential tax bite (or at least a fraction of the tax bite). The legislation will be accompanied by face saving adjuncts: a requirement (toothless and unenforceable) that companies that bring home cash invest in "job creating" investments and a promise that this will be the last tax holiday ever (Yeah... right...) The stock price impact of the legislation will be minimal even for companies with large trapped cash balances. The day after the tax holiday firms will go back to accumulating more foreign cash and waiting for the next tax holiday.

If the cash is released, what will happen?
As talk of a tax fix fills the air, proponents of the tax holiday are already thinking about what they see emerging in the aftermath, with each group seeing their preferred option winning out.
  1. The first group believes that the freed cash will be used by companies to make new investments and "create jobs". In my view, that's not going to happen! US companies have plenty of cash on hand already and are not taking new investments. Why would adding to the hoard change that? The roots for sagging real investment in the US are in a stagnant economy with excess capacity on most fronts, where good investments are scarce. I know that there is talk of linking a change in the tax law to "forced investment", where firms will have to invest remitted cash into job-creating investments to qualify for the tax benefits. That will create more harm than good.
  2. The second group is convinced that they will see stock prices pop up for companies with significant cash balances, as the discounts that markets have applied to the trapped cash disappear. That too is a misconception. To the extent that the expectation that the tax law will be changed has already been built into market prices, the actual change (if and when it happens) will not be a surprise. 
  3. The third group sees the released cash as potential dividends and buybacks. History suggests that they have some reason to be optimistic, since that is exactly what happened the last time there was a tax holiday for foreign cash. While the higher dividends and buybacks will increase cash returned to stockholders, it will be partially (or perhaps even fully) offset by a decrease in equity value as cash leaves these companies.
In summary, a tax holiday is likely to be a non-event for markets and have little impact on corporate investment or economic growth. 



    Momentum versus Contrarian: Two Reads of the ERP

    I am not much of a market timer but there is one number I do track on a consistent basis: the equity risk premium. I follow it for two reasons. First, it is a key input in estimating the cost of equity, when valuing individual companies. Second, it offers a window into the market mood, rising during market crises.

    For the ERP to play this role, it has to be forward looking and dynamic. The. conventional approach of looking at the past won't accomplish this. You can however use the current level of the index, with expected cashflows, to back out an expected return on stocks. (Think of it as an IRR for equities.) You can check out the spreadsheet that does this, on my website (http://www.damodaran.com) on the front page.Here is the link for the July 1 spreadsheet. Just replace the index and T.Bond rate with the current level and use the Goal seek in excel:
    http://pages.stern.nyu.edu/~adamodar/pc/implprem/ERPJune11.xls

    A little history on this "implied ERP": it was between 3 and 3.5% through much of the 1960s, rose during the 1970s to peak at 6.5% in 1978 and embarked on a two decade decline to an astoundingly low 2% at the end of 1999 (the peak of the dot com boom). The dot com correction pushed it back to about 4% in 2002, where it stagnated until September 2008. The banking-induced crisis caused it to almost double by late November 2008. As the fear subsided, the premium dropped back to pre-crisis levels by January 2010. I have the month-by-month gyrations on my site, also on the front page.
    http://pages.stern.nyu.edu/~adamodar/pc/implprem/ERPbymonth.xls

    Now, to the present. The ERP started this year at 5.20% and gradually climbed to 5.92% at the start of August. Today (8/8/11) at 11.15 am, in the midst of market carnage, with the S&P 500 at 1166 and the 10-year T. Bond at 2.41%, the implied ERP stood at 6.62%.

    So what? If you are a contrarian, you could view this as an opportunity: a return to past norms (4-5% ERP) would translate into a 30-40% jump in the index). If you are a momentum investor, you see the thundering herd and join in, selling short or buying puts. If you are a fence sitter, you are liquidating your stocks and holding cash, waiting for steady state (which may be a long time coming). My last post should provide enough clues as to where I stand but if you are in one of the other camps, I will not try to convert you. Different strokes for different folks!



    Chill, dude! It is not the ratings downgrade.. It is how you react to it!

    Sorry about the title, but I am in Southern California, in surfer terriotory! I guess that the debt ceiling debate was not the end game it was made out to be. In spite (or perhaps because) of the fact that the debt ceiling was raised by Congress, S&P decided to downgrade the sovereign rating for the US from AAA to AA+. As the headlines trumpet the news and the airwaves are filled with self-styled experts telling us how this will change the world as we know it, it is useful to step back and ask a few questions about yesterday's momentous events:

    1. Was there  "information" in yesterday's ratings change?
    Let's see. S&P's rationale for the ratings change is that the US has a lot of debt, that it is adding to with large continuing deficits, that are perpetuated by a dysfunctional political system. Duh! I don't think any of us needed S&P to tell us this... I don't see any news in this ratings change. You may wonder why that rationale cannot be applied to any ratings change, for corporates as well as sovereign ratings. And it can... For well-followed corporates, ratings changes are almost never big news with the bulk of the effect occurring before the change is made. The confirmation of conventional wisdom does carry some weight, but not very much. Ratings agencies are like those guests who show up at the party just as it is breaking up, too late to join in the fun and not early in to make a difference.

    2. What do ratings agencies do?
    Ratings agencies are "measurers", not "diagnosticians": they can tell you (they think) that something is wrong but they are not very good at telling you why or what to do about it. I think that S&P is pointing to the fact that the default risk in US government debt has increased over the last year and I think that they are right on that count. Beyond that, though, I would not lend too much credence to any of the policy changes that they feel will alleviate the problem... and the answers to the next two questions should explain why...

    3. Can bad things follow this downgrade?
    Of course, but it is not the downgrade itself that would worry me.. it is the reactions to the downgrade. We have seen the script before and here is the most negative (and unfortunately, most likely scenario). First, you will have representatives of the downgraded entity (in this case, the US treasury) argue that the ratings agencies got it wrong. Second, the same entity will do everything in its power to make the ratings agencies happy so that they can reclaim lost glory.
    I cannot predict the end result here, but corporations that have played this game have almost always lost. Fighting a ratings agency just prolongs the effect of the ratings action and gives the ratings agency even more power. You cannot run a healthy business (or economy) with the objective of keeping ratings agencies happy. After all, if a business were run with the sole objective of minimizing default risk, it would not borrow much, it would never take risky investments or pay dividends. It would just be a pile of cash backing up debt obligations. The bankers will be happy but who else would gain? You can draw the analogies to an entire economy yourself....

    4. Can good things follow this downgrade?
    In a perverse way, a ratings downgrade can free decision makers to focus on what matters. With a business, this would translate into decisions that maximize the value of the business rather than maintain a high rating. An interesting article in the NY Times a few days ago highlights this proposition:
    Note that this does not mean that default risk is not a factor in decision making but rather that ratings are an artificial constraint.
    Can the same rationale be applied to a government? I don't see why not. Now that the bogeyman of "losing the AAA rating" is out of the closet, it can focus on policies that make the economy more vibrant, with the constraint of keeping default risk (and deficits) under control. If I were Tim Geithner, on Meet The Press tomorrow, I would not waste my time arguing with S&P about whether the ratings downgrade was merited on or not. Instead, I would accept it as a fait accompli and move on to set the agenda for what I would do in terms of economic policy. Am I hopeful that this will happen? Not really... but I am glad that I am not the Secretary of the Treasury at the moment...

    At the risk of adding my voice to the cacaphony, here is what I would suggest. The worst thing that investors, analysts, legislators and policy makers is to change the tried and the true (ways to invest, analyze companies or set policy) because S&P has changed a rating. The best thing that they can do is to realize that the world has not changed over the last 24 hours and to use common sense as a guide to good practice. For investors, this will mean staying diversified across asset classes and globally in their asset allocation decisions, and due diligence in picking companies. For analysts, it will require going beyond assuming that the government bond rate is the riskfree rate and using historical risk premiums. So, my advice is that you skip the S&P press conference on Monday, stop reading newspapers for a couple of weeks and take a break... I am...



    Risk free rates and value: Dealing with historically low risk free rates

    Last week, the 10-year US treasury bond rate dropped to 1.75%. While it has risen since to about 2%, there can be no denying a  basic fact. Government bond rates have dropped in almost all of the developed market currencies: the Euro, the British Pound, the Swiss Franc and the Yen. Since government bond rates are used as risk free rates to estimate discount rates in valuation or hurdle rates in corporate finance, there has been a great deal of hand wringing and angst among valuation practitioners on the consequences. In fact, if you allow for the increase in sovereign risk across the globe, you could argue that the "true" risk free rates are even lower than the already low government bond rates. In my previous post on the sovereign rating downgrade for the US, I noted that the default spread would have to be netted out against the government bond rate to get to the risk free rate. If, for instance, you accepted the S&P rating of AA+ for the US and estimated a default spread of 0.20% for that rating, the US dollar risk free rate right now would be about 1.80% (2% minus 0.20%).

    So what effect do lower risk free rates have on value? The answer, if you follow conventional valuation practice, seems obvious. Lower risk free rates, holding all else constant, result in lower discount rates, and lower discount rates, all else held the same, will result in higher value. In fact, this seems to be the implicit message in the Fed's Operation Twist 2: that lower risk free rates are good for the economy and markets. It is also this facile conclusion that makes some practitioners uncomfortable with using today's rates in valuations; the angst gets deeper when the practitioner in question wants a "low" value for an asset (for tax assessments or to tilt the scales in a legal tussle). It is not surprising then that these practitioners flirt with an alternative: why not use "normalized" risk free rates instead of today's "abnormally" low risk free rates? The normalized risk free rates are generally computed by looking at the past: thus, the average 10-year treasury bond rate over the last 30 years, which is closer to 4%, is suggested as an option. Alluring though this option seems, not only is it the wrong solution to the perceived problem (of low risk free rates and out of control valuations), there may be no problem to solve in the first place. And here is why..

    1. The risk free rate is not just a number in a discount rate computation but an opportunity cost. One way to think about the risk free rate is that it is the rate you will earn if you choose not to take the risky investments that are out there (stocks, corporate bonds, real estate, a business venture). So, let's carry this to its logical extreme. Let's assume that you do replace today's risk free rate (2% or lower) with your normalized rate (4%) and that the resulting high discount rate gives you a low value for your risky asset. Let's then assume that you choose not to invest in that risky asset. Where do you plan to invest that money instead? In your normalized bond earning 4%? Since it exists only on your spreadsheet, I am afraid that you will have to settle for that "abnormally" low 2% interest rate.

    2. The risk free rate is a reflection of what people expect in the overall economy for the foreseeable future. Harking back to an equation that I have used before, note that the risk free rate is the sum of two market expectations: an expectation of inflation for the future and an expectation of real growth.
    Risk free rate = Expected inflation + Expected real growth
    Viewed through these lens, it is quite clear that a very low risk free rate is not generally compatible with a vibrant high growth economy. In fact, the biggest factor driving down ten-year bond rates this year from 3.29% to 2% has been the increasing pessimism about global economic health, pushing down both expected real growth and expected inflation. That is the basis for my argument that the Fed has become a side player in this game and that its push for lower risk free rates is actually at odds with its desire that the US return to healthy economic growth.

    3. The risk free asset is also where investors flee when the fear factor rises, the much vaunted "flight to safety" during crises. But this flight does not just affect the risk free rate.... It affects risk premiums for all risky asset classes: equity risk premiums rise, default spreads on corporate bonds widen and cap rates on real estate become higher. If you define the expected return from stocks as the sum of the risk free rate and the equity risk premium, the last decade has seen changes in that composition:


    Note that while the overall expected return on stocks (backed out from level of the S&P 500 index and expected cash flows from stocks) has been in a fairly tight range (8%-9%), the proportions coming from the risk free rate and equity risk premium have changed. And there are consequences for value as well. To see why assume that you are valuing a  mature, average risk company (growing at the same rate as the economy) with $ 100 million in cash flows to equity currently in a market where the risk free rate is 4% and the equity risk premium is also 4% (thus creating a cost of equity of 8%). Since the risk free rate is the proxy for nominal growth in the economy, this company's value is:
    Value of company = 100 (1.04) / (.08-.04) = $2,600 million
    Now consider valuing the same company when the risk free rate is 2% and the equity risk premium is 6%. Since the nominal growth rate expectation is down to 2%, the value of the company is:
    Value of company = 100 (1.02)/ (.08 - .02) = $1,700 million
    The effect on value will be greater for higher risk companies, where the risk premium is magnified, and lower for lower risk companies, but it will be significant across the board. Note that the first scenario resembles the market numbers in 2007 whereas the second is close to where we are today. The shift in risk free rates/ risk premiums may explain why stocks look cheap today, relative to historic metrics.

    So, what do we do about low risk free rates? As I see it, you can choose one of four routes, ranging from dysfunctional to dynamic:
    1. The dysfunctional valuation: You leave risk free rates at today's low levels, while your risk premiums and growth rates come from happier, more stable times. Implicitly, this is exactly what you will do, if you use equity risk premiums from historical data (Ibbotson, for instance) and earnings growth rates that reflect the "good old days". Using the example above, you would value the average risk, mature company, using a 2% risk free rate, a 4% nominal growth rate and a 4% equity risk premium:
    Value of company  = 100 (1.04)/ (.06-.04) = $5,200 million
    You will find everything you look at to be dramatically under valued, but the model is internally inconsistent. In effect, though, you are combining a crisis risk free rate with a good times risk premium/growth rate to estimate too high a value.
    2. The depressed valuation: You could replace the risk free rate today with a higher, normalized risk free rate, while using the higher risk premiums and growth rates that characterize crisis marks. Thus, in the valuation example, you would be using a 4% risk free rate in conjunction with a 2% nominal growth rate and a 6% equity risk premium, leading unsurprisingly to a low value:
    Value of company = 100 (1.02) / (.10 - .02) = $1,275 million
    Here, the inconsistency is that you have combined a good times risk free rate with a crisis risk premium/growth rate to estimate too low a value.
    3. The denial valuation:You could be a normalizer, replacing current numbers with normal numbers, not just on the risk free rate but on the other inputs (equity risk premiums, cash flows, growth rates) as well. This faith in mean reversion leaves the intrinsic value of the hypothetical company stuck at $2,600 million, as risk free rates and risk premiums change, and views the crisis as "nightmare" that will soon be forgotten. Unlike the first two choices, this one is internally consistent and may, in fact, be the valuation that is used by a classic contrarian investor, who believes that markets over react and adjust back to norms over time.
    4. The dynamic valuation: You could use today's combination of a low risk free rate, high risk premium and low nominal growth to estimate a value of $1,700 million for the company. The valuation is internally consistent but the downside is that it will be volatile and change as the macro environment changes, creating discomfort for those who believe that intrinsic value is a stable number that stays unchanged over time.

    I would steer away from the internally inconsistent valuations, either dysfunctional (giving you too high a number) or depressed (giving you too low a number) because your inputs are at war with each other. As for denial and dynamic valuations, I prefer dynamic valuations because I am not sanguine that reversion back to historic norms will happen soon. I can see why long term, value investors may be attracted to denial valuations but they better have a road map to their alternate pre-crisis universe, or the valuations will not come to fruition. But the bottom line about risk free rates is worth repeating. Lower risk free rates do not always translate into higher values for risky assets and it is not necessarily a "problem" that needs to be solved.




    Ruminations on Rogue Trading

    We are in the midst of a "rogue trading" scandal and the media loves it. It started with this report in the Wall Street Journal about an unnamed trader who had lost $ 2 billion for the Swiss banking giant, UBS. The trader was quickly identified and named as Kewku Abodoli, a director at the UBS Delta One desk (more on that later). Today's story has more details, with a comment from Abodoli's lawyer about how much he regrets his actions (or at least getting caught). If you have a sense of deja vu, it is because you have seen this story play out before. Just to refresh your memory, here are some memorable rogue traders from times past, with one being famous enough (Nick Leeson) that he had a movie (and not a very good one) made about him.

    What is rogue trading?
    Rogue trading is trading by an individual, that violates his or her employer's norms and rules on investing and risk taking, exposing the entity to catastrophic risk. Note that rogue trading does not require "losses" to qualify. A rogue trader can take "catastrophic risks" and make millions or lose millions. Only the latter join the gallery of rogue traders, tarred and feathered by the media, and forced to do the perp walk. What about the rogue traders who make money? They are richly rewarded, celebrated as master traders and generally leave to start their own hedge funds. Enough said!

    Why is there rogue trading?
    So, why is there rogue trading? The answers are surprisingly simple and universal:
    1. Trading is addictive: Anyone who has traded knows that the process can be addictive, where trades lead to more trades, and at least for some people, there is no stopping the trading. 
    2. The search for the "big" payoff: It is human nature to aspire for the pot of gold at the end of the rainbow, the mega million dollar prize on the lottery and the trifecta  at the race track. In trading, that big payoff is (or at least seems) closer than in any other profession and many rogue traders start down their chosen path hoping to make the "big trade"...
    3. House money and Breakeven effects: In an earlier post on Jerome Kerviel, I noted that two well documented tendencies in behavioral finance: the tendency to take more risk than you should with other people's or house money and the proclivity to reckless risk taking, once you start losing money, to get back to break even. As you look across the rogue trading episodes, they all share this characteristic. These traders all started with small losses, which they tried to recover from with bigger bets, and the process kept escalating until you get to hundreds of millions of dollars. 
    How do rogue traders generate these losses and how do they get away with it?
    When we read about the magnitude of the losses that are generated by rogue traders, we are faced with two questions: How do you lose hundreds of millions of dollars? How is it possible to do so undetected?

    Let's start with the first question. For a trader to lose hundreds of millions, he or she has to "lever" up and there are at least three ways this can be accomplished:
    1. Buy on borrowed money: You can borrow immense amounts of money on a small capital base, especially if you work at a large bank, and invest the amount in risky assets. You increase the upside on your equity investment, if you are right, but you magnify the downside, if you are wrong.
    2. Derivatives: You can make bets on derivatives that have potentially unlimited losses: this is the case when you buy or sell a futures contract on a commodity or a currency or when you sell options (either calls or puts).
    3. Long-short strategies: You can sell short on some risky assets, collect the proceeds and buy other risky assets, i.e., the hedge fund strategy. If the asset prices move in the right direction (your short sold assets have to drop in value while your long assets have to increase in value), you can make dramatic returns on small investments. However, if asset prices move in the wrong direction, your losses can be many times your equity investment.
    Coming back to Kewku Abodoli, the rogue trader of the moment, it is worth noting that he traded on the "Delta One" desk. On the surface, Delta One desks are relatively placid and profitable places, where traders trade derivatives and exchange traded funds (ETFs) to take advantage of movements in the underlying assets (the delta in the desk name references the option delta, i.e., the percentage change in the option value for a unit change in the stock price). However, access to derivatives and ETFs can be a double edged sword, allowing a rogue trader to take very large risk exposures.

    As for how rogue traders evade being caught, there are at least three possible explanations:
    1. Time lags in risk measurement/management systems: Given how quickly prices move in financial markets, there can be time lags in marking investments to market and learning about risk exposures. These problems are exacerbated with ETFs, since they are themselves often portfolios of traded assets which have to be marked to market. 
    2. Systematic measurement error in risk management systems: All risk management systems are based upon risk measures that are estimates. Thus, Value at Risk (VAR), a widely used risk measure at banks, has measurement error on many of its inputs, and some of these errors are systematic. For instance, a VAR that is based upon the assumption that asset prices move in a normal distribution will understate the risks of assets whose prices are discontinuous and tend to jump. Traders that learn about these systematic errors can then exploit them to hide real risks in their portfolios.
    3. Avoidance and Denial: It is possible that those who monitor the rogue trader get a sense that something is wrong much earlier than the final denouement. However, in a very human response, the first response is to deny that a problem exists and avoid it, until it blows up.
    How can you stop rogue trading?
    So, how can you stop the next rogue trader from bringing an institution down? As an institution, you can reduce the chance that you will be the next victim by doing the following:
    1. Hire the right traders: In my post on Jerome Kerviel, I pointed to the folly of entrusting trading to young men, a group that tends to take bigger and more reckless risks than any other subgroup of the population. I also suggested, only half in jest, that investment banks hire a few traders' mothers to trade alongside the traders, since older women are the perfect counterweight to young men in risk taking. I am sure that Mr. Abodoli would have been more cautious in his risk taking, if his mother had been sitting at the next desk.
    2. Real time and dynamic risk measurement systems: Risk management systems should track prices in real time and capture bad risk exposures early. 
    3. Restrict trading in illiquid assets: Even the most sophisticated risk management investments have trouble dealing with assets that are illiquid, where the prices are appraised values and not transaction values. As investing choices widen from traded stocks and corporate bonds to ETFs, derivatives and mortgage backed securities, risk management systems have come under more strain.
    4. Simple and focused risk management systems: Since inputs into risk measurement and management systems have systematic measurement error that traders exploit, simpler risk management systems that have fewer bells and whistles are more difficult to game. In addition, investment banks can borrow a technique that El Al, the Israeli airline, has used for years to keep terrorists off their planes. Rather than spreading their resources wide and check every passenger, they profile passengers and focus on those most likely to create problems. Banks can adopt a similar practice: rather than have risk management systems that track every trade in the bank, they can identify those areas, where rules are most likely to be broken and focus attention on them.
    5. Stress testing: Every risk management system will fail. It is a question of when, not whether. The key to good risk management is how you respond to failures in the system, not successes. Rather than assume that everyone is playing by the rules and measuring the consequences, it makes more sense to assume that some will not play by the rules and prepare for the consequences.
    6. Look at outcome and process, not just outcome: I started this post by noting that rogue traders who make millions are feted and celebrated. As long as we continue to do that, we will incite traders to take unconscionable risks. The best way to bring home the point that you will not put up with rogue trading is to fire a rogue trader who makes millions and to deny him his bonus.
    Here is the bottom line. The breast beating that happens after every rogue trading episode will subside. Banks will revamp their risk management systems and tell you that these new systems are now rogue-trader proof. I am a cynic, and I am sure that a few months or years from now, no matter what is done now, there will be another rogue trader at another bank. Consequently, I think it behooves all of us to be proactive about rogue trading:

    1. Top managers at banks: The six suggestions that I have above are all directed at management, but they will reduce, not eliminate, the likelihood of rogue trading. Top managers at banks have to consider rogue trading to be one of the risks that comes with proprietary trading. When allocating capital to different businesses (corporate banking, investment banking, proprietary trading) should incorporate this risk. (Proprietary trading will have to make a higher return on the equity invested in it to break even than commercial banking...)
    2. Investors in these banks: By the same token, investors in banks have to be cognizant of the risks that come with proprietary trading. A bank that generates a higher proportion of its profits from proprietary trading is riskier, other things held equal, than a bank that generates its revenues from traditional banking. If these banks trade at the same multiple of earnings, I would pick the latter over the former. In practical terms, I am suggesting that when screening for bargains among banks, we look at the percentage of profits from proprietary trading as a risk measure.
    3. Regulatory authorities: If rogue trading is part and parcel of proprietary trading, then it follows that institutions where the government provides a backstop should not be allowed to indulge in it. This is the basis for the Volcker rule in the US and the new banking rules that are being discussed in the UK, both of which would bar commercial banks from proprietary trading. I agree.



    The Buffett Plan: An apt name for a sanctimonious, hypocritical and superficial proposal

    At the start of this week, President Obama laid the groundwork for his deficit plan, with one of the proposals being what he termed the "Buffett" tax. Like Bank of America, a few weeks prior, he was perhaps hoping to borrow on Buffett's credibility to increase support for his plan. Put briefly, here is the what the plan is designed to do. Taxpayers who earn more than a million dollars will be required to pay at least as high a tax rate as what the average tax payer pays. What  constitutes a average taxpayer (I guess it is a good thing that it is not the median taxpayer; since that would comprise an income tax cut for millionaires, not a tax increase) and how high this "alternative" tax rate should be has been left to Congress to specify.

    This plan has the right moniker, since it's qualities are reflective of the man after whom it is named:
    1. It is sanctimonious: The word that best comes to my mind as I read Buffett's views on investing and business is "sanctimonious". He is the noble CEO, who puts stockholders' interests first, in a world full of cynical, self interested CEOs. He is the keeper of the value investing flame, while those short-term money managers in New York and London have abandoned Ben Graham, fundamentals and first principles. He is the brilliant financial thinker, standing alone against those clueless academics and their betas & option pricing models. In his latest foray, he is the "good" billionaire, who wants to pay his fair share of taxes, unlike those bad ones who shirk paying their share. This tax plan echoes this refrain. In effect, it says, the details don't matter because the intentions are noble: the rich can not only afford to pay more in taxes but they should be happy to do so. 
    2. It is hypocritical: All this sanctimony might be tolerable if it came from someone who not only talks the talk but walks the walk. Warren Buffett is a hypocrite on many of the issues that he is most vocal on. Consider corporate governance. The same man who said that managers are stewards of their shareholder capital has not always followed his lead, in structuring and running his own company. First, Berkshire Hathaway has adopted the dual-voting share plan that has been the weapon of choice for entrenched insider control in other companies (See New York Times, News Corp, Google, Washington Post... ). Second, while I admire Buffett's frugality, I don't see any transparency at Berkshire Hathaway. In fact, it looks to me like the board at the company exists to rubber stamp whatever Buffett and Munger want.  A case in point: look at the successors that have been hired to take Buffett's place: Ted Wechsler (his recent hire) and Todd Combs. Both seem like nice men with, but we know little about them (other than the fact that Buffett and Munger like them). One of the few data points we have on Wechsler is that he was the winning bidder, two years in a row, paying $2.6 million each year, in an auction where the prize was lunch with the Oracle from Omaha. If you see nothing wrong with that, you should be okay with Bob Iger picking his successor for Disney from a Mickey Mouse look-alike contest or Steve Ballmer choosing the next winner of the hot dog eating contest at Coney Island (Was that Joey Chestnut?) as the CEO for Microsoft. Third, for those who argue that Buffett can be trusted to make these judgments, I do remember that he did hand-pick his last successor and that did not end well, did it? No one is impervious from making mistakes, but people who live in glass houses should not throw stones.
      This tax proposal is just as hypocritical. While it is couched in terms of fairness, it is based on a false argument: that millionaires pay less in taxes because they exploit massive tax loopholes and have very good tax lawyers. While there may be some who do, we know why the effective tax rate for millionaires is so low. It is because a significant portion of the income comes from capital gains and dividends, which are paid out by corporations from after-tax income, and taxed at a lower rate than ordinary income (from wages and profits). I would have had much more respect for the proposal if it had directly confronted this issue. Should investment income be taxed at a lower rate? Should we be taxing consumption or income? That would be a debate worth having.
    3. It is superficial: To be honest, there is really no tax proposal, because the key details of the proposal, the "average" tax payer and the "millionaire minimum tax rate" are not specified. That is very much in keeping with the Buffett rule book. I know that much has been made about the brilliance and home-spun wisdom of Buffett's aphorisms. But as I read the letters that he has written to his stockholders (which comprise the heart of his writing), I am left with the feeling that when Buffett wanders from his preferred habitat - talking about investing in and managing mature companies - there is less there than meets the eye, especially when it relates to macro and market issues. What seems profound and wise at the first reading seems less so with each subsequent reading. Put differently, when it comes to a great deal of investing wisdom, Buffett's sayings seem to draw more on the fortune cookie tradition than from Confucius. 
    As far as this tax proposal goes, it looks like it was conceived by a union of a rogue economist and an over-the-top populist. (Perhaps, it was.. Has anyone seen Robert Reich and Paul Begala hanging out together?) It will, without a doubt, make the tax code more complex. As a taxpayer who has had to deal with the effect of capped itemized deductions and the alternative minimum tax rate (AMT) for the last decade, I think that they rank among the worst tax code abominations ever, and this proposal is more of the same, just directed at millionaires. It will also be ineffective. The administration estimates that it will raise $ 400 billion in tax revenues from the Buffett tax, which strikes me as unlikely. First, since the "millionaire tax rate" is unspecified, the fact that they can estimate revenues from it reveals exceptional brilliance. Second, since much of the income that will be taxed comes from dividends/price appreciation in the stock market, it would require a rising market and healthy economy.

    Am I being unfair in using a tax proposal named after Buffett to attack the man? Perhaps, but this tax proposal has its roots in Buffett's assertion that the rich don't pay enough in taxes and I am sure that the administration got his permission to attach his name to it. To those Buffett acolytes who are upset at my critique of the master, I have a simple suggestion. There are plenty of people, websites and books that revere the man and write puff pieces about him. Why not stick with those? Warren Buffett is a savvy investor, who has an uncanny ability to spot weakness and take advantage of it. I admire his skill but that does not mean that I have to treat him as infallible or exalt everything that has his name attached to it as good. My view is that the "Oracle from Omaha" no longer fits and that we need to come up with something better. I like the "Nag from Nebraska", the "Berkshire Bloviator" and the "Hypocrite from Hathaway", but I am sure that you can come up with your own variations.   Any suggestions? (As some of you have pointed out, this last part is over the top and unnecessary. So, let me retract it but leave it up so that I am not erasing history.. But I stand by my overall thesis.)



    Breaking up is easy to do...

    Breaking up may have been hard to do for the Carpenters, but it seems to be easy to do for some companies. Here are just  a few examples of companies that have announced plans to dismember themselves, in the last few months:
    1. Kraft Foods: Kraft Foods split itself into two companies: a division that sells candy and snacks (Oreo, Cadbury, Tang) globally and a division that sells grocery brands in the US (Oscar Meyer, Jell-O). 
    2. McGraw-Hill: The company responded to demands by investors that it break itself up by dividing itself into two businesses: McGraw-Hill Markets, which includes the S&P rating and index businesses and McGraw-Hill Education, composed of the publishing and education businesses owned by McGraw-Hill.
    3. Netflix: Reed Hastings, the CEO of Netflix stated that the company would separate its DVD rental business (and give it the name Qwikster) from its streaming-only service (which will continue to be called Netflix). 
    4. Tyco:  Tyco announced its intention to break itself up into three separate companies: a residential security business (ADT), a unit selling valves and controls to energy, mining and water markets and a commercial fire and security business. This represents the closing salvo in a multi-year effort by Tyco to deconglomeratize (I know.. I know.. there is no such word... but there should be) itself.
    What happens in a break up?
    To understand the mechanics of breaking up a publicly traded company, recognize that  there are three dimensions on which break up can have varying effects, depending on how it is structured: 
    1. Control of the management of the business(es), where the effect can range from a complete separation of control (with each of the broken up businesses becoming independent companies, completely delinked from the parent company) to de facto serf status for the separated units (with the parent company exercising complete or near complete control over the separated businesses).
    2. Market pricing of the units, where the effect can range from the broken up businesses trading as independent units (with their own shares, market price and traded value) to no change in the status quo, with the parent company trading as a single company, composed as a holding company for the separated business units.
    3. A break up can have tax implications for the investors in the parent company. To the degree that a break up can be viewed as a transition from owning stock in one consolidated company to owning shares in multiple companies, tax authorities may assess capital gains taxes (relative to what was originally paid for the stock) or treat distributions as dividends (and tax them accordingly). Again, in the continuum, you can have break ups that create no tax consequences for investors and break ups that create large tax bills.
    The good news is that the details of the break up ultimately have to be made public to investors, who can then assess the control, pricing and tax implications. The bad news is that the details may not be accessible at the time of the initial announcement of the break up.

    Does breaking up make sense?
    There are many reasons why companies may (or should) break themselves up, and here is a synopsis for each one:
    1. Market mistakes: The simplest rationale for a break up is that the market is mistakenly valuing the whole company at less than the sum of its pieces. Many analysts/ activist investors use this "sum of the parts" argument to push companies that they feel are being under valued to break up. While the story is intuitive, I would be skeptical of any argument that is premised entirely on "market mistakes", partly because most "sum of the parts" valuations are really "seat of the pants" valuations. Analysts will often take the earnings reported by division for a company, which are contaminated by accounting allocation and transfer pricing decisions made by the company, and apply sector-average earnings multiples (without correcting for differences between companies) to estimate the divisional or parts values.  (See the end of this post for a spreadsheet that will allow you to do your own sum of the parts valuation)
    2. Contaminated Parts: One division of a company may be saddled with actual, perceived or potential liabilities that are so large that they drag down the valuations of the rest of the company. This was the rationale for tobacco companies, faced with potential billion-dollar payouts on lawsuits brought by smokers, spinning of their non-tobacco businesses (See, for instance, the Kraft spin off from Altria (Philip Morris) in 2007). In the same vein, a company with a heavily regulated or constrained subsidiary may find that the regulations and constraints on that subsidiary spill over into its other businesses, rendering them less profitable. If restrictions on commercial banking are tightened (think of Dodd-Frank, with teeth...), it is conceivable that the large money center banks may want to spin off their investment banking arms to operate independently.
    3. The efficiency story: In the 1960s and 1970s, imperial CEOs  (Like Julius Caesar, they brooked no dissent and looked to no one for advice)  like Harold Geneen (ITT) and Charles Bludhorn (Gulf and Western) built up companies that spanned multiple businesses, arguing (with lots of help from strategists and consultants) that conglomerates would have significant advantages over their smaller competitors. Studies over the last three decades suggests that this optimism was misplaced and that conglomerates are often less efficient than competitors, earning lower returns and profit margins. In fact, markets responded by "discounting" conglomerates by about 5-15%, to reflect the inefficiencies. If conglomerates are less well run than the competition, perhaps because managers are spread too thin across business or because there is cross subsidization, then breaking them up into their individual businesses should increase efficiency, profits and value. The break up of Tyco, a company built on the conglomerate premise (and accounting gamesmanship), over the last decade can be a case study in deconglomeration.
    4. The simplicity story: Multi-business companies are not only more difficult to manage but they are also more difficult to value. With companies like GE and United Technologies, different businesses within each company can have very different risk, cash flow and growth characteristics and coming up with a consolidated number can be cumbersome. In my book, the Dark Side of Valuation, I examine why valuing their "octopus" companies is so difficult (you can just download the paper... you don't have to buy the book..)  and how to do a true sum of the parts valuation. In good times, investors may overlook the complexities of valuation, trust the managers and value these multi business companies highly. In bad times, they will not be as charitable and will punish complex companies by discounting their value. Breaking up the companies in bite size pieces that are easier to value and trade may therefore increase value, especially if you are in a "crisis" market.
    5. The tax story: When tax codes are complex (and when are they not?), companies may be able to lower their tax bills by artfully breaking themselves up. For instance, let us assume that the US government decides to take the populists' advice and tax all income generated by US corporations, anywhere in the world, at the US corporate tax rate in the year in which the income is generated (rather than when it is repatriated back to the US, as is the current law). Multinationals like GE and Coca Cola that generate a significant portion of their taxes in foreign locales, with lower tax rates, will be able to lower their tax bill by breaking up into independent domestic (US) and international entities, with different stockholders, managers and corporate governance structures.
    On the other side of the ledger, there are costs to breaking up as well:
    1. Loss of economies of scale: Combining businesses into a company can create cost savings. Thus, a group of consumer product businesses may benefit from being consolidated into one unit, with shared advertising and distribution costs. Breaking up with result in a  loss of these savings. 
    2. Reduced access to capital (and higher cost): If external capital markets (stock and bond) are undeveloped or under stress, combining businesses into a consolidated company can provide access to capital. How? The excess cash flows from cash rich businesses can be used to finance reinvestment needs in cash poor businesses. 
    3. Lost synergies: I am generally a skeptic about synergy but it does exist. In some multi-business companies, businesses feed off each other's successes, thus making the whole greater than the sum of its parts. Disney is a good example, especially in its kid-oriented products: its movie business generates opportunities for its licensing businesses and increases revenues at its theme parks. Separating Disney into independent movie, toy and theme park businesses will result in a loss of these benefits.
    If companies were rational, they would be looking at this trade off and making judgments on whether to break up, based upon the net effect. A rational explanation for the surge in break ups is that we are in a market phase, where risk is front and center, and complexity is being punished.

    By focusing on sensible reasons for breaking up firms, we do miss the most important factor that explains corporate actions: herd behavior. Investment banks, consultants and corporations often get stuck on the same page in the value creation cookbook and dole out the same advice for each company that comes looking for help at a point in time. Break ups may be the flavor of the moment, and companies are jumping on the bandwagon, expecting stock prices to go up, even if the break up makes no economic sense.

    Assessing break ups and potential break ups...
    As investors, the breaking up of a company can be good, neutral or bad news. In assessing either announced or potential break ups, here are some things to consider:
    a. Past performance: I know.. I know.. I have read the disclaimers too, but if you are performing well (both in terms of earnings and stock prices), why mess with a winning formula? A firm that is performing well (both in terms of profitability and stock price measures) should therefore be less inclined to consider breaking up than a firm that is under performing its competition.
    b. Separate and independent businesses: The benefits of breaking up increase and the costs decrease if the businesses that are being broken up are stand alone, independent businesses, with few or no cross business links. Conversely, companies with interlocked businesses that have synergies should be wary of break up plans.
    c. Management rationale and consistent actions: A break-up is more likely to succeed if  the managers of the parent company are  clear about their objectives and structure the break up consistently. For instance, if the rationale for a break up of a company is that one business is contaminating the remaining businesses, the break up makes sense only if it creates separate legal entities that operate independently.

    So, how do the break ups in the news measure up?
    • The Tyco break up makes the most sense: the businesses are separate and independent and managers seem clear on the rationale. It is also part of a long term plan and is not a knee-jerk response to market developments.
    • The McGraw-Hill merger also makes sense, since there is little overlap between S&P and the education businesses. These firms operated independently until a few years ago and the transition back to independence should be easier. Finally, the current legal and public relations problems with the ratings agencies could hurt the rest of McGraw Hill. (In fact, a surprising number of break ups are reversals of acquisitions done in prior years, an admission that the acquisitions did not work.)
    • The Netflix break up seems like a clumsy solution to a pricing problem: the cost of maintaining a DVD customer is higher than the cost of a streaming customer and that cost difference will widen as fewer people use DVDs. But do you have to break up a company to accomplish this? 
    • I am at a loss on the Kraft break-up. The businesses that are being divided have more in common than they are different. Oreo, Cadbury, Jell-O and Oscar Meyer are all strong brand names with a global presence. The fact that the latter two may get more of their revenues from US grocery story sales does not strike me as a big difference. Perhaps, there are differences in growth prospects, but the costs of breaking up (lost economies of scale and synergies) seem to vastly outweigh the benefits. In short, this break up seems to fit into "action is better than inaction" rationale for break ups.
    Finally, are there other companies that meet the criteria for "good" break up candidates? There are plenty, but let me suggest three high profile candidates:

    1. Time Warner: Time Warner is a company with tentacles in every aspect of entertainment. Unlike Disney, which does get significant cross business synergies, Time Warner has less overlap across businesses. The company has had trouble on both profitability and stock performance measures and a management that will never outlive the consequences of having made the worst acquisition in history.
    2. GE: In the days of Jack Welch, GE was a case study of a large company that seemed to have found the fountain of everlasting growth. Not only have we discovered in hindsight that this growth (mostly from acquisitions) was more expensive than it seemed at the outset, but GE Capital has taken on an outsized role in determining the value of GE as a company. As one of the largest financial service companies in the world, with its own share of costly mistakes, GE Capital is an impediment to valuing GE and an brake on its stock price. Unlike other captive financing arms (Ford Capital, GMAC), where the bulk of the revenues come from within the company and separation is difficult, GE Capital derives a significant portion of its revenues outside GE and should be easier to separate from the company.
    3. Citigroup/Bank of America/ JPM Chase: The strategies that the big money center banks embarked on, a decade or more ago, of being financial supermarkets, with business interests in banking, real estate, portfolio management and housing finance has blown up in their faces. Instead of the diversification helping the company, one or two portions of each bank (with bad lending practices or toxic assets) is threatening to bring down the rest of the institution. Perhaps, it is time to break up.. or in the case of Bank of America, put one of its businesses into bankruptcy..
    So, embark on your proactive exercise of looking for potential break up candidates: if you can get ahead of the curve, you should profit, even if only a fraction of these companies do break up. Just to help you along, I have attached a very simple spreadsheet for assessing the effect on value of a break up, in both intrinsic and relative valuation terms. Have fun with it! 





    Operation Twist II: The Fed as Chubby Checker


                Since the banking crisis of 2008, neither fiscal nor monetary policy has proved up to the task of rejuvenating the US economy. The Federal Reserve, in particular, has explored almost every tool in its arsenal to increase economic growth. In 2009, there was Quantitative Easing II (QE II), where an influx of $ 600 billion was used to buy long-term bonds and lower long term interest rates. Those lower rates, it was argued, would help get housing back on track and increase real economic growth. At the time, I argued (though I admitted my limited credentials to be involved in this debate) that I did not think it would work, for the simple reason that interest rates were already low, with the 10-year T. Bond rate at 3.3%.

                Two years later, the 10-year T. Bond rate stands at 2.09% and treasury bill rates are close to zero. The Fed is now planning to get back into the game with a maneuver that it has last tried in 1961: Operation Twist. Simply put, here is what the Fed hopes to do. Rather than introduce more funds into the system (like QE2 did), Operation Twist is a shift in what securities the Fed invests in, rather than how much. The Fed, which holds about $1.7 trillion of US treasuries is planning of reducing its purchases of short term treasuries (1 month, 3 month etc.) and increasing its holdings of long term treasuries (10 years and higher). Assuming that the rest of the market stays in a holding pattern, the increased demand for long term bonds should lower those rates, while the rate for the short term notes and bills will increase.

                Now, let’s look at the why. There seem to be three stories offered:  an “interest rate” story, where real growth will increase as a consequence of this maneuver, a “confidence” story, where US companies and consumers will be heartened by the Fed’s activism and and a “valuation” story, where stock prices will react favorably to the shift in the term structure:
    1. The “interest rate” story goes as follows. There are a number of key consumer (mortgage financing) and corporate interest rates (corporate bonds, long term bank loans) that are tied to the long term rate.  In its optimistic version, for consumers, QE3 will reduce the rates on mortgages, inducing those staying on the sidelines to either borrow and buy a new house or to refinance an existing house at the lower rate, with the savings going into consumption. Companies, it is argued, will also be more likely to borrow more, if corporate bond rates decrease, and make new capital investments.
    2. The “confidence” story is based upon the presumption that both producers and consumers in the United States prefer a Fed that acts to one that does not. Since QE3 would qualify as action, both groups, it is argued, will become more inclined to invest, consume and take risks.
    3.  The valuation story builds on the first two. Here is what the optimistic take is: a lower long term rate will trump higher short term rates, pushing discount rates down. The higher real growth, coming from the interest rate story, and lower risk premiums, emanating from the confidence story, will then augment this impact, causing stock prices to increase even more.
    Nice stories, but QE2 was also supposed to make a real difference in real growth and put the economy back on track. Here is why I think QE3 is destined for the same fate:
    • For the interest rate story to work, long-term interest rates have to go down significantly without short term rates shooting up too much. In the figure below, I have the yield curve in September 2011. If the 10-year bond rate is at 2%, how much lower can it go? Even the optimists at the Fed seem to foresee a drop of about 20 basis points as the outcome and no one seems to have an estimate on the concurrent increase in short term rates. Since mortgage rates are already at historic lows, I don’t see a further drop of 0.20% making much difference.



    •  I don’t buy the confidence story, simply because I don’t think action always trumps inaction. In fact, my reaction to hearing that the Fed was trying to twist the yield curve is that they must be scraping the bottom of the barrel, if this is the best that they can do.
    • Finally, the valuation story. Does the level of interest rates affect stock prices? Of course! Does the slope of the yield curve matter for equities? Also, yes! One way to see this is to look at the Earnings to Price (EP) ratio (the inverse of the PE ratio) for the S&P 500 (using trailing earnings) in relationship to the 10-year T. bond rate (measuring the level of rates) and the difference between the 10-year rate and the T.Bill rate (measuring the slope of the yield curve) from 1960-2010. Regressing the EP ratio against the ten-year rate and the yield spread differential (with t statistics in brackets):
    EP = 2.66% + 0.67 Ten-year T.Bond rate  - 0.31% (T.Bond rate - 3 month T.Bill rate)
            (3.37)     (6.41)                                  (1.36)
    How would I read this? At least between 1960 and 2010, every 1% increase in the long term bond rate increases the EP rate by 0.67% and every 1% increase in the slope of the yield curve decreases the EP ratio by 0.31%.

    The EP ratio for the S&P 500 right now is about 6.97%, based upon a trailing PE of 14.34. Assume that the best case scenario unfolds and that long term rates drop by 0.20% and that short term rates increase by 0.20%. By my estimates, the EP ratio for the S&P 500 will remain almost unchanged at 6.96%, resulting in the trailing PE of 14.36. Thus, stock prices will not change by much as a result of this action. Perhaps, long term rates will drop by more and/or short term rates will rise less. You can download the spreadsheet that I used for my computation and input your best estimates: this spreadsheet has four worksheets: the raw data on the index and fundamentals, the chart of the historical EP ratios, the regression output (backing the regression above) and a prediction worksheet (where you can estimate the effect on stock prices). Have a go at it! As for myself, I will stick with my favored version of the twist.



    Class is in session...

    As some of you probably already know, I teach at the Stern School of Business at NYU. Well, summer is officially over and a new semester is beginning. In a rite that I repeat at the start of every semester that I teach, I want to invite you to be part of my class this semester. Note, though, that this invitation is completely unofficial and approaching NYU for credit for taking the class is a definite no no.

    This semester's class:Valuation
    The only class that I will be teaching this fall is Valuation. A little history, though it may bore you, is in order here. I came to NYU in 1986 and the very first class that I was asked to teach was a Security Analysis course, a class with deep and venerable roots (Ben Graham taught this class at Columbia and Warren Buffett took it in the 1950s). It was a class on valuing securities of all types, bonds, futures, options and stocks, but it had outlived its useful life by the mid 1980s, partly because there were other electives that focused on bonds and derivatives and partly because there was no narrative left that fit the class. I hijacked the class, revamped its content (without renaming it), and made it a semester-long class on valuing businesses: small and large, public and privately owned, growth and mature and developed and emerging markets. About 4 years ago, the administration recognized the obvious and changed the name of the class to reflect its content.

    What is this class about?
    While the class is centered around intrinsic valuation (or discounted cash flow valuation, if you prefer to use its applied form), and I am a firm believer that intrinsic value matters, I try (though I do not always succeed) to keep an open mind and not force feed my views. Consequently, you will hear me talk a lot about the limitations of discounted cash flow valuation and what I see as its dark side. In addition, a significant portion of the class is devoted to multiples and comparables (what I term relative valuation), since it is the dominant approach used by analysts to value companies. I do also bring in the role that option pricing has played in valuation, in the form of real options. Thus, I try to make this class as broad as possible in terms of approaches covered and businesses valued.. My objective is that you should be able to value any asset or business, using any approach, and from any perspective (investor, acquirer, appraiser), by the end of this class.

    What background do I need to take the class?
    This class is an elective that is taken primarily by second year MBAs, most of whom have had the misfortune to take a full semester class in Corporate Finance from me in the previous year. However, I do make the assumption that a summer is all you need to wipe out everything you have learned over the previous year and the first three or four weeks of this class provide a quick review of the corporate finance class.
    I do assume that you have some working knowledge of accounting, present value and statistics. If you do not, I would recommend quick primers that I have online that may be useful to you:
    http://people.stern.nyu.edu/adamodar/New_Home_Page/background.html
    But even if you don't have time to do these things, why not just drop by and listen to a lecture or two?

    How do I take this class?
    a. The first thing to do is to visit the website for the class:
    http://www.stern.nyu.edu/~adamodar/New_Home_Page/equity.html
    This is the central repository for everything to do with the class.
    b. The second is to download the lecture notes for the class and watch the webcasts for the class. Both are available on this page:
    http://people.stern.nyu.edu/adamodar/New_Home_Page/webcasteqfall11.htm
    You have two choices with the lecture notes. You can print them off on paper and use them in conjunction with the webcasts. Alternatively, you can download them as pdf files and read them on your iPad or Kindle (if you have one). On the webcasts, you have three choices:

    1. Streaming video (The file will be streamed to your computer. This will work only if you have a good internet connection, but should be of the best quality)
    2. Video podcast (The .m4v file will be downloaded to your computer and you can watch the video using Quicktime or video software or on your iPad or Smartphone)
    3. Audio podcast (The .mp3 file will be downloaded as an audio file and can be played on any audio player)
    c. If you really want to feel involved in this class, you can go further:

    • Take quizzes/exam: I will post the quizzes on the website, right after I give it in class and the solutions the day after (with grading guidelines). You can take the quizzes/exam and grade yourself (follow the honor code).
    • Valuation project: This class has a big project that is a valuation of a company. You can pick any company and follow along on the project. On this one, unfortunately, I cannot be a full service operation. While I do give feedback to those who are officially in the class, I cannot do the same with everyone who is taking the class unofficially. If you do get stuck on a concept, and I can help, I will try.


    One final resource that you may want to use. I am trying out a new device put together by a few very smart, enterprising young people called coursekit. It essentially pulls together everything that is on the website for the class and adds a social media component (think Facebook embedded in the course page). I like the look and you can see it by going to:
    http://www.coursekit.com
    Enter the code FHGN2P and you will become part of the course online. I will put the emails that I send on here and it will let you raise questions/issues related to valuation that can be discussed. 


    In closing, I hope you do drop by and become part of this experience.... See you in class!



    Growth (Part 4): Growth and Management Credibility

    If you buy a growth company, the bulk of the value that you attach to the company comes from its growth assets. For these growth assets to be valuable, though, not only do you need high growth potential, but the company has to be able to scale up its growth while ensuring that it generates returns that exceed its cost of capital, while delivering this growth. That is tough to do, and it should come as no surprise that most young, growth companies do not make it through these tests. Investors who are able to look at a large group of young, growth companies, and separate those that will survive from those that will not, will see immense payoffs. But can this be done? Those who are firmly in the value investing school argue that this is the impossible dream and that there is too much uncertainty in this process and too many variables that cannot be controlled for this strategy to work. However, if this were true, how do we explain the success of some venture capitalists and growth fund managers? Are they just lucky? I don't think so. In fact, these investors share a characteristic: they are excellent judges of management at companies, since so much of the value at young growth companies comes from trusting managers to make the right choices and to follow through. Here are some of the dimensions on which managers of young, growth companies should be judged:

    Does the management have a vision for the future that is grounded in the product/service offered by the company?
    As noted in part 1 of this series, the revenues of a young, growth company are bounded by the potential market for its products and services. A management that defines its business too narrowly is limiting its growth potential and by extension, its value. If a management defines its business to broadly, the vision becomes unrealistic and thus not credible. In a sense, management needs to have a vision that is both large and grounded in reality at the same time... Not easy to do, but why is that a surprise? If it were easy, we would all be founder/CEOs of our own businesses!

    Is there an operating plan to bring this vision to fruition?
    As businesses have found through the ages, a soaring vision and/or a great product is just the first step. Without the grunt work of operations (production, marketing and distribution), commercial success will remain elusive. Since relatively few visionaries have the patience or aptitude for the "nuts and bolts" of operations, this will require having the right people in place and the willingness to delegate power to these people.

    Is there clarity on the trade offs that the firm faces for the future?
    It is true that the founders of young, growth companies have to sell investors on their potential for success. Many founders, though, view this mission as requiring them to sounds relentlessly optimistic and highlighting only the positives. However, the most persuasive pitches are made by founders who are open about the trade offs involved in success and the risks they face, and are willing to outline how they plan to make their choices. Thus, a CEO who talks about growth potential without mentioning how much she needs to spend to deliver this growth (and how she plans to finance it) and/or the competition she will face is less credible than one that talks about growth and then goes on to discuss how the company plans to deliver this growth and what it will cost.

    Is there flexibility built into the plan?
    No matter how well thought out a concept may be, young, growth firms will be buffeted by unexpected occurrences, some bad and some good: that is the essence of risk. One key test of managers in young, growth companies is whether they have contingency plans for "bad" events. It may be mark of a brave soul to embark on a mission with no second thoughts or escape hatches, but for young businesses, that could be suicidal. Just as critical a test is how well managers have prepared for success, since success will bring with it different types of tests: new competitors, financing needs and staffing requirements. In fact, you will learn a great deal about a company, when you see it navigate through its first few crises and opportunities.

    Are managers willing to trust you (as investors) with news (especially bad news)?
    When you invest in a young company, you know that the pathway to success is never  smooth. You recognize the risks involved and price the company accordingly. However, you do need managers of the company to keep you in their confidence, giving you both good news and bad news promptly and without shading the truth. A failure to do so only magnifies your risks. As a cynic, you may wonder why managers would ever do this. I would argue that it is in their own best interests, since so much of the value comes rests on their being credible. A growth company that burns its investors will face immense trouble getting them to believe again...

    Are managers willing to trust you (as investors) with the power to challenge them?
    I start with a simple presumption. If a company wants my money (as capital), it should give me a say (limited by share of the company) to how it is run. While most CEOs claim to be willing to listen to their stockholders, there is a much more tangible measure of whether they trust their own stockholders in the voting power that they grant them. In an earlier post, I noted the spread of the Google dual voting class model to other technology companies. This graph from the Wall Street Journal is telling:

    By giving the founders/insiders 150 voting rights per share, Groupon effectively is issuing common shares with no voting rights. They are telling me that they want my money but not my input on how the company is run. That is their prerogative but I will exercise mine and not play this one sided game.

    If you are interested in investing a young, growth company, pick up a filing for a prospective IPO or the annual report for a and review it. Make your best judgment on whether the management sounds credible, truthful and is worth trusting.. and also look for the clues on whether they trust you back. And keep updating your views, based on how the company responds to events.


    Blog post series on growth



    Growth (Part 3): The Value of Growth

    Consider a firm that has $ 100 million invested in capital that generated $ 10 million in after-tax income in the most recent year. For this firm to generate more income next year, it has to do one of two things:
    1. Manage its existing capital (assets) more efficiently: Thus, if the firm can cut its operating expenses and increase its income to $12 million next period, it will have a growth rate of 20% for the next period. Let's call this efficiency growth.
    2. Add to its capital base: If the firm can add another $ 10 million to its capital base and maintain its current return on capital (10%), its income next period will be $ 11 million, with a growth rate of 10% over the prior year. Let's call this "new investment" growth.
    While both components feed into observed growth, they are not equal in their effect on value on two dimensions:

    • Time: A firm can cut costs and make itself more efficient over time but only to the extent that these inefficiencies exist. Thus, a firm that is badly managed may be able to generate efficiency growth for 3, 4 or maybe even 5 years, but not forever. New investment growth is called sustainable growth because it can be continued for as long as the firm can maintain its policy on reinvestment and the return it generates on its investment. 
    • Value: Efficiency growth always creates value, since no investments are needed and earnings and cash flows will go up.  Whether new investment growth creates value revolves around whether the higher earnings created are justified by the additional investment that is required to generate them. Since it costs companies to raise capital (the cost of equity for equity and the cost of debt for borrowed money), the return generated on that capital has to exceed the cost of capital for growth to add value. In the example above, introducing a cost of capital of 10% into the analysis will make the new investment growth "worthless", since what is added in value through the higher growth  will be exactly offset by the higher reinvestment (and lower cash flows) needed to generate that growth. As an exercise, you can try entering different combinations of growth, return on capital and reinvestment and measure the value effect in this spreadsheet.

    Looking at any company's past, you can draw conclusions about whether the growth registered in the past was valuable, neutral or value destroying, by comparing the return on capital generated on the growth investments to the cost of capital. The return on capital itself is computed based on operating income and the book value of capital invested:
    Return on capital = Operating income (1- tax rate)/ (Book value of equity + Book value of debt - Cash)
    This calculation is also in the spreadsheet referenced in the last paragraph. It is the only place in valuation/corporate finance, where we use book value and we do so because we are looking at the profits generated on what was originally invested in existing assets (rather than their updated market values). There are a host of dangers associated with trusting accounting numbers and I have written about them and what to do to compensate in a paper on measuring returns.

    So, how well do publicly traded companies do in terms of delivering returns? Which sectors do the best? To answer the first question, I computed the return on capital and cost of capital for all publicly traded companies listed globally in 2007 and 2008 and found the following:

    While the crisis in 2008 took at toll on returns, even in 2007, a good year for most companies globally, about a third of all companies in the US and a higher proportion elsewhere generated returns on capital that were less than the cost of capital. While you may quibble with the year and have issues with how I computed cost of capital and return on capital, I think you will agree that value destruction is far more common at companies than we would like to believe and that quality growth (that increases value) is rare. To answer the second question, I compute returns on capital and cost of capital, by sector, for US companies and report them on my website at the start of every year. You can get the most recent update (from the start of 2011) by clicking here.

    For those of you who do not want to go through the process of computing return on capital and cost of capital, I have a simpler proxy for measuring the quality of growth. Start by computing the capital invested thus:
    Capital invested = Book value of equity + Book value of debt - Cash
    Divide the change in operating income over the period by the change in capital invested over the period; the ratio is a measure of the the quality of the growth, with higher ratios representing higher quality. In the table below, I have computed the number for Google going back to 2003:

    In the last column, I computed the marginal return on capital in that year by dividing the change in operating income that year by the change in capital. Based on this measure, in 2009 and 2010, Google saw a drop off in its quality of growth, a drop off I would attribute to acquisitions made by the company to keep its growth rate high. Its pre-tax marginal return has dropped to about 20%; in after-tax terms that would be closer to 13 or 14%, a good return on capital, but not a great one.  Investors have had wake up calls in Amazon and Netflix as well in recent days, as the costs of delivering growth have come to the surface. In most growth companies that disappoint, the clues are available in the years before.


    Blog post series on growth



    Growth (Part 2): Scaling up Growth

    As companies get larger, it becomes more difficult to sustain high percentage growth rates in revenues for two reasons. The first is that the same percentage growth rate will require larger and larger absolute changes in revenues each period and thus will be more difficult to deliver. The second is that a company's success  will attract the attention of other firms; the resulting competition will act as a damper on growth.

    I know! I know! You have your counter examples ready: Apple and Google come to mind. First, note that even these exemplars of success have seen growth rates decline over time. In fact, I posted Google's revenue growth (in dollar and percentage terms) in a prior post and while growth rates remain healthy, they have declined over the last decade. Second, the very fact that you can name these great growth companies is an indication that you are talking about the exceptions rather than the rule. Could the company you are looking at right now be the next exceptional company? Sure, but do you want to value your company to be the exception? I would not, since pricing your company for perfection will open you up to mostly negative surprises in the future.

    Metrick and Yasuda, in their book on venture capital, have a sobering study on the persistence (or lack thereof) of growth at high growth companies. They compared the revenue growth rates at companies at the time of their IPOs to the average for the sector to which they belong and then followed up by looking at these growth rates in subsequent years.

    Reading the graph, the revenue growth rate of the  "median" IPO company is 15% higher than the revenue growth rate of other companies in the sector one year after the IPO, drops to 8% two years after, to 5% three years after and to the sector growth rate 5 years after. Put succinctly, company-specific growth at the typical high growth company dissipates in about 4 to 5 years. Even the star IPOs (in the 75th percentile) see precipitous drops in the differential growth rate over the five year period.

    Given this evidence that growth decelerates quickly at companies, how do we explain valuations where analysts use 50% compounded growth rates for 10 to 15 years or longer? I think the problem lies in the "percentage illusion", where analysts feel that their growth assumption is not changing if they keep the growth rate unchanged. However, delivering a 25% growth rate is far easier in year 1 than the same firm delivering a 25% growth rate in year 9. The best way to introduce some realism in growth rates is to convert the percentage growth rate in revenues into dollar changes in revenues and consider what the company will have to do in terms of operations to deliver that change. When valuing a retail company, for instance, computing that the company will have to open 300 new stores to deliver a 25% growth rate in year 10 (as opposed to 30 in year 1) may quickly lead to a reassessment of that growth rate. I have a very simple spreadsheet that does little more than this: convert percentage growth rates into revenue changes each period. As an exercise, take any young, growth company that you want to value, put in the current revenues and try different compounded revenue growth rates. The power of compounding continues to amaze me!


    Blog post series on growth



    Growth (Part 1): The Limits of Growth

    When valuing young, growth companies, a key input into the valuation is the expected growth rate in revenues. For these companies to become valuable, small revenues have to become big revenues (and negative operating margins have to become positive ones...) and revenue growth is the driver of value. It is a tough number to estimate and it is easy to get carried away, especially in hot sectors. In this post, I will look at the information that can be used to put limits on this estimate, reasons why some companies may be able to blow through these limits and the disconnect that often emerges between company level estimates (made by analysts) and sector-wide estimates.

    The Limits on Growth
    Let's start with the fundamental question. When valuing an individual company with potential for growth, how high can the revenue growth rate be? Put differently, how big can dollar revenues become at a company, assuming that it is successful? As I noted in the Green Mountain Coffee discussion in my last post, there are at least two numbers that need to be used as sanity checks.
    • The first is the overall size of the market for the product(s)/services that the company offers. Clearly, the expected revenues for Whole Foods, a company operating in a huge market (groceries) can become much larger than the expected revenues for Green Mountain Coffee, operating in a narrower market. (Whether it will or not remains a judgment call you have to make when valuing the company...)
    • The second are the revenues of the largest players in that market. In effect, you are looking for the point at which revenues will plateau in a particular business. Thus, the fact that Folgers, the largest company in the coffee market, made only $2 billion in revenues in 2010 operated as a cautionary note in how much revenues you could project for Green Mountain Coffee. In contrast, Safeway,one of the largest grocery store companies, had revenues of $42 billion in 2010.
    If you are valuing a company in a sector that you are unfamiliar with, you should get a sense of the revenues generated by the entire sector and how much revenues the largest company or companies in the sector had. To help, I have put together a spreadsheet that lists aggregate revenues, by business, for companies in the US, as well as the highest revenue company in each one. While my business categorization may be too broad for some of you, it should help provide some perspective on what comprises large revenues. In making these estimates, though, you will have to exercise judgment, which can cause your "limits" to be different from mine (and your valuation to be higher or lower than mine). The first judgment is the potential market for the product or service provided by the company. While that may be easy for Green Mountain, what is the potential market it for Groupon or Google? In the case of Groupon, is it a slice of the retail business (which would be huge) or it is a smaller subset? In the case of Google, is it the online advertising market or the entire advertising market or is its something else altogether? The second is the market share that you see your company gaining, if it makes it through to mature firm status. In other words,  do you see your company becoming one of the largest companies in the business or remaining a smaller player?

    The Exceptions
    Now, for the follow up. Over history, a few companies have surprised us be growing beyond even the most optimistic assumptions. How did these legendary growth companies bust through the limits? I see three possible sources for these "positive" surprises:
    1. Expand product/service offerings: A company can increase its potential market, by altering its product/service mix. Amazon.com, in its early days in the 1990s, was primarily an online book retailer. If it had stayed in that business, the potential market would have been small and Amazon's value would have been constrained. By remaking itself as an online retailer (of pretty much any product), Amazon expanded its potential market (and with it, its value).
    2. Expand geographically: While most companies initially target domestic or local markets, the potential market can be increased by expanding geographically. The list of big name companies that have rediscovered growth by going global is long - Coca Cola, McDonald's and Procter and Gamble come to mind.
    3. Expand product reach: In perhaps the most interesting scenario, a company can expand the potential market for a product or service through innovations. The secret for Apple's success in the last decade has not only been a stream of winning products - iPod, iPhone and iPad, but each product has expanded what were small markets (music players, smart phones, computer pads) into much larger ones.
    Can these surprises be incorporated into conventional valuation? By their very nature, I don't think they can, since they are unexpected at the point of initial analysis. (If you invested in Apple at the time of the iPod introduction, foreseeing the iPhone and iPad, you have a far better crystal ball than I do...) However, these "market expansion possibilities" can be viewed as options, where companies use existing platforms to generate new products and enter new markets, and can be valued as such. Even if you choose not go down the road of using option pricing models, these options will translate into a premium on conventional valuations, albeit one that cannot be easily quantified. You would expect this premium to be greatest in companies that have a proprietary edge (Apple, with its ownership of its operating system, is a perfect example...) and smallest when products can be imitated at low cost. As an investor, I tend not to include these "options to expand" premium in my initial valuations. If I can find a stock that is cheap relative to intrinsic value, the option premium is just icing on the cake.

    From micro to macro... It has to add up.. 
    One final note on growth limits. I believe that investors (and markets) generally get the macro story right but are not always consistent on the micro story. Put in revenue growth terms, optimistic investors are right that the social media businesses collectively will generate high revenues in the future. However, here is where I think that they make their mistake. First, if you add up the expected revenue numbers (that are implicit in the valuations you see for these companies) of the individual companies that comprise the social media space, the collective revenues will significantly exceed the forecasted revenues for the entire  market. In other words, your collective market share across companies will be well in excess of 100%. Second, I think that investors are under estimating the ease with which new companies can enter these businesses, under cutting margins and profitability. You can have a growing market where companies have trouble making money.
    In fact, the dot com boom provides an interesting historical perspective. In hindsight, investors clearly got the macro story right: that consumers would get more and more of their products/services online. It was in the valuation of the individual companies that they made their mistakes, over estimating growth at these companies and under estimating both the ease of entry/exit into the business and the effect of competition on profitability.


    Blog post series on growth



    Growth and Value: Thoughts on Google, Groupon and Green Mountain



    In the last week, I noticed three stories that at first sight seem to be unrelated but I think share a common theme:


    While the stories are on different issues, the questions they raise all revolve around the sustainability of growth at these companies, the price paid to generate the growth and the relationship between growth and value. 


    The feasibility of growth: With growth companies, the debate about how high growth rates can be and how long growth can be sustained falls along predictable lines. The optimists argue for high growth and the pessimists argue that this growth is not feasible and investors are caught in the middle, wondering which side to believe. Ultimately, though, a company’s growth is constrained by the size of the market in which it operates. Green Mountain Coffee, for instance, had revenues of $1.36 billion in 2010, a sizable market share of the processed coffee market. To provide a measure of what is feasible, the overall revenues from coffee sales at supermarkets, drugstores and retailers in the US in 2010 amounted to little more than $ 5 billion; Folger's is the largest of the grocery store coffee producers has revenues of about $ 2 billion. While this total revenue does not count revenues from products like Keurig, it leads me to believe that Green Mountain Coffee is not a "small" company in this market. It is always possible that Green Mountain could expand its product line but what are its choices? Green Mountain maple syrup comes to mind, but that is a tiny market; Green Mountain chocolates may work, but the premium chocolate brands carry Swiss or Belgian imprimaturs. It is also possible that Green Mountain could increase the overall size of the market by convincing tea and soda drinkers to switch to gourmet coffees... but I think that is unlikely to happen.


    Scaling Growth: As companies get larger, their growth rates will decline. That is indisputable, though great growth companies may be able to slow the decline and extend it over longer periods. Google, for instance, has been more successful than most growth companies in the last decade in sustaining high growth for an extended period, but even it has found that it is far more difficult to post high growth rates in revenues as its gets bigger. In the figure below, I graph out the percentage change in revenues and the dollar change in revenues each year at Google from 2001-2010. While the $ change in revenues has increased over time, the percentage change in revenues has decreased every year (except 2009). And consider this: Google is one of the most successful growth companies of the last decade.
     


    Growth and Value: While many analysts view higher growth as good for value, it is clearly not that simple. After all, going for higher growth requires companies to make a trade off. On the one side, there is the good stuff: higher growth boosts revenues and earnings. On the other side, there is the bad stuff: growth is not free. Companies have to invest to generate sustainable growth: those investments can be in long term assets (factories if you are a manufacturing firm, R&D if you are a technology or a pharmaceutical firm, recruiting & training if you are a consulting firm), short term assets (inventory or accounts receivable) or acquisitions of other companies. All of these investments reduce cash flows. The net effect can therefore be positive or negative and is captured by looking at whether the firm generates a return on its investments (return on invested capital or return on equity) that exceeds its cost of funding (cost of capital or cost of equity). In the case of Google, the price of growth has risen over time, as the company seems to be caught in a cycle of making acquisitions that get larger each year, to post the same growth rates. With Groupon, this debate has morphed into an accounting question. Even if we accept the company’s argument that customer acquisition costs should be capitalized (see my earlier post on the issue), the question that follows is a simple one. How much value is added by a new customer? (To answer this question, the company will have to provide more information on customer behavior.) More critically, is it becoming less positive over time as the company gets bigger and goes after more elusive customers, in the face of  increased competition from Amazon and LivingSocial? Unfortunately, the firm is providing little information on these key questions.


     Growth and Credibility: My favorite framework for thinking about businesses is a financial balance sheet.

    Within this framework, here is the key difference between mature and growth companies. The former derive most of their value from assets in place, whereas the latter get the bulk of their value from growth assets. Since the value of growth assets rests entirely on perceptions and expectations about the future, it also rides on the credibility of management. In other words, you need to believe managers when they tell you their plans for the future and you expect them to be disciplined in following through. If managers are not credible and disciplined, the value of growth assets can very quickly melt away. That is the lesson that Groupon and its investment bankers do not seem to get. As a potential investor in Groupon, I am not valuing it based on how much money it made or lost last year but on my expectations about its future. All the accounting moves made by Groupon over the last year seem to be centered around making their numbers (revenues, earnings etc.) from last year look better. Even if they succeed in this endeavor, all they will do with these actions is change the value of their existing assets marginally. In the process, though, they have damaged the trust that investors have in them and put the value of their growth assets at risk. When 90% or more of your value comes from growth assets, that is just dumb.


    Each of these issues deserves a full post and I will make a series of posts in the next few days on each one. In the meantime, these companies will continue to entertain us for the next few months. Let's face it! Growth companies are a lot more fun to assess than mature companies. 

    Blog post series on growth
    Growth and Value: Thoughts on Google, Groupon and Green Mountain
    Growth (Part 1): The Limits of Growth
    Growth (Part 2): Scaling up Growth
    Growth (Part 3): The Value of Growth
    Growth (Part 4): Growth and Management Credibility



    How much diversification is too much?


    As an investor, should you put all of your money in one stock or should you spread your bets across many investments? If it is the latter, how many investments should you have in your portfolio? The debate is an old one and there are many views but they fall between two extremes. At one end is the advice that you get from a believer in efficient markets: be maximally diversfied, across asset classes, and within each asset class, across as many assets you can hold: the proverbial “market portfolio” includes every traded asset in the market, held in proportion to its market value. At the other is the “go all in” investor, who believes that if you find a significantly undervalued company, you should put all or most of your money in that company, rather than dilute your upside potential by spreading your bets.

    Cuban versus Bogle
    These arguments got media attention recently, largely because two high-profile investors took opposite positions. The first salvo was fired by Mark Cuban, who made his substantial fortune (estimated by Forbes to be $2.5 billion in 2011) as an entrepreneur who founded and sold Broadcast.com for $ 6 billion by Yahoo!, at the peak of the dot com boom. Cuban's profile has increased since, largely from his ownership of the Dallas Mavericks, last year's winners of the NBA championship, and his intemperate outbursts, about referees, players and the NBA in general. With typical understatement, Cuban claimed that diversification is for idiots and that investors, unless they have access to information or deals, should hold cash, since hedge funds have such a tremendous advantage over them. In response, John Bogle, the father of the index fund business, countered that "the math (for diversification) has been proved over and over again. It's not just the first thing an investor should think about, but the second, the third and probably the fourth and the fifth thing investors should think about".

    The limiting cases
    So, should you diversify? And if so, how much should you diversify? The answers to these questions depend upon two factors: (a) how certain you feel about your assessment of  value for individual assets (or markets) and (b) how certain you are about the market price adjusting to that value within your specified time horizon.
    ·      At one limit, if you are absolutely certain about your assessment of value for an asset and that the market price will adjust to that value within your time horizon, you should put all of your money in that investment. Though this may seem like the impossible dream, there are two possible scenarios where it may play out:
    o   Finite life securities (Options, Futures and Bonds): If you find an option trading for less than its exercise value: you should invest all of your money in buying as many options as you can and exercise those options to make a sure profit. In general, this is what falls under the umbrella of pure arbitrage  and it is feasible only with finite lived assets (such as options, futures and fixed incomes securities), where the maturity date provides a endpoint by which time the price adjustment has to occur.
    o   A perfect tip: On a more cynical note, you can make guaranteed profits if you are the receipient of inside information about an upcoming news releases (earnings, acquisition), but only if there is no doubt about the price impact of the release (at least in terms of direction) and the timing of the news release. (Rumors don’t provide perfect information and most inside information has an element of uncertainty associated with it.) The problem, of course, is that you would be guilty of insider trading and may end up in jail... .
    ·      At the other limit, if you have no idea what assets are cheap and which ones are expensive (which is the efficient market proposition), you should be as diversified as you can get, given transactions costs. If you have no transactions costs, you should own a little piece of everything. After all, you gain nothing by holding back on diversification and your portfolio will be deliver less return per unit of risk taken.
    Most active investors tend to fall between these two extremes. If you invest in equities, at least, it is inevitable that you have to diversify, for two reasons. The first is that you can never value an equity investment with certainty; the expected cash flows are estimates and risk adjustment is not always precise. The second is that even if your valuation is precise, there is no explicit date by which market prices have to adjust; there is no equivalent to a maturity date or an option expiration date for equities. A stock that is under or over priced can stay under or over priced for a long time, and even get more under or over priced.
    There is one final point worth making. Note that how much you diversify will be based upon your perceptions of the quality of your valuations and the speed of market adjustment, but perceptions are not reality. In fact, psychologists have long noted (and behavioral economists have picked up the same theme) that human beings tend to have too much confidence in their own abilities and too little in the collective wisdom of the rest of the world. In other words, we tend to think our valuations are more precise than they really are and that the market adjustment will occur sooner than it really will.

    How diversified should you be?
                Building on the theme that diversification should be attuned to the precision of your valuations and the speed of market adjustment, the degree to which you should diversify will depend upon how your investment strategy is structured, with an emphasis on the following dimensions:
    a.     Uncertatinty about investment value: If your investment strategy requires you to buy mature companies that trade at low price earnings ratios, you may need to hold fewer stocks , than if it requires you to buy young, growth companies (where you are more uncertain about value). In fact, you can tie the margin of safety (referenced earlier in this chapter to how much you need to diversify; if you incorporate a higher margin of safety into your investing, you should feel more comfortable holding a less diversfied portfolio. As a general propostion, your response to more uncertainty should be more diversification, not less.
    b.     Market catalysts: To make money, the market price has to adjust towards your estimated value. If you can provide a catalyst for the market adjustment (nudging or forcing the price towards value), you can hold fewer investments and be less diversifed than a completely passive investor who has no choice but to wait for the market adjustment to happen. Thus, you will need to hold fewer stocks as an activist investor than as an investor who picks stocks based upon a PE screen. Ironically, this would mean that the more inefficient you believe markets are, the more diversified you will need to be to allow for the unpredictability of market movements.
    c.     Time horizon: To the extent that the price adjustment has to happen over your time horizon, having a longer time horizon should allow you to have a less diversified portfolio. As your liquidity needs rise, thus shortening your time horizon, you will have to become more diversifed in your holdings.
    In summary, then, there is nothing irrational about holding just a few stocks in your portfolio, if they are mature companies and you have built in a healthy margin of safety, and/or you have the power to move markets. By the same token, it makes complete sense for other investors to spread their bets widely, if they are investing in young, growth companies, and are unclear about how and when the market price will adjust to value. So, the choice is not between diversification and active investing, since you can pick stocks and be diversified at the same time. It should be centering on  making the right decision on how much diversification works for you,.

    Evidence from the field
                So, how diversified is the typical investor’s portfolo? And if it is relatively undiversified, is it undiversifed for the right reasons? And what is the payoff or cost to being undiversified? The evidence from many studies over the last decade or so is enlightening:
    1. Investors are thinly diversified: The typical investor is not well diversified across either asset classes, or within each asset classes, across assets. A study of 60,000 individual investor portfolios found that the median investor in this group (which was a representative sample of the typical active investor in the United States) held three stocks and that roughly 28% of all investors have portfolios composed of one stock. In a later study, the same authors find that not only do investors hold relatively few stocks but that these stocks tend to be highly correlated with each other (same sector or type of stock).
    2. Many are thinly diversified for the wrong reasons: While the lack of diversfication can be justified if you have good information or superior assessments of value, many of the undiversfied investors in this study failed to diversfy for the wrong reasons. On average, not only did younger, poorer less eductated investors diversify less, but they, as a group, tend to be over confident in their abilities to pick stocks. 
    3. And they pay a price for being thinly diversified: Not surprisingly, investors who fail to diversify because they are over confident or unfamiliar with their choices pay a price. On average, they earn about 2.40% less a year, on a risk adjusted basis, than their more diversified counterparts.
    4. But some undiversified investors are good stock pickers: On a hopeful note, there are clearly some active investors who hold back on diversification for the right reasons, i.e., because they have better assessments of value for stocks than the rest of the market and long time horizons. A study of 78,000 household portfolios finds that the among households wealthy enough to be diversified, those with more concentrated portfolios (holding one or two stocks) earn higher returns than those with more diversified portfolios (holding three or more stocks) by about, though they are also more volatile. The study goes on to note that the higher returns can be attributed to stock picking prowess and not to market timing or inside information.

    Bottom line
    Most investors are better off diversifying as much as they can, investing in mutual funds and exchange traded funds, rather than individual stocks. Many investors who choose not to diversify do so for the wrong reasons (ignorance, over confidence, inertia) and end up paying dearly for that mistake. Some investors with superior value assesssment skils, disciplined investment practices and long time horizons can generate superior profits from holding smaller, relatively undiversified portfolios. Even if you believe that  you are in that elite group, be careful to not fall prey to hubris, where you become over confident in your stock picking and market assessments and cut back on diversification too much. 



    Following up on Groupon

    In my last post, I made an attempt to value Groupon and came up with $14.62/share, before the voting right adjustment. Now that the offering is complete and the first day of trading is over, I thought it would be useful to take stock of general lessons that can be drawn from this deal. The offering price was raised to $20/share and the stock jumped another 40% during the course of the day. So, here are a few questions that I am fielding today...

    1.     Is it possible that you are wrong in your assumptions and that other investors are far more optimistic about revenue growth/ operating margins?
    There is no room for hubris in markets. Investors who do not admit to their mistakes, fix them and move on are doomed to pay a steep price. So, I will start with the presumption that I am wrong and the market is right and assess the likelihood, using two techniques.
    • Implied growth/margins: The two key inputs in this valuation are revenue growth and the target operating margin. In the table below, I changed both those numbers and assessed the impact on value per share. I also highlighted the combination of growth/margin assumptions that would get me to $28/share. For instance, if Groupon can maintain a revenue growth rate of 70% a year for the next 5 years (which will give them revenues of $64 billion in ten years) and a target operating margin of 23% a year, the value per share is $39.81. Notice that there is no scenario where the revenue growth is less than 60% a year for the next five that delivers a value greater than $28/share. (There are a few odd quirks in the table, where the value decreases as the margin increases, for a given revenue growth rate. That is because the NOLs that you accumulate spill over into the terminal value. Suffice to say that if your plan with Groupon is for them to lose so much money that they will never run out of NOLs, you should think again...)
    (Revenues in year 10 in brackets next to five year growth rate)
    • Simulations: In the last few years, I have used an add-on to Excel called Crystal Ball to run simulations. In a simulation, you input distributions for key inputs where you feel uncertain about the future. In the Groupon valuation, I made revenue growth and operating margin into distributions – compounded 5-year revenue growth is uniformly distributed between 30% (pessimistic end) and 70% (optimistic limit) and the target operating margin is assumed to be normally distributed, with an average of 23% and a standard deviation of 4%.  I then ran 10,000 simulations, drawing from the distributions, and presents a distribution of values, shown below. Note that there is only a 15% chance that the value is greater than $28 (1500 outcomes out of the 10000 yielded values of $28 or higher). In fact, while the average value is around $14, there are far more outcomes under $10 than above... Put differently, you are not going to win on this stock most of the time, but if you do, you have to hope it is a big win.

    2.     Is it a problem with the approach? Does DCF systematically undervalue young, growth companies?
         As many of you know, I am a staunch defender of discounted cash flow valuation, but here are a couple of criticisms I have heard of the model (especially in the context of valuing young, growth companies like Groupon) that I want to address.
    a. DCF valuation is inherently conservative. It will under value growth companies.
    An analyst that I was chatting with in the last day  was dismissive when I gave him the result of my Groupon valuation, and his claim was that  “DCF valuations always understate the value of young, growth companies”. But is that true? Those of you who have been reading my blog  and know that I valued Facebook, Skype and Linkedin earlier this summer (and found them all over valued) may very well conclude that I would find all social media companies to be over valued right now. That may be true, but it cannot be generalized to DCF as a technique. There is a bias that comes from the timing of these valuations: I chose these companies to value because they were in the news and were either going public or thinking about it. But when do companies in a sector think about going public or offering themselves for sale? It is when managers believe they will receive a favorable valuation. Put differently, I am valuing social media companies at a time when the market is most likely to be over valuing them. To provide some perspective, I valued dozens of dot com companies in the 1998, 1999 and 2000 and I found every one of them to be over valued. In 2001 and 2002, when I revisited the sector (or what was left of it), I found many of the same companies to be under valued. In the graph below, for instance, I have my value and the market price for Amazon.com each year from 2000 to 2003; notice how over valued it was in early 2000 and how under valued it looks in 2001. The bottom line: DCF is not inherently conservative, but done right, it is contrarian. You are likely to find stocks to be under valued when the market mood for a sector is darkest and stocks over valued when investors are enamored about a sector.

    b. DCF valuation misses components of value
    1. There is some truth in this statement and I did cover one aspect when I talked about the “option” premium in some growth companies in my earlier post on the value of growth. What am I talking about? If I had valued Apple as a personal computer company in 2000, I would have missed its expansion into the entertainment business in the last decade. Similarly, if I had priced Google as a search engine in 2004, I would not have considered its expansion into other businesses in the last few years. If Groupon is successful in its core business, could it expand into other businesses? Sure, but there are two levels at which I would be skeptical in this case. First, I am not sure what Groupon competitive edge will be in these unspecified new businesses. Second, even when I have estimated a real option premium, I have never obtained an increase of more than 20-25% on my DCF value. 
    2. The other argument is that Groupon is issuing only 5% of its shares in the IPO and that the shares are therefore scarce: investors who want the stock therefore have to pay a scarcity premium. But shares in a company is not a Tiffany lamp or a Mickey Mantle baseball card. It is a claim on a set of cash flows and who generates these cash flows or how they are generated is not relevant. (As far as I can tell, a dollar you generate in cash flows from your Groupon investment buys exactly the same amount as a dollar in cash flows you generate from your Apple or Google investment.)
    3.  If you  believe that the value is only $14 or $15 a share (or lower), how do you explain the $28/share price?
         My first response is that I feel no urge to explain the $28/share price, since I did not pay it. My second is that this is a snarky response and that I should be able to put myself in the shoes of those who did buy the stock today and explain why.  I could take the generous view and attribute their actions to  more optimistic assumptions about growth/profitability (and a higher value). I think that there is a simpler, more likely explanation. I would wager than most of the investors buying Groupon stock today have absolutely no idea what its value is and could not care less. They are playing a very different game than I am. With a time horizon measured in minutes, hours and days, they are buying the stock today, hoping to flip it to someone else at a higher price next week. Will some of them make money? Sure, and I don't begrudge them their profits. It is just a game I am good at and I won't even try!

       4.  If you believe that the intrinsic value is only $10-$15, should you short the stock?
    In the Google shared spreadsheet that I put up in my last post, I notice that many of you, who found the stock to be over valued, plan to sell short the stock. You are far braver than I am! I did not sell short on any of the dot com companies that I found over valued in 1999 and early 2000. In hindsight, could I have made money by doing so? Eventually, yes, but eventually would have been a long time coming on some of those stocks... My problem with selling short has always been that I don’t control my time horizon; the person who has lent me the shares does. After all, even if you are right in your assessments of value, you will not make money until the market corrects its “mistakes” and that may take weeks, months or even years. With hot sectors, where prices are based on perceptions and the herd is “optimistic”, I think it is far more prudent to get out of the way and let the momentum investors have their day in the sun. My day will come!!!!



    Are you ready to value Groupon?



    After a series of missteps, it looks like the Groupon valuation is ready to hit the market on Friday, with the final pricing to be done on Thursday. To bring you up to date on this unfolding story, the initial talk during the summer was that the company would be valued at $20 billion or more. In the months afterwards, loose talk from management of how customer acquisition costs were not operating expenses and what should be recorded as revenues got in the way of the sales pitch. As management credibility crumbled, the value dropped by the week and it looks like the company will now go public at an estimated value of about $12 billion, though only 5% of the shares will be offered in the initial offering.

    As with the Linkedin and Skype valuations that I did earlier this year, I thought it would be useful to do a valuation of Groupon. Before I put my numbers down, though, let me emphasize that I don't have an inside track on this valuation and that these are just my estimates. Rather than contest them, I would suggest that you go into the spreadsheet that I have attached with the valuation and make your own estimates.

    Before I do the valuation, though, a little on Groupon’s business model. Groupon works with any business (retail, restaurant, service) allowing it to sell products/services at a discount (usually 50% or higher). Thus, a restaurant that normally would charge $50 for a meal can offer a 50% discount to Groupon customers who would buy it at $25; Groupon and the business then split the $25. With a 50/50 split, Groupon's revenues would then be $12.50. (One of the controversies over the last few month was whether Groupon could claim revenues of $25 (the discounted price of the service) or $12.50 (its share)).

    Valuation of Groupon business
    Current numbers
    To get the current numbers, I started with the S1 that Groupon filed with the SEC in October 2011. This filing has the numbers from 2010 and for the first nine months of 2011 (as well as the first nine months of 2010), which can be used to extract the trailing 12-month numbers for the company.
    Trailing 12 month = Last 10K - First 9 months, 2010 + First 9 months, 2011

    Revenue growth
    Rationale: This was a tough one! Groupon’s revenues increased from $312 million in 2010 to $1,290 million in 2011, an increase of more than 300%. That is going to be impossible to sustain but to make a judgment on growth rates for the future, I had to estimate the potential market. The potential market is large since it encompasses “long term excess capacity” at almost any consumer-oriented businesses. It is worth noting that this excess capacity is high right now, because of the poor state of the economy, but even allowing for halving in excess capacity across the board, there is plenty of room to grow. 
    My estimate: 50% compounded revenue growth for next 5 years, declining to a stable growth rate of about 2% in year 10. Groupon’s total revenues in year 10 will be about $25 billion.

    Target operating margin and reinvestment
    Rationale: Groupon is losing money right now and it is doing so because its marketing and customer acquisition costs are huge. That, by itself, is to be expected, given their focus on increasing the number of subscribers. To estimate what their margins will be, if they succeed with their business model, we have to estimate what these two expenses will look like for a mature Groupon. I tried to estimate these numbers, using the very limited information that is in the financial statements for the last two years.
    Since I am assuming high growth in revenues, I thought it prudent that the firm reinvest to generate this growth. I have estimated a dollar in capital invested in the business will generate $2 in incremental revenues. Since the average subscriber in Groupon generates only $11.6 in revenues for the company, continued high growth will require substantial costs in acquiring new customers and holding on to existing ones.
    My estimate: The pre-tax operating margin will improve gradually over time to 23% in year 10, with operating margins staying negative through year 6A legitimate argument against high margins is that this is a business where the competition is active and aggressive, both from established players like LivingSocial and Amazon but from new players. If you buy into this argument, you will use lower, more conservative margins.

    Cost of capital
    Rationale: Groupon is a small, high growth, high risk business right now. If my revenue growth and margin estimates come to fruition, though, it will become a larger, more profitable and more stable entity over the next 10 years. As that happens, its cost of capital should change.
    My estimate: In the initial period, I assumed that Groupon would continue to be all-equity funded and have a cost of equity of firms in the top decile in terms of risk. (With a beta of 2, a riskfree rate of about 2% and an equity risk premium of 6.5%, this works out to a cost of capital of 15%). In its mature state, I dropped this cost of capital to the market-wide average in November 2011 of about 8%.

    Steady State
    Rationale: At some point in time, Groupon’s growth days will be behind it and it will be a mature company, growing at roughly the same rate as the economy. When that happens, its risk profile and cost structure will resemble that of a mature company. I am also assuming, rather optimistically, that there is a 0% chance that the firm will collapse over the next 10 years.
    My estimate: Groupon will become a mature company in 10 years, growing at the same rate as the economy (2.05% in nominal terms). Its cost of capital will drop to 8%. Since it will have built up some significant competitive advantages at that point, I will assume that it can generate a return on capital of 10% in perpetuity after year 10.


    Overall valuation
    Based on these inputs for compounded revenue growth, target margin, reinvestment and cost of capital, the value that I obtain for the operating assets of the firm is $9.73 billion. Look at the valuation page on the Groupon spreadsheet for the numbers. It is worth noting that the present value of the expected cash flows over the next 10 years is -$5.4 billion. That reflects the expectation that the firm will need to raise fresh equity (and thus dilute your share of value) to fund it's cash flow needs over the next decade.

    Valuation of Groupon equity per share
    Cash: The cash balance as of September 30, 2011, was $243.9 million. To this, I added the expected proceeds of $478.8 million from the IPO, since the proceeds will be kept in the firm to meeting working capital and investment needs. (If the founders had withdrawn the proceeds to cash out some of their ownership, I would not have done this.)
    Debt: Groupon has no conventional interest bearing debt but it does have some leases. Since the magnitude of these leases is small (about $91 million, see page 76 of S1), I have ignored it in both my cost of capital computation and in this stage of the valuation.
    Equity options: Groupon has 18.4 million options outstanding, with an average exercise price of $1.11 and an assumed maturity of 5 years. Using the company-provided estimate of volatility of 44% and the expected IPO price of $16 as the stock price, the option value was estimated to be $275.53 million.
    Value per share: The value per share can be computed now:
    That is based on the presumption that all shares are equal (in voting rights). Since the shares that will be offered to the public are the lesser voting right shares, the value would have to be adjusted down to reflect that. My estimate would be that the class A shares are worth about $14/share and that the class B shares are worth about $15.50/share.

    Bottom line
    With my estimates for Groupon, the value per share that I get is $14.62, not far off from the low end of the IPO range of $16-$18 per share. Allowing for the difference in voting rights, I would lower the value per share to less than $14. Given the high-ball estimates that we have seen on other social media companies that have gone public in the last few months, this would suggest one of the following:

    1. The market for social media companies is growing up and attaching more reasonable values for these companies.
    2. The antics of Groupon management have hurt it in the market’s eyes; this is the "mismanaged IPO discount" on value.
    3. The stock has been deliberately under priced because only 5% of the shares are being offered in the IPO and the company (and its investment bankers) want to see it pop on day one.
    My guess is that it is a combination of all three factors. Groupon has to be credited with building an interesting business model that has a large potential market and is scaleable.  What makes this company interesting is that investing in it is indirectly a bet on the economy. Unlike most young growth companies that are dependent on the economy becoming stronger and more vibrant for higher value, Groupon's value is likely to be higher if the economy stays in the doldrums. After all, what business in a healthy economy wants to sell its products for 70% or 80% of list price?


    Would I buy Groupon? No, and not just because it is over priced at $16 to $18 ... Having watched how the company's management has played games with investors for the last few months, I am unwilling to tango with them, especially since they have already telegraphed their unwillingness to accept input from me (by cutting my voting rights essentially to zero). But that is my choice. You can make your own estimates and judge for yourself...


    Postscript: A few of you have already noted that I have been optimistic in my assumptions and you are absolutely right: high revenue growth, a healthy target margin, declining cost of capital and no chance of failure. My point is that even with those assumptions, I am falling short of the IPO price. Better still, I would like you to go in and make your own estimates in the Groupon spreadsheet and value the company. To keep tabs on all of our different estimates, I have created a shared Google spreadsheet where you can input estimates and value per share. Should be fun!



    Auld Lang Syne: Remembering 2011

    There are only a couple of hours left in 2011 in New York and it is already the new year in many parts of the world. Let me spend my last post for this year, looking back at the year that was and looking forward to the year to come, using a few of my favorite market props: cash flows/earnings, market prices, risk free rates and risk premiums.
    1. It was a good year for earnings at US companies, with earnings on the S&P 500 companies rising about 16%. That makes what happens to stock prices a little puzzling, since the S&P 500 index started the year at 1257.64 and ended the year at 1257.60. As a result , the aggregate PE ratio for the index declined from 15.03 at the start of the year to 12.96 at the end. 
    2. It was an even better year for cash flows: dividends on the S&P 500 companies rose 12.5%, but buybacks surged more than 80%. The total dollar buybacks in 2011 (at least for the four quarters ending September 2011) almost matched buybacks in 2006, though they still remained well below the historic highs set in 2007. While the dividend yield on the index remained anemic (2.07%) the total cash flow (including buybacks) yield on the index was 5.90%, again well above the ten-year average of 4.72%.
    3. The ten year treasury bond which started the year at 3.29% ended the year at 1.87%, the first time it has ended a year at below 2% in the last 50 years. The drop in the  rates also made US treasuries one of the better investments for the year, with the ten year bond returning 16.04% for the year; the price appreciation component accounted for 12.75%. Ironic, don't you think? After all, this was the year of the great S&P downgrade of the US sovereign rating that I talked about on my summer vacation in August. Are lower interest rates good news? I don't think so and I posted on the point earlier this year.
    4. As many of you know, I have been estimating an implied equity risk premium for the S&P 500 for a long time, annually until 2008 and monthly since September 2008. I back out the premium using the level of the index and expected cash flows in the future. The premium started the year at 5.20%, surged during the summer to hit a high of 7.64% at the end of September and ended the year at 6.04%. The fact that stocks were flat for the year (the return with dividends was 2.07%) had the opposite effect on the historical risk premium (where you look at the difference between annual returns on stocks and treasuries over long periods of past history), with the historical risk premium dropping to 4.10%. After a long period (1981-2007), where historical risk premiums exceeded implied premiums, this is the fourth year in a row that implied premiums have exceeded historical premiums.


    So much for last year! What does all this tell us about next year? It strikes me that the numbers are sending discordant messages. The earnings and cash flows point to a recovery, at least in corporate earnings, the treasury bond market is awfully pessimistic about future growth and the stock market vacillates between euphoria and despair. I really have no idea what next year will bring, but I am willing to make a guess. I expect the treasury bond market to grudgingly acknowledge higher economic growth prospects and move up (to 3%), equity risk premiums to become less volatile and move back towards lower numbers (5-5.5%). Buybacks and dividends will stay strong but will stabilize and earnings growth will moderate. The net effect will be to make the stock market a more hospitable place to invest and the bond market a less attractive investment. So, I am adding to my equity exposure, selling my treasury bonds and praying that the Eurozone does not turn my predictions to dust.

    I apologize for both the US-centric and macro nature of this post but I am starting on my annual data update this week. Over the next ten days, I will be exploring the raw data that I have downloaded on 50,000+ companies globally, since the close of trading yesterday, and will be generating my industry average tables. During that analysis, I will be looking at how equities have moved globally and world-wide trends in both valuation multiples (PE, Price to book, EV/EBITDA etc.) and corporate finance variables (dividends, debt ratios, returns on equity/capital). I will have a much more detailed post when I am done but I look forward to learning a great deal more from the numbers than from listening to expert prognostications. 

    So, happy New Year! I wish you, your families and your loved ones the very best for the coming year! Be happy and healthy!




    Do markets punish long term thinking? Amazon as a case study

    This morning's New York Times has an article from one my favorite business writers, James Stewart, on Amazon. His focus, largely admiring, is on the fact that Amazon has made decisions that hurt it in the short term but create value in the long term. To provide at least two examples, he talks about Amazon's decisions to cut prices on products and go for a larger market share and to invest in in the Kindle, their book reader. The tenor of the article is that the market has short sightedly punished the company for its long term focus. Stewart uses one piece of anecdotal evidence to back up his claim that markets are short term: the stock price reaction to the earnings report on October 25, when Amazon announced earnings and revenues that were largely as expected but announced that it had been spending a great deal more than investors thought it had to deliver that growth.

    I am no knee jerk defender of financial markets and accept the fact that markets not only make mistakes in assessing value, but also that a subset of investors are short term and over react to earnings announcements. In fact, I am sure that there are companies that you can point to that have been unfairly treated by markets for their long term focus (and other companies that have been unfairly rewarded for delivering short term results at the expense of long term value). I just don't think Amazon is the example I would use to bring this point on. Let's start with some general facts. Here is how the market has and is continuing to punish Amazon for its long term focus.
    • In the last decade, Amazon has seen its market capitalization increase from $4.55 billion in 2001 to $82 billion in 2011; the market cap for Amazon at the peak of the dot com boom was only $30 billion. An investor who bought Amazon stock in 2001 would have generated a cumulated return of 1300% over the last 10 years. 
    • In November 2011, after the earnings report that Mr. Stewart alludes to, Amazon was trading at 96 times trailing earnings and at two times trailing revenues. In contrast, the median PE ratio for a retail firm was about 15 and the median EV to revenue multiples was 0.8. By my estimate, Amazon is one of the most richly priced large retailers in the world.
    • Over the last decade, the firm has made multiple bets on growth and asked the market to trust it to make the right judgments. For the most part, its actions have been welcomed by markets that have been willing to look past disappointing earnings reports at the future. Jeff Bezos is celebrated as a great CEO, with comparisons made to Steve Jobs.
    So, why was the market reaction to Amazon's last earnings report so brutal? As someone who has valued Amazon almost every year since 1998, I think I can provide some historical perspective. Amazon has been, at alternate times, revered and reviled by financial markets. In January 2000, at the peak of the dot com boom, based on my estimate of value for Amazon at the time, it was over valued by about 60%. A year later, based again on my assessment of value, it was under valued by about 50%. During the 12 years that I have valued the company, it has been overvalued in 7 of the years and under valued in 5 of those years. Since the beginning of 2009, notwithstanding the reaction to the last earnings report, investors have been on their manic phase with Amazon, pushing the stock price up more than 300% (from $54 to over $200). At its price of almost $200/share, just before its October earnings report, Amazon was valued to perfection and beyond. In fact, for it to be worth $200/share, it would have to deliver about increase revenues to more than $200 billion in ten years, while increasing its pre-tax operating margin from 2.5% to 4%, while generating a return on capital of 70%+ on its new investments. If you disagree on these assumptions, feel free to change them for yourself in the attached spreadsheet.

    It is the last item that I would draw your attention to, because the last earnings report was a sobering reminder that while Amazon will continue to grow, the growth is not going to be easy or cheap. In my view, the market is still much too optimistic about the quality of Amazon's growth going forward and I think it remains over priced. In Mr. Stewart's world, that would make me a short term investor, but not in mine. At the risk of repeating a theme that has run through my posts for the last few months, growth has value only if it is delivered at a reasonable cost and a growth stock is cheap only if the market price reflects that cost. Amazon does not look cheap to me, even with a great CEO and a long term focus!



    Living within your limits: Thoughts on Research In Motion (RIM)

    I have a sixteen-year old daughter who calls me "old man" and while I know she is using the term lovingly (of course.. I believe the best about my kids), the moniker still strikes home as a reminder that I am older and that age brings limits that I can choose to ignore at my own peril. I know that I can no longer go to bed late and get up early, that I have to watch what I eat and that I need my reading glasses to read restaurant menus. As I watched Research in Motion (RIM) go through painful contortions in the financial markets yesterday, I was reminded that companies also go through an aging process, and how they deal with the limits that come with age determines their value to investors.

    RIM has had a pretty good run as a company, but they have a problem. Their core technology which powers the Blackberry is a cash cow but it is one that faces corrosion in market share, as smart phone users turn to Androids and iPhones, with their more open operating systems and extensive app libraries. As the CEO of RIM, you have two choices.
    1. Go for growth: You can invest hefty portions of the cash flows from your core technology back into the business in R&D and new products, hoping for a breakthrough, but you are competing against two companies, Apple and Google, that have more resources and imagination than you do. You may be able to eke out growth but the amounts you would have to reinvest to generate that growth may make it a losing proposition for your stockholders.
    2. Go for cash: You can accept the reality that you have a product with a limited life but solid cash flows. You invest just enough to keep this product on its feet and a cash flow generator for the near future, and give up on new products and technologies.  You also change your capital structure and dividend policy to reflect your new status as a limited life, cash cow: use more debt in your financing and you return more of your cash to stockholders as dividends or stock buybacks. You are, in effect, liquidating yourself over time, and while your stock price will approach zero by the end of the Blackberry's life, your investors would have collected enough cash flows not to care.
    So, what are the value implications of your choice? In the fiscal year ended February 2011, RIM reported pre-tax operating income of $4.6 billion and net income of $3.4 billion, but this income was after R&D expenses of $$1.4 billion. While their earnings has plummeted in the last two quarters (operating income in the 12 months ended November 2011 was down to $3.4 billion), and some of the drop can be attributed to a loss of market share for Blackberries, the drop was accentuated by losses on new products such as the Playbook tablet.  In fact, let's be conservative and assume that the operating income in 2012 will come in at less than $ 2.5 billion and that RIM, if it gives up on developing new products, can cut $ 1 billion out of R&D. (The remaining $400 million or more can go to maintaining the Blackberry Franchise). That would translate into a base pre-tax operating income of roughly $ 3.5 billion and after-tax cash flows of $3 billion. Assume further that you can milk the franchise for five more years, losing 20% of your customers each year. On an after-tax basis, using a tax rate of 30% and a cost of capital of 9% (which is the cut off for the top quartile of US companies), you get a value of about $8.125 billion. At its current market capitalization of $7.3 billion and enterprise value of $ 6 billion, that would make RIM a bargain (under valued by about $2 billion). In fact, make your own estimates and judgments, using this spreadsheet. So, what can go wrong? If managers continue to operate under the delusion that they can recreate their glory days and invest on that presumption, they can very easily wipe out the $ 2 billion difference. In fact, I think that the market is building in the expectation that RIM will continue  not to act its age, investing as if it were a growth company, whose glory days lie ahead of it.

    As a potential stockholder in RIM, here is my unsolicited advice to the management of the company. Rather than fight the critiques of your product (that it is closed, corporate and limited), embrace them. In fact, I have names for your next few models: the Boring Blackberry, the Blackberry Funsucker and the Blackberry Stolid. Let's face it! The primary market for Blackberries is composed of paranoid (often with good reason) corporate entities that worry about their employees revealing business secrets and playing games on their iPhone and Android Apps, and you will appeal to them with your "cant have fun with these" Blackberries. Disband your research and development teams, forget about product revamps and don't even dream about more Playbooks. In effect, accept that you are an "old company" and behave like one. Your stockholders will be deeply grateful!



    Moneyball and Investing: Data, Information and my 2012 Update

    I loved Moneyball, both the book, by Michael Lewis, and movie starring Brad Pitt, because they bring together two things I love: baseball and numbers. At the risk of shortchanging the book, the central story in the book is a simple one. For most of baseball’s hundred plus years of existence, insiders (baseball managers, scouts and experts) have used stories and narratives to keep themselves above the riff raff (which is where you and I as fans belong). Thus, scouts claimed to have special skills (based on their long history of having done this before) to find potential superstars in high schools and the minor leagues, and managers justified their personnel decisions and game day choices with gut feeling and baseball instincts. Billy Beane, the general manager of the Oakland As, a storied but budget-constrained franchise, upended the game by shunting hoary tradition and putting his faith in the numbers.

    I think that financial markets and baseball share a great deal in common. Equity research analysts are our baseball scouts, asking us to trust their story telling skills when picking stocks. Executives at companies are our baseball managers, flaunting their industry experience and asking us to trust their gut feeling and instincts, when it comes to big decisions. Like Billy Beane, I trust the numbers far more than either analyst stories or managerial instincts, and it is for that reason that I started gathering raw data on individual companies about two decades ago and computing industry averages for a few key inputs into investments: risk, return and growth. Initially, it was a limited exercise, where I looked at only US companies and  a handful of statistics. I put those numbers online, not anticipating many downloads, but was pleasantly surprised at how many people seemed to find the data useful (I won’t flatter myself. The fact that it was free did help…)

    Each year my coverage has expanded, driven partially by external demand and mostly by easier access to raw data. Starting in 2003, I went global and a year or two later started providing data on the individual companies as well. So, here is where the long windup is leading. I have just finished the January 2012 update to my data. You can get to it by going to the updated data page on my website:
    http://www.stern.nyu.edu/~adamodar/New_Home_Page/data.html
    My sample includes all (a) publicly traded firms, (b) listed on any global exchange and (c) have data on the data sources that I use (Value Line for US companies, Capital IQ and Bloomberg for non-US companies). In January 2012, there were 41,803 companies in my overall dataset.

     I have computed industry averages for about 35 variables, covering a wide range of inputs:
    a. Risk measures and hurdle rates: Betas and standard deviations, as well as costs of equity and capital, by sector.
    b. Profitability measures: Profit margins (net and operating), tax rates and returns on equity and capital.
    c. Growth measures/ estimates: Historical growth rates in revenues and earnings, as well as forecasted growth rates (where available)
    d. Financial leverage (debt) measures: Book value and market value debt to equity and debt to capital ratios.
    e. Dividend policy measures: Dividend yields and payout ratios, as well as cash statistics (cash as a percent of firm value).
    f. Equity multiples: Price earnings ratios (current, trailing, forward), PEG ratios, Price to Book ratios and Price to Sales ratios.
    g. Enterprise value multiples: Enterprise value to EBIT, EBITDA, revenues and invested capital.
    I generally stay away from macro economic data but I do report equity risk premiums (historical and implied) over time and marginal tax rates across countries.

    You are welcome to use whatever data you want from this site, but please keep in mind the following caveats:
    1. Data yields estimates, not facts: In these days of easy data access and superb tools for analysis, it is easy to be lulled into believing that you are looking at facts, when you are really looking at estimates (and very noisy ones at that). Every number that is on my site, from the historical equity risk premium to the average PE ratio for chemical companies is  an estimate (and adding more decimal points to my numbers will not make them more precise).
    2. Data has to be measured: That is again stating the obvious, but implicit in this statement are two points. The first is that someone (an accountant, a data service, me) is doing the measurement and imposing his or her judgment on the measured value. The second is that there can be error in measurement. Thus, with my data, you can be assured that there are errors and mistakes in the final numbers. While I can blame some of these mistakes on the data services that I get my raw data from, many are mine. So, if you find a mistake or even something that looks like a mistake, please let me know and I promise you two things. First, I will not be defensive about it and will take a look at the issue you have raised. Second, if I do find myself in error, I will fix the error as soon as I can. (With a staff of one (me), this data service can get stretched sometimes… So, please have some patience).
    3. Data for post-mortems versus data for predictions: As I see it, data can be used in two ways. The first is to generate post-mortems (about past performance) and the other is make forecasts for the future. Given my focus on corporate finance and valuation, I am more interested in the latter than the former. Thus, my data definitions are more attuned to forecasting than to after-the-fact analysis. Just to provide an example, the cost of capital that I am interested in computing for a company is the cost of capital that I can use for the next five years, not the one for the last three years. 
    4. Data anchoring: Whether we like it or not, our instinct when confronted with a number, and asked to decide whether it is high or low, is to compare it what we consider reasonable numbers (at least in our minds). Thus, if I came to you with a stock with a PE of 10, your determination of whether the stock is cheap or expensive will depend largely on what you think the average PE is across all stocks and what comprises a high or low PE and all too often, in the absence of updated and comprehensive data, these are guesses.  It is for this reason that analysts and investors create rules of thumb: a EV/EBITDA of less than six is cheap, a PEG ratio less than one is cheap or a stock that trades at less than book value is cheap. But who comes up with these rules of thumb? And do they work? The only way to answer these questions is to look at the data across all companies and make your own judgments.

    There is one final point generally about data that I have to make, and it relates back to Moneyball. Much as I agree with Billy Beane on the importance of data, I think that his mistake was focusing far too much on the data. The data should be the starting point for your assessments, but not the ending point. Stories do matter, if they can be backed up by the data, or to draw implications from it. The secret to great investing is a happy marriage between plausible investment stories and numbers, with the recognition that even the best sounding stories have to be abandoned at some point, if the numbers don’t back them up. So, explore the data and make it your own!!



    My small challenge to the "university" business model

    I am not a great fan of the university business model as a delivery mechanism for learning. The model can be traced back to the middle ages and is built around physical location and arbitrary requirements for graduation (that have less to do with learning and more to do with maximizing university revenues and faculty comfort). I know! I know! I am a beneficiary of the system and I gain from the low teaching loads and a tenure system that is indefensible. With four children, I am also a consumer of the same system and I am flabbergasted at how little accountability is built into it. How many classes have you taken (or your children taken) where you should have received your money back because of the quality of the learning experience? How often have you been able to get your money back?

    For hundreds of years, we (as consumers) have had no choice. Universities have operated with little competition and substantial collusion. There is no other way that you can explain how little variation there is in tuition fees across US universities and the rise in these fees over time. Outside the US, the fees may be subsidized by governments, but the quality of the learning experience is often worse, with the rationale being that if you paid little or nothing for your education, you should eat whatever crumbs fall of the table in you direction. But I think that the game is changing, as technology increasingly undercuts the barriers to entry to this business. I am not just talking about online universities (which, for the most part, have gone for the low hanging fruit) or the experiments in online learning from MIT, Stanford and other universities. These are evolutionary changes that build on the university system and don't challenge it. I am talking about a whole group of young companies that have made their presence felt by offering new tools for delivering class content and learning. I am convinced that the education market is going to be upended in the next decade and that the new model is going to do to universities what Amazon has done to brick and mortar retailers.

    To back up my point, I am running an experiment this semester with the classes that I am teaching at the Stern School of Business: Corporate Finance, a first-year MBA class, and Valuation, an elective. I have taught these classes for more than 25 years now and have tried to make the material and the lectures available to the rest of the world, but I have never formally tracked those taking these classes online. In fact, if you were not an MBA student in the class, taking the class online would have required you to forage through my website for materials and keep track of what's going on. And I would have no idea that you even were taking the class... So, I want to change that..

    Last semester, I used a company called Coursekit to package and organize my class and was impressed with their clean look and responsiveness to my requests. This semester, which starts in a few days, I have created a coursekit page for each class that is focused on just online students. I will use this page to deliver content (lecture notes, handouts and assignments that those who are in my physical class get), webcasts of lectures (though not in real time, but the links should show up about an hour after the actual class ends ) and even the exams (you can take them and grade them yourself). The site also has a social media component, where you can start or join discussion topics, which I hope will provide the element of interaction that is missing when you do an online course. When you do get to the home page for Coursekit, you will notice my mugshot in the entry way. I promise you that I have zero financial interest in the company but I really want to see it succeed, because I think the education business needs to be shaken up.

    The first session for both classes is on Monday, January 30. If you want to take these classes online, here is what you need to do:
    a. Corporate finance class
    What is it? This is my "big picture" class about how financial principles govern how a business should be run. It looks at everything that a business does, through the lens of finance, and classifies them into investment, financing and dividend decisions.
    Who can use it? I am biased but I think that everyone can use a corporate finance class: entrepreneurs starting new businesses, managers at established businesses and investors valuing these businesses.
    How do you join? Go to the site (http://coursekit.com/finance). Enter RWHZYG as your code and you can then register for the class. Once you are registered, you will automatically be put into this page, every time you enter the site.

    b. Valuation
    What is it? This is a valuation class and it is about valuing any type of business: private or public, large or small and across markets. My focus is on providing the tools that will allow you to create your solution to valuation challenges, since new ones keep popping up.
    Who can use it? While investors interested in valuing companies may be the obvious target, I teach the class more generally to be useful (I hope) to managers running the businesses and those who are just curious about value.
    How do you join? Go to the site (http://coursekit.com/app#course/b40.3331.damodaran). Enter EH7WZN as your code and you can then register for the class. Once you are registered, you will automatically be put into this page, every time you enter the site.


    Just to be clear, my first obligation is to the students in my MBA classes and I will not stint or compromise on that obligation, but I view delivering a great learning experience to those taking the class online as a close second. Note also that you will not get any credit from NYU for taking this class. While I will give you the grading templates to grade your own exams and evaluate your own assignments, I will not be able to give you direct feedback on your work. But then again, the price (at zero) is set right. So, these classes definitely come with a money back guarantee. In fact, the more the merrier... So, pass the message in this post on to any friends who may be interested. See you in cyber space on Monday.




    Snowmen and Shovels: Investing Lessons?

    I live near New York and woke up this morning to our first snowstorm of the winter (we had a freak one in the fall but no snow in November and December). As I looked out of my window, I heard two sounds. The first was of small children squealing in delight, as they tromped through the snow and started building snowmen and throwing snowballs. The second was the grating sound of snow shovels being used by their (mostly morose) parents to clear the snow from their driveways. Three things came to mind. The first was the oddity of the same phenomenon (a snow storm) evoking such different reactions from two different groups. The other was the irony  that the parents were one day (long ago in the past) happy to see the snow and today's  happy children will one day grow up and be wielding their own snow shovels. The third is that a week from now when it warms up, the snowmen will melt away, and the unshoveled driveways will look just as good as the shoveled ones.

    I am sure that there are some deep life lessons in this phenomenon but I am not a philosopher. I do see some investing and valuation lessons in snowmen and shovels. After all, you can divide the world of active investors into two broad camps: growth investors and value investors. Consider the extremes in each camp. Extreme growth investors (you know the ones.. they go for momentum, love IPOs and are dazzled by high growth) remind me of the happy children, looking at snow and seeing snowmen, whereas extreme value investors (and you also know these ones.. they love net net investing and read Ben Graham's Security Analysis for inspiration)  more closely resemble the snow-shoveling parents. Each group views the other with disdain. Extreme value investors consider growth investors to be dilettantes, unserious and unwilling to grow up, who see the world through rose-colored lens. Extreme growth investors view value investors as boring, stuck-in-the-mud pessimists, who see only the dark side of things.

    So, which side is right? I think both sides are right and both are wrong. While each side sees a portion of reality, each side is also missing a piece of the real world. While the value investing group is right in its view that most growth companies will not make it through the challenges of the real world, the growth investing group is also right in its view that some of these growth companies will be the big winners of the future. By staying dogmatic, both groups open themselves to significant investing/valuation mistakes. A growth investor who closes his eyes to the very real likelihood that a growth company will not survive will over value that company. By the same token, a value investor who insists on incorporating only the worst case scenarios, estimates cash flows “conservatively” and then applies a huge “margin of safety” before investing will never find growth companies to be bargains.

    The key to investing, as in so much in life, is to maintain balance, recognizing that dreams sometimes come true, while keeping your feet grounded in reality. Put in valuation terms, the key to valuing a company well is to estimate what will happen (to earnings and cash flows) not only in good scenarios (let’s call these the snowman scenarios) but also in bad ones (the shovel scenarios).  It is a challenge I face whenever I do valuation. As I value a company, I have to constantly stop and look at the assumptions I am making and whether I am tilting too much to one side (snowman or shovel). If I find myself tipping too much into the “snowman” camp, I have to bring in some of my “shovel” side to play to get back to synch. If, on the other hand, I am letting my pessimistic shovel side dominate, I have to consciously force my fun snowman side come into play. 

    So, here is how I am going to start today’s path back to balance. I shoveled this morning, just before I came in and wrote this post. My kids are too “old” to enjoy building snowmen, but I am not. I am going to go out and build a snowman, make a snow angel and perhaps throw some snowballs. Why should those kids have all the fun?



    Private Equity: Hero or Villain?

    The battle for the Republican presidential nomination seems to have claimed another "financial markets" casualty, at least in public opinion. In the last few weeks, we have seen Mitt Romney, who made his fortune at Bain Consulting, attacked for being a heartless, job-destroying private equity investor. I prefer not to enter political debates, but some of the critiques of private equity are so misdirected and over the top that I have to believe that these critics have no sense of what private equity is, the companies that they target and what they do at these companies. 


    What is private equity?
    If asked to provide a prototype of a private equity investor, many critics present you with Gordon Gekko , endowed with all of the characteristics that they want to attribute to a villain: a greedy, immoral man who delights in inflicting pain on the less fortunate. I could tell you that most private equity investors that I know don't even come close to that stereotype, but that is unlikely to convince anyone. In my view, here are the three ingredients for an investor to qualify to be a private equity investor:

    1. Equity: At the risk of stating the obvious, to be a private equity investor, you have to be an investor in equity, either in publicly traded companies (as stock) or in private business (as owners' equity). So any criticism of private equity that segues into mortgage backed securities, which are generally debt, or into overreach at investment banks prior to 2008 is mixing up its villains.
    2. Activist: A second feature of that separates private equity investors from most other equity investors is that they are activist, rather than passive investors. Thus, you and I, as passive investors, may buy stock in a company, believing it to be under valued or sub optimally managed, and then sit back and hope that the price moves up. An activist investor would buy stock in the same company and put in motion actions aimed at changing the way the company is managed (shutting down bad businesses, take on more debt, pay more dividends) or in fixing the reasons for under valuation (spin off, split offs, divestitures).
    3. Private: While activist equity investors have been around as long as markets have been around, there is a third aspect to private equity investing that sets it apart. Private equity investors preserve the option (though they don't always use it) of "taking private" some of their targeted publicly traded companies. In effect, they remove these companies from the public space, run them as private companies for a period of time (during which they make changes), and then either go public again or sell them to other public companies.

    With this definition in place, you still see diversity within this group. Broadly speaking, private equity investors can be classified into three categories: lone wolves (like Carl Icahn, Nelson Peltz and Bill Ackman), institutional activists (mutual funds and pension funds that trace their lineage back to the Calpers fund in the 1980s and are activist on the side) and activist hedge funds (which is where I would put Romney's Bain fund, KKR and Blackstone).


    What types of companies do private equity investors target?
    If activist investors hope to generate their returns from changing the way companies are run, they should target poorly managed companies for their campaigns.
    • Institutional and individual activists do seem to follow the script, targeting companies that are less profitable and have delivered lower returns than their peer group. 
    •  Hedge fund actvists seem to focus their attention on a different group. A study of 888 campaigns mounted by activist hedge funds between 2001 and 2005 finds that the typical target companies are small to mid cap companies, have above average market liquidity, trade at low price to book value ratios, are profitable with solid cash flows and pay their CEOs more than other companies in their peer group. Another study of the motives of activist hedge funds uncovered that the primary motive is under valuation, as evidenced in the figure below.


    In summary, the typical activist hedge fund behaves more like a passive value investor, looking for under valued companies, than like an activist investor, looking for poorly managed companies. Activists individuals are more likely to target poorly managed companies and push for change.

    What do they do at (or to) these targeted companies?
    The essence of activist investing is that incumbent maangement is challenged, but on what dimensions is the challenge mounted? And how successfully? A study of 1164 activist investing campaigns between 2000 and 2007 documents some interesting facts about activism:
    • Two-thirds of activist investors quit before making formal demands of the target. The failure rate in activist investing is very high.
    • Among those activist investors who persist, less than 20% request a board seat, about 10% threaten a proxy fight and only 7% carry through on that threat.
    • Activists who push through and make demands of managers are most successful (success rate in percent next to each action) when they demand the taking private of a target (41%), the sale of a target (32%), restructuring of inefficient operations (35%) or additional disclosure (36%). They are least successful when they ask for higher dividends/buybacks (17%), removal of the CEO (19%) or executive compensation changes (15%).  Overall, activists succeed about 29% of the time in their demands of management.
    A review paper of hedge fund activist investing finds that the median holding for an activist hedge fund is 6.3% and even at the 75th percentile, the holding is about 15%. Put differently, most activist hedge funds try to change management practices with well below a majority holding in the company. The same paper also documents an average holding period of about 2 years for an activist investment, though the median is much lower (about 250 days).
    Following through and looking at companies that have been targeted and sometimes controlled by activist investors, we can classify the changes that they make into four groups as potential value enhancement measures:

    1. Asset deployment and aperating performance: There is mixed evidence on this count, depending upon the type of activist investor group looked at and the time period. Divestitures of assets do pick up after activism, albeit not dramatically, for targeted firms. There is evidence that firms targeted by individual activists do see an improvement in return on capital and other profitability measures, relative to their peer groups, whereas firms targeted by hedge fund activists don’t see a similar jump in profitability measures.
    2. Capital Structure: On financial leverage, there is a moderate increase of about 10% in debt ratios at firms that are targeted by activist hedge funds but the increase is not dramatics or statistically significant. There are dramatic increases in financial leverage at a small subset of firms that are targets of activism, but the conventional wisdom that activist investors go overboard in their use of debt is not borne out in the overall sample. One study does note a troubling phenomenon, at least for bond holders in targeted firms, with bond prices dropping about 3-5% in the years after firms are targeted by activists, with a higher likelihood of bond rating downgrades.
    3. Dividend policy: The firms that are targeted by activists generally increase their dividends and return more cash to stockholders, with the cash returned as a percentage of earnings increasing by about 10% to 20%.
    4. Corporate governanceThe biggest effect is on corporate governance. The likelihood of CEO turnover jumps at firms that have been targeted by activists, increasing 5.5% over the year prior to the activism. In addition, CEO compensation decreases in the targeted firms in the years after the activism, with pay tied more closely to performance.
    Do private equity investors make high returns?

    The overall evidence on whether activist investors make money is mixed and varies depending upon which group of activist investors are studied and how returns are measured.
    • Activist mutual funds seem to have had the lowest payoff to their activism, with little change accruing to the corporate governance, performance or stock prices of targeted firms. Markets seem to recognize this, with studies that have examined proxy fights finding that there is little or no stock price reaction to proxy proposals by activist institutional investors.  Activist hedge funds, on the other hand, seem to earn substantial excess returns, ranging from 7-8% on an annualized basis at the low end to 20% or more at the high end. Individual activists seem to fall somewhere in the middle, earning higher returns than institutions but lower returns than hedge funds.
    • While the average excess returns earned by hedge funds and individual activists is positive, there is substantial volatility  in these returns and the magnitude of the excess return is sensitive to the benchmark used and the risk adjustment process. Put in less abstract terms, activist investors frequently suffer setbacks in their campaigns and the payoff is neither guaranteed nor predictable.
    • Targeting the right firms, acquiring stock in these companies, demanding board representation and conducting proxy contests are all expensive and the returns made across the targered firms have to exceed the costs of activism. While none of the studies that we have reference hitherto factored these costs, one study that did concluded that the cost of an activist campaign at an average firm was $10.71 million and that the net return to activist investing, if these costs are considered, shrink towards zero
    • The average returns across activist investors obscures a key component, which is that the distribution is skewed with the most positive returns being delivered by the activist investors in the top quartile; the median activist investor may very well just break even, especially after accounting for the cost of activism.
    Here is an indisputable fact. If you are a stockholder in a publicly traded company, the entry of a private equity investor into your stockholder ranks is good news, since stock prices go up substantially:

    Is private equity good or bad for the markets? How about for the economy? And for society?
    For some of you, this entire post may be missing the point of the criticism, which is that private equity investors are job killers, not job creators. To me, that criticism is misplaced, because you cannot measure the success of a business by the jobs it creates or saves, but by the value it creates for its stockholders, by making money, and for its customers, by providing a needed product or service to customers. In the process, if it is successful, it will hire people and create jobs.
    In fact, today's New York Times carries a story about one of the companies targeted by Bain in its Romney days, where 150 people lost their jobs, and it specifies that the company primary products was photo albums. Thus, while it is easy to blame Bain for the layoffs, the real reasons lay in a shifting market, where digital photography and computerized albums were replacing conventional photographs. The story's bigger point is that the people in the town have moved on, found other businesses to work for and are frankly surprised by the attention.
    Since the critics are using fictional characters to beat up private equity investing, I will use one of my favorite fictional characters, from a great movie, "Other People's Money", to counter:


    If private equity investors are primarily interested in slimming down companies and creating value for stockholders, do they create value for society? I believe that they do, and for two reasons. First, they are the battering rams that we use as passive investors to initiate and create change at public companies, and especially at companies that need to change. Second, even when private equity investors target companies, force them to divest assets, slim down and pay out the cash to stockholders, the cash does not disappear into thin air. The stockholders who receive the cash use it to pay for products and services (which creates jobs) and to invest in other companies with better growth prospects (which in turn hire more people).
    In fact, my response to those who have a problem with private equity would be to ask the following question: Which aspect of private equity investing do you want to ban? Assuming that it is not equity investing collectively, it has to be either the activism or the "taking private" components. And what would that accomplish? Banning these practices would leave incumbent managers ensconced at publicly traded companies, unchallenged and unwilling to make changes, and the only jobs saved will be theirs.

    Bottom line: If you don't like Mitt Romney, don't vote for him. Find a good reason, though! The fact that he worked at a private equity firm, and was good at his job, should not be that reason. In fact, since the US government looks more and more like a badly managed enterprise in need a major restructuring, a "good private equity investor" in charge may be just what the doctor ordered. 



    Facebook: Playing the "IPO pop" game?

    In my last post on Facebook, I provided my estimate of value (about $ 70 billion) and concluded that I would not be a buyer of Facebook shares even if the company was valued at close to $ 70 billion. A few of you have taken me to task for leaving what you see as easy profits on the table, noting that if I were able to get Facebook shares at the offering price, that I would be guaranteed (or close to guaranteed) a substantial profit. More generally, there is the perception that investing in IPOs at the offering price (and making money on the offering day pop) is a low-risk, high return strategy that can be used to augment your portfolio returns. Like most "sure" things in investing, this one comes with implicit assumptions and costs and is definitely not "sure". Here is my list of caveats for those considering the "Facebook IPO Pop" strategy.

    1. You have to be able to get the shares at the offering price
    Let's say that when the Facebook IPO does get "priced", you bid to buy shares at the offering price. One of two things will happen: you will either get your requested number of shares or you will not, and ironically, it is the former that should worry you. If you are right in your basic hypothesis, i.e., that IPOs are under priced, the demand for the shares at the offering price will exceed the supply and the investment bankers managing the IPO will have to ration the shares. If the process is fair, you should get only a proportion of the shares you asked for, with the proportion getting smaller as the shares get more under priced. If the process is fixed and the investment banks give first dibs to their preferred customers, the proportion you get, if you are not one of the preferred customers, will be even lower. Thus, the only scenario you should dread if you are not a preferred customer is one where you get your entire allotment filled, because that is an indication that the shares are over priced.

    This allotment process has always been the achilles heel of strategies that try to invest across all IPO offerings. You may bid for $100,000 worth of shares of every IPO for the next year, but you will end up with a portfolio that has too little invested in the most under priced IPOs (since you will get far fewer shares than you requested in these) and too much in the most over priced IPOs (since you will get all of the shares you asked for with these).

    2. The stock has to pop on the offering date
    Once you have been allotted the shares at the offering price, you have to hope for a stock price pop on the offering date. You do have history on your side. Looking across all IPOs, there is evidence of an offering day increase in stock prices. The figure below graphs out the average "under pricing" across all IPOs, by year, for US stocks:

    Note, though, that this return presupposes that you can invest an equal amount in each IPO, under priced or not, but it is still impressive. Over the entire 50 year time period, there have been only four years (1962, 1973-1975) where the average returns were negative, and there are periods, such as the late 1990s, where the average return is close to 100% (doubling of price on the offering date). That is good news for the "Facebook IPO Pop" strategy.

    Before you get too excited, though, note that the under pricing is greatest with the smallest offerings, as evidenced in the graph below:

    Given the size of the Facebook offering (even 5% of $100 billion makes this a big offering), this graph should lead you to lower your expectations of the price pop on the offering date.

    There is also evidence that this under pricing is by design. The IPO pricing cookbook at most investment banks includes a "take 15% off the value" ingredient in every pricing recipe, since the positive news stories that accompany the pop are viewed as a sales pitch for future stock issues. The under pricing also is consistent with the incentives for investment banks, who generally guarantee the offering price to the issuers, and thus have fare more to lose by over pricing than from under pricing.

    This IPO under pricing has been the source of angst for some, who feel that the under pricing is unfair to the founders/owners of the company going public, since they are leaving money on the table, by offering their shares at a discounted price. That argument, though, becomes less persuasive, when you recognize that only a small portion of the outstanding shares is generally offered on the offering date. The discounted price on these shares operates the same way a loss leader operates in a retail store: it is designed to whet your appetite and get you to buy more. You hope that those who buy these shares (and feel good about the profits they make) will be back in six months or a year to buy more shares in the company. So, if you are feeling sorry for poor Mark Zuckerberg on the offering date, don't worry! There are plenty more shares in Facebook that will be hitting the market in future years.

    From an investor's perspective, what can go wrong? Note that the average is across all IPOs (and is skewed by the smallest IPOs) and that a subset of IPOs see a drop in price on the offering date. These are of course the IPOs where you got all of the shares you asked for. If you are not a preferred customer, your odds of making money on IPOs decrease. Even the preferred customers are offered a mixed bag. Not only does their preference stem from the large amounts that they pay the investment banks for other services rendered, but they are expected to be "good" investors. In other words, if they flip the stock soon after the offering, it may endanger their preferred status on future IPOs. More on that in the next section!

    3. You have to time your exit well
    Assume now that the first two pieces of the puzzle have fallen into place. You have been allotted shares in the Facebook IPO and the stock has popped 15% on the offering date. Should you sell now or should you wait? That eternal  question has particular resonance with IPOs, because the gains on the offering date can be fleeting. Remember that Groupon's 20% jump on the offering date is now all gone!

    Studies that track the post-offering performance of IPOs suggest that they do are not good investments in the aftermath. In the figure below, we compare the returns in the first five years after an initial public offering, with the returns on non-IPO stocks.

    The returns on IPOs lag the returns on other stocks in the market and do so much more in the first few years after the offering. Thus, if buying at the offering price requires you to hold the stock for a year or two (which may be required of you as a preferred customer), you may not be getting a great deal.

    In fact, my valuation of Facebook is predicated on the assumption that you may want to hold Facebook for more than a day in your portfolio. If you do, once the buzz fades and the IPO paparazzi leave, the company will be judged increasingly by how it performs relative to expectations. If price and value are on a collision course, value always wins out.

    4. You are playing a sector and momentum game, even if you don't want to...
    If you bid for shares in the Facebook IPO offering, I do believe that the odds may be in your favor for winning the game, if you define winning as getting the shares at the offering price and flipping them very quickly after the IPO. Much as I am tempted to join you, I am afraid I will sit out that game and not because of any noble impulses (such as wanting to be a long term investor or not speculating).

    The IPO game is a subset of the momentum game, on which I have posted before. It is a game that produces big winners but momentum always turns, and when it does, it creates big losers. To see the link, note that IPOs go through hot and cold phases, with years in which you have hundreds of IPOs and years in which you have a few dozen.

    In addition, also note that IPOs in any given year tend to be concentrated in a few sectors and those sectors generally have momentum on their side (dot com stocks in the 1990s, social media companies today). Thus, the success of IPOs in a sector is closely tied to whether the sector maintains it "hot" status.

    One worrisome aspect of IPOs is that they may operate as canaries in the coal mine in signaling momentum shifts; the loss of enthusiasm for dot com IPOs (and the withdrawals of some) coincided with the epic collapse of the sector that year. The momentum driving social media companies will end one day and it may very well be the day that Facebook goes public. "Unlikely", you say, and I agree, but the tough part of being a lemming is that you never know where the cliff is coming. Of course, you may be able to sense momentum change much better than I, in which case you should be able to play the game successfully.

    Bottom line
    A strategy of investing in IPOs at the offering price looks much better on paper than it works in practice. All of the academic studies that show the average underpricing are implicitly based upon the assumption that you can create an equally weighted portfolio of all IPOs, when in fact, a non-discriminating investor will end up  will be with too much invested in all of the worst IPOs.

    The strategy can be made to work by an investor who uses analysis (valuation or information) to invest only in IPOs that are most likely to be under priced and follows through with timely selling to capture profits after the offering. Even for that investor, it is a supplementary strategy since there will extended periods where there are no or very few IPOs in the market.

    So, if you are bidding for those Facebook shares, good luck. I hope you get only a fraction of the shares you ask for (see part 1 for why), that the stock price pops on the offering date, that you get out before the you-know-what hits the fan. and that you are not the unfortunate soul who helps ring in the end of the social media circus.



    The IPO of the decade? My valuation of Facebook

    The Facebook IPO gets closer and I don’t think I can put off this valuation much longer. While we don’t have an offering price yet, the preliminary estimates are that the company will be valued somewhere between $75 billion and $100 billion. As with my Skype, Linkedin and Groupon valuations, I will present my assumptions and valuation of Facebook, with the admission that I have no crystal ball and know that your estimates will be very different from mine. So, with that disclaimer out of the way, here are my valuation assumptions for Facebook.

    1. Where Facebook stands right now: I started with the Facebook S-1 filing which contains their financials from last year. The pdf version is available here, with my highlights and annotations (just ignore my snarky comments... I cannot help them). Looking at the most recent year's numbers, here is what I see:
    (a) Revenues in 2011 were $3,711 million, up  88% from revenues of $1,974 million in 2010, which, in turn, were up  150% from revenue of $777 million in 2009.
    (b) The firm's pre-tax operating income increased from $1,032 million in 2010 to $1,756 million in 2011. The firm's net income increased from $ 606 million in 2010 to $ 1 billion in 2011, though a third of that net income was set aside for participating securities (convertible preferred and restricted stock units... More on that later...). Incidentally, Facebook paid 41% of its taxable income as taxes in 2011.
    (c) The company is primarily equity funded and its book value of equity at the end of 2011 was $5,228 million; the only debt on the books was $398 million in capital leases. They did have operating lease commitments, which when capitalized yielded a value of $776 million. The total debt is therefor $1,174 million.

    2. Future revenues: Facebook is on a "high growth" path, with revenues growing by 150% in 2010 and another 88% in 2011, but as even that sample of two observations suggests, the big question is how that growth rate will hold up as the firm becomes larger. I estimate a compounded revenue growth rate of 40% for the next five years and a scaling down of that growth rate to the nominal growth rate in the economy (set equal to the risk free rate of 2.01%)  by the end of ten years. While both assumptions may strike you as conservative, I am effectively assuming that Facebook will follow a revenue growth path close to Google's over the next 8 years, as evidenced in the chart below, where I compare Google's actual revenues in the 8 years since their IPO with Facebook's forecasted revenues for the next 8 years:


    Since advertising revenues are the drivers of both firms' growth engines, and they may very well be competing for the same advertising dollars, I think a comparison of their competitive advantages is in order. Facebook's primary advantage is that they can use what they know about their users (which is a lot... scary thought!) to offer focused advertising. Google's advantage is that it has a more direct and easy business model, since its revenues come from user clicks. In contrast, Facebook has to be careful about making its focused advertising too obvious, since some users will find this creepy. Google has added other products to its mix, with the Android as the most prominent example, and Facebook also has potential avenues for expansion.

    3. Operating margin: Facebook has a phenomenal pre-tax operating profit margin in excess of 45%. To provide a contrast, Google's operating margin is currently about 31% and has seldom exceeded 35%. However, Facebook's margins will come under pressure as they actively seek out more revenues and I am assuming that the pre-tax margin will decrease to 35% over the next decade. Even with this assumption, I am estimating operating income for Facebook will exceed Google's by a wide margin over the 8 years following the IPO:


    4. Reinvestment: In one of a series of posts on growth, I argued that growth does not come free (or even cheap). That is true for even a company with the pedigree of Facebook. There is some information in the financial statements about reinvestment: the company had net capital expenditures of $ 283 million, an acquisition that cost $24 million and an increase in capital leases of about $ 480 million. To estimate reinvestment in future years, I assumed that the firm would be able to generate about $1.5 million in revenues for every million in additional capital investment. At this stage, it is impossible to tell what form the reinvestment may take, but looking at Google over the last few years should provide clues; the company has moved increasingly to using acquisitions to augment growth. Lest you feel that I am being too conservative, I am estimating that Facebook will generate a return on its capital of about 32% in year 10, up from just over 26% now.

    5. Risk and cost of capital: Facebook is a company that is funded almost entirely with equity and while it is a young, growth company, it does have a business model that is working and delivering substantial profits. While we can start from the bottom and work up to a cost of capital, using parameters estimated for Facebook, I will employ a far simpler approach. Looking across the costs of capital of all US companies at the start of 2012 (you can find this on my website), I estimate a cost of capital of 11.42% for advertising companies. I will assume that Facebook will face a similar cost of capital to start. The median cost of capital for US companies is roughly 8% and as Facebook grows and matures, I do adjust the cost of capital down to 8%.

    6. Cash and Debt: The assumptions above are sufficient to estimate the value of the operating assets. Discounting the cash flows back at the cost of capital (with changes over time) results in a value of $71,240 million. To get to equity value, I subtract out the outstanding debt ($1,174 million) and add the current cash balance ($1,512 million). While I would normally augment the cash balance with any cash proceeds from the IPO, Facebook is open about the fact (See S1, page 7) that the proceeds will be going to Mark Zuckerberg to cover tax expenses from option exercise and will not be coming to the firm.
    Value of equity = $71,240 + $1,512 - $1,174 = $71,578 million
    Based on my estimates, the values being bandied around ($75 billion- $ 100 billion) are not unreasonable. As with my Groupon valuation, I ran a simulation,making assumptions about distributions for my key assumptions (revenue growth, operating margin, cost of capital and reinvestment). The results are summarized below:

    Note that the median value of $ 70 billion is close to the base case estimate (as it should) but there is a 10% chance that the value could be greater than $ 117 billion and a 10% chance of a value of $ 43 billion or less.

    7. Value per share: At some stage in this IPO process, Facebook's investment bankers will have to arrive at a value per share (offered) and you and I will have to decide on whether to buy or not. That could be messy because Facebook has multiple claims on equity, starting with:
    a. Equity options: There are 138.54 million options outstanding, from earlier year compensation schemes, with an average maturity of about 2 years and an exercise price of $0.75. My estimate of the value of these options collectively, net of the tax benefits that I see Facebook getting from the exercise, is $3,782 million. I will net this value out against the equity value to get to a value in the shares:
    Value in shares = $71,578 million - $3,782 million = $67,795 million
    b. Restricted Stock Units: In the last few years, Facebook (like many other tech companies) has shifted to granting restricted stock units. These are regular shares but the holders who receive have to first stay long enough with the company (vest) to lay claim to them and often face restrictions on trading. The liquidity restrictions, in particular, should make these shares less valuable than regular shares. There are 380.719 millions class B shares, in restricted stock units, that will eventually become regular shares and I will add them to current shards outstanding.
    c. Class A and Class B shares: After the IPO, there will be 117.097 million Class A shares (with one voting right per share) and 1758.902 million Class B shares (with ten voting rights per share). Other things remaining equal, the latter should trade at a premium on the former, though I don't think that the expected value of control in this company is significant.

    If I take the equity value, net of the value of options, and divide by the total number of class A, class B and RSU shares outstanding, the value per share that I get is $29.05. Allowing for a slight discount (3-5%) on the non-voting shares, I would anticipate that the class A shares in the IPO will have a value of about $28 (assuming that my share count is right... I will wait to get a firmer update as we get closer to the offering, before I close in on a per share value). You can access the excel spreadsheet with the numbers by clicking here. If you don't like my inputs or assumptions, don't stew about them. Go in and change them and see what you get as the aggregate value of equity in Facebook. If you can post it in the Google spreadsheet that I have created for this purpose, even better... Let's see if we can get a consensus value for the company.

    If you are investing in Facebook, give credit to the company for being upfront and honest about where the power rests in this company. On page 20 of the filing, you will find this "Mr. Zuckerberg has the ability to control the outcome of matters submitted to our stockholders for approval, including the election of directors and any merger, consolidation, or sale of all or substantially all of our assets. In addition,  Mr. Zuckerberg has the ability to control the management and affairs of our company as a result of his position as our CEO  and his ability to control the election of our directors. Additionally, in the event that Mr. Zuckerberg controls our company at  the time of his death, control may be transferred to a person or entity that he designates as his successor." A little later on page 31, you will find this "We have elected to take advantage of the “controlled company” exemption to the corporate governance rules for publicly listed companies. Because we qualify as a “controlled company” under the corporate governance rules for publicly-listed companies, we are not required to have a majority of our board of directors be independent, nor are we required to have a compensation committee or an independent nominating function." Let's be clear about this: this is Mark Zuckerberg's company and you and I are just providing him with capital.

    For those of you who are familiar with my valuations of Linkedin and Groupon, you will note that I am more positive about Facebook than those companies. Part of that can be attributed to Facebook being further along in developing a business model that works and delivers profits. Another reason, though, is that Facebook has a real chance at being the next “winner take all” company. What am I talking about? In conventional businesses, a company that gets a large portion of the market is subject to competitive assaults that cap the market share and reduce profitability over time. In some parts of the technology business, controlling a large share of a market seems to give the winner the capacity to take over the whole market. Consider three big winners from the last 30 years. Microsoft started off in the “office suites’ competing with many players in the word processing, spreadsheet and presentation program businesses, but at some point, its dominance drove the competition out. To a lesser extent, Amazon’s dominance of online retailing and Google’s ownership of online advertising (so far) reflect similar “winner take all” phenomena. I am not suggesting that Facebook has a lock on social media advertising, but it has a chance to get a big chunk of it, and if it does, the value that I estimated will be too low. Note that the simulation does yield values of $120 billion or higher for the company, if the stars align.

    Would I buy Facebook stock, if its equity were valued at $75 billion? No, and not because I believe that the price is outlandish, but for two other reasons.

    • The first is that the price reflects the expectation that Facebook will become a phenomenal success. Anything less than superlative will be viewed as a failure.
    • The second is that what Facebook is brazen about the fact that they don't see any need for input from stockholders. In effect, they want my money but don't want me to have any say in how the company is run. This does not jell with the notion that stockholders are part owners of the companies that they owned stock in. You may be comfortable with Zuckerberg as CEO for life but I am not. I am sure that I am in the minority on this one, but different strokes for different folks....
    In closing, Facebook has immense promise as a company and it is being priced on the premise that the promise will be delivered. Could it be worth $ 100 billion? Sure, but you are fighting the odds as an investor. Social media companies today collectively and Facebook in particular resemble stores with tremendous foot traffic (850 million users in the case of Facebook) but with nothing on the shelves. You are buying access to the foot traffic and hoping that you can get something on the shelves that they will stop and look at and buy. Given that social media is still in its infancy, we really don't know whether this promise will pan out, and that remains the basis for the uncertainty, and why short cuts that are based on value per member (a metric that I see with social media companies all the time) are fraught with danger.



    Options and Taxes: Is a "Facebook" tax next?

    Facebook is in the news and I will do my usual pre-IPO valuation and posting in a few days on the company but I want to focus in on an interesting story in this morning's New York Times about option exercise and taxation (at both the individual and corporate levels).

    The story itself focuses on two tax issues. The first is that Mark Zuckerberg is planning to exercise about $ 5 billion of options ahead of the offering, resulting in a tax bill of roughly $ 2 billion for him, about $1.5 billion in federal taxes and $ 500 million in California taxes.  The second is that Facebook will be claiming a tax deduction of roughly the same value, which will shelter them from taxes this year and allow them to claim tax refunds of about $ 500 million from prior years. All of this has some in Congress in full "indignation" mode, with Senator Carl Levin saying "“When profitable corporations can use the stock option tax deduction to pay zero corporate income taxes for years on end, average taxpayers are forced to pick up the tax burden,” he said. “It isn’t right, and we can’t afford it.” Before we embark on another tax policy change predicated on a sample of one (Facebook), it is worth examining the broader question of how employee options get taxed, especially at the corporate level.

    At the moment, if you are a company that grants options to its employees, the accounting laws require you to value those options as options (rather than at exercise value) and expense them when you grant them (though you can amortize these expenses over a period of time). Thus, what you see reported as operating or net income for a company today is after employee options have been expensed. This, of course, is a sharp reversal of accounting policy prior to 2006, when firms had to show only the exercise value of the options at the time of the grant. Since at the time of the grant, employee options were usually at the money (strike price = stock price), this effectively meant that option grants had no effect on earnings when they were granted. However, if and when the options were exercised, companies were required to show the difference between the stock price and the strike price as an expense. 

    To illustrate the difference, assume that you grant 100 million options with a strike price of $10, when the stock price is also $ 10, in 2008. Let's also assume that the options get exercised 2 years later when the stock price is $ 40. With pre-2006 accounting, you would not have shown an option expense in 2008 but you would have shown an expense of $ 3 billion [$40 - $10) (100)] in 2010. In the post-2006 time period, the company would have had to show an option expense in 2008, with the expense computed by valuing the options at the time. (For instance, an at-the-money option with five years to expiration on a stock with a price of $ 10 and a standard deviation of 40% would have a value of $3.36. Carrying this through, the company would have to record an expense of $336 million in 2008 and revisit this expense in subsequent years, as stock prices go up or down.  If you want to, you can try your hand at valuing options with the attached spreadsheet).
    [Update: I have been taken to task by the accountants among my readers for being simplistic (and wrong) on the accounting rules, since they are far more complex than what I have described in this example. I confess to the crime but I feel no remorse. I think that I am being truer to the underlying accounting principle of matching expenses up to revenues than the current accounting rules claim to be. My point is that accounting has moved grudgingly to accept the fact that options have to be expensed when they are granted and not when they are exercised, though the accounting obsessions with smoothing and back filling finds their way into the rules. In fact, more on that in my next post]

    So, what does this have to do with today's story? While the accounting treatment of options changed in 2006, the tax treatment did not. In effect, the tax authorities still use the pre-2006 convention, not allowing companies to expense options when they are granted but only when they are exercised. This creates a disconnect between accounting earnings and tax earnings, which can make valuation more difficult. But is it a loophole? Seems like it, if you only consider Facebook, which will save a billion dollars in taxes because its options will be exercised at a time when its stock price is sky high. But let's add to this sample of one. Take a company like Cisco, which has granted hundreds of millions of options over the last decade. Since the stock has stagnated over the period, many of these options are now under water and will either end up un-exercised or exercised for far less than the value at the time of the grant. If Cisco had been able to deduct these options at the time they were granted (at option value), they would have saved hundreds of millions of dollars, which they may now will lose forever, if these options remain under water. In the aggregate, with the current tax treatment of options, the government collects less in taxes from Facebook and more in taxes from Cisco.  

    Do I think that the tax rules on options should be changed? Perhaps, but it is not because the tax law is unfair or because I think it creates a loophole. As I see it, here are the three choices:
    1. Continue with the existing policy of taxing options when they are exercised. The net effect is that the most successful companies (at least in terms of creating market value) will get bigger tax deductions from option expensing than the least successful companies.
    2. Change tax law to match accounting law and allow companies to expense options in the year that they grant them. It will smooth out tax collections, level the playing field across companies and create more consistency. But here is the follow up question that gives me a little pause:  Should employees who receive the options then have to show them as income in the year that they receive them? If you are being consistent, the answer is yes, but where will they come up with the cash to pay the taxes? After all, employee options are not liquid and the employee while wealthy (in terms of options) may be cash poor.
    3. If you follow Senator Levin's logic that this is a loophole, and you try to craft legislation, I am not sure where it leads you. Should we ban the expensing of options by companies? I would accept that, if you stop taxing employees who receive these options. (If that had been in place this year, Facebook would have to pay about a billion more in taxes but the government would be collecting two billions less in taxes from Zuckerberg...)
    As someone interested in valuation, I have wrestled with options and their effect on value for a while. I think that options are mishandled in many valuations, with flawed arguments (Options are non cash expenses...) and perilous short cuts (treasury stock and fully diluted value approaches) overwhelming common sense. In fact, I wrote a paper on the topic that you can download by clicking here



    Equity Risk Premiums: The 2012 Edition

    As many of you who have been reading this blog for a while know, one of my obsessions is the equity risk premium. To me, it is the "number" that drives everything we do, while investing, and two events precipitated this post. The first was an article in the Economist on the topic, arguing that investors are expecting misreading the past and expecting higher returns from equities than they should. The second was the culmination of what has now become an annual ritual for me, which is updating my paper on equity risk premiums for the fifth year (I started in September 2008). You can download the paper by clicking here. For those of you who have no time for reading long tomes, I am going to try to summarize the paper in this post.

    What is the equity risk premium? 
    While it is always foolhardy to talk about "one" number encapsulating the stock market, I think the equity risk premium comes closest to meeting the requirements for such a number. The equity risk premium is the "extra return" that investors collectively demand for investing their money in stocks instead of holding it in a risk less or close to risk less investment. As a consequence, it reflects both their hopes and fears about stocks, rising as the fear factor increases.

    Why does the equity risk premium matter?
    The equity risk premium is used by almost everyone in finance, though it is often either taken as a given or used implicitly. Thus, a portfolio manager who decides to pull out of the stock market because she feels are stocks are over priced is telling you that she thinks that equity risk premiums will increase in the future. Investors who estimate the intrinsic value of assets or stocks are making explicit judgments about the equity risk premium (when they use DCF models) or implicit judgments (when they use book value or multiples). The costs of equity and capital that firms use to decide whether to invest in a project are built on equity risk premiums, as is all discounted cash flow valuation. Legislators and pension administrators decide how much to set aside to meet future pension obligations, based upon assessments of equity risk premiums.

    What determines the equity risk premium?
    Since the equity risk premium (ERP is a number for the entire stock market, it is determined by the overall characteristics of the investor population and macroeconomic factors. In particular:
    a. The ERP should increase as investors become more risk averse and/or prefer current consumption more.
    b. As uncertainty about economic growth, inflation and other macroeconomic variables increases, the ERP will rise.
    c. Since investors are dependent upon the flow of information from firms (accounting or other), the ERP will rise as information becomes less reliable or less available.
    d. The fear of catastrophe always hangs over equity investments and as that fear rises, the ERP will go up as well.
    Since all of these factors can change over time, you should expect the equity risk premium to vary across time as well.

    How do you measure the equity risk premium?
    There are three broad approaches to estimating the equity risk premium and they can yield very different values:

    1. Surveys: You can ask investors or analysts what they think stocks will generate as returns in the future and net out the risk free rate from this value to get to a equity risk premium. For instance, Merrill Lynch surveys global portfolio managers and reports a survey premium of 4.08% in early 2012, i.e., portfolio managers expect stocks to earn 4.08% more than the risk free rate. A survey of CFOs by Harvey and Graham yields a 3.50% equity risk premium but another one by Fernandez yields higher numbers (5-5.5% for the US and higher values for emerging markets). I distrust survey premiums because they often represent hopes (more than expectations) and are more reflective of the past than the future.
    2. Historical premium: You can look at the past and estimate the premium you would have earned investing in stocks over a risk free investment. Thus, if you look at the 1928-2011 time period for the US, you would have earned an annual compounded return of 9.23% if you had invested in stocks, over this period, but an annual return of only 5.13%, investing in treasury bonds. The difference (4.10%) would be your historical risk premium. Even with historical data, you can get different numbers using different time periods, treasury bills instead of bonds as your risk free investment, and computing an arithmetic average instead of a compounded average. The values, for the US markets, range from 7.55% (arithmetic average premium for stocks over T.Bills from 1928-2011) to -3.61% (geometric average premiums for stocks versus T.Bonds from 2002-2011). Given the volatility in stock returns, you should be wary of equity risk premiums computed with less than 40 or 50 years of data (almost always the case with emerging markets) and be skeptical even when longer periods are used (the standard error, even with the 1928-2011 data, is about 2.36%). Implicitly, no matter which of these numbers you decide to use, you are assuming that the equity risk premium for the US market has not changed in any material fashion over the last century and that they will revert back to historical norms sooner or later.  If I had to use a historical risk premium, I would go with the 4.10%, since it is long term, a compounded average and over a long term risk free rate. However, I am much more uncomfortable with the assumption of mean reversion in the US market than I used to be. since, in my view, the structural shifts that have come out of globalization have changed the rules of the game. As a consequence, I no longer use historical premiums in either valuation or corporate finance.
    3. Implied premium: Just as you can compute a yield to maturity (a forward looking value) for a bond, based upon the price you pay and the expected cash flows on the bond (coupons and face value), you can compute an expected return on stocks, based upon the price you pay and the expected cash flows on stocks (dividends and buybacks). On January 1, 2012, for instance, with the S&P 500 at 1257.60, I estimated an expected return on stocks of about 7.88%, which yielded an equity risk premium of 6.01% over the treasury bond rate of 1.87% on that day. It is true that this premium is a function of my assumptions about expected cash flows in the future, but there are two reasons why I trust it more than the historical premium. First, it is forward looking since it is based upon expected cash flows in the future. Second, there is real money backing up this number, since it is based on what investors are paying for stocks today (rather than what they are saying). Third, the error on your estimate (arising from your errors on expected cash flows) will be far lower than the standard error on a historical risk premium. Given the dynamic and shifting price of risk that characterizes markets today, I think it makes sense to compute and use an updated implied equity risk premium in valuation and corporate finance.
    The range of estimates we obtain for the equity risk premium from the different approaches is large but they should be judged based upon how well they perform in forecasting the future (both of equity risk premiums and actual stock returns)

    Looking at the correlations, the implied equity risk premium performs best, yielding the best predictor of not only next year's equity risk premium but also of actual returns on stocks over the next decade. The historical premium performs worst, often moving in the wrong direction.

    How is the equity risk premium related to risk premiums in other markets (bonds and real estate, for instance)? 
    In the corporate bond market, the price of risk is measured with the default spread, i.e., the difference between the yield to maturity on a risky bond and the risk free rate at the time. Even in the real estate market, the capitalization rate operates as a measure of expected return and the difference between that rate and the risk free rate is a measure of the risk premium in real estate. In the figure below, we graph all three numbers (the implied equity risk premium, the default spread on a Baa rated bond and the cap rate premium for the US from 1980 to 2011.

    Note that real estate behaves like a very different asset class in the 1980s, with the cap rate premium often in negative territory. This was the basis for the advice that many of us got in that period that investing in a house or real estate provided diversification benefits, especially if the bulk of our wealth was tied up in financial assets. Starting in the 1990s, real estate has begun to look more like a financial asset, a finding that hit home with many in the last few years, as housing prices collapsed just as stock prices and corporate bond prices declined. If these trend lines continue to hold, we may need to find a new asset class to get the benefits of diversification in the future.

    It is also worth noting that when the risk premiums in the three asset classes diverge, it is a sign that one market or the other is in a bubble. Note that in early 2000, the equity risk premium dropped to almost the level of the Baa default spread, reflecting the dot com bubble. In the 2004-207 period, default spreads and the cap rat premium plummeted, relative to the ERP, reflecting the housing and credit market bubble in that period.


    What is the "right" equity risk premium to use in corporate finance and valuation?
    So, what is the risk risk premium to use in today's markets? The answer depends upon what you are trying to do.
    1. If you are making a judgment on asset allocation, i.e., the percent of your wealth that you want to invest in equities, bonds, real estate or other asset classes, you can bring your point of view into play. Thus, if you feel that the current implied premium of 6% is too high (low) and will thus come down (go up), you should invest more (less) in equities than you normally would (given your age, cash flow needs and risk aversion).
    2. If you are valuing companies or assets, you generally should stick close to the current implied premium, notwithstanding your views in the asset allocation component. The reason is simple. Using an equity risk premium that is significantly different from the current implied premium brings in a market view into your valuation and thus confounds your final conclusion. To illustrate, if you use a 4% equity risk premium to value a stock in January 2012, you are effectively assuming that the S&P 500 is undervalued by about 25%. As a consequence, if you find your stock to be cheap, based on the 4% ERP, it is not clear whether you did so because the stock is in fact cheap or because of your market views.
    3. If you are a business, using the ERP to estimate your costs of equity and capital, you have a little more leeway. You can use an average implied equity risk premium over time (it has been about 5% over the last decade) in your estimation, built on the premise that there is mean reversion even in implied premiums and that your projects are long term.
    4. If you are a legislator or pension fund administrator, you also have some leeway. If you do not want your contributions to the fund to be volatile, you should use the average implied equity risk premium as well.
    Back to the Economist
    I like the Economist, as a news magazine and as a commentator on financial issues, but I think that this article does not quite hold together. First, it starts with a premise that I investors who look at historical data are getting an estimate of the premium that is too high and that a sustainable long term expected return on stocks should be a sum of the dividend yield and the expected long term growth in dividends (which would yield a lower value). Fundamentally, I don't disagree with that notion but I think that the use of the dividend yield is far too narrow a measure of cash flow. Incorporating the additional cash that firms are generating into the yield (either by adding in buybacks or computing a potential dividend) does provide a much higher expected return for stocks. Second, it implies that using a high risk premium is an aggressive assumption, i.e., it leads to investors paying more for stocks than they should, but the opposite is true. If you demand a higher return on stocks, you will pay less for them today, thus pushing down stock prices, making it the conservative assumption to use. In fact, if we take the article's suggestion and build in a lower equity risk premium, you would be be pushing up stock prices today dramatically. 

    As a general rule, I find that discussions about the equity risk premium are rife with misunderstanding about what it is, why it changes over time and how it affects investing/valuation. It would be far healthier for all concerned if analysts and investors were more explicit about why they use the equity risk premiums they do and what market views are at their basis. 



    Greg Smith on Goldman: An indictment of investment banking?

    Greg Smith, the Goldman VP who resigned with a searing indictment of Goldman Sachs in the New York Times, has created quite a commotion. Predictably, the responses, which are understandably heated, have fallen into two extremes. On the one side are those who are predisposed to believe the worst about investment bankers and view this as vindication for their view that investment bankers are shallow, self serving and greedy. On the other are defenders of investment banking, who argue that this article states the obvious (that investment bankers are focused on making money) and that Greg Smith is a failed, middle level banker, having a midlife crisis.

    I think I have the credentials to be on either side. On the one hand, many of my best and brightest students work at investment banks (including Goldman) and I teach training programs for both incoming analysts and associates at many of the investment banks. On the other hand, I have never been shy about critiquing investment banks for creating and marketing products that add little value or for providing self serving advice to some of their clients. In fact, I begin my corporate finance class with a clear statement that the class is not an "investment banking" corporate finance class but one that is structured around how businesses (who are the potential clients of investment banks) should make decisions. And I end the class, imploring students who do go into investment banking to preserve their options to abandon, if they find themselves unhappy with the grind or uncomfortable with the consequences of their actions.

    Given that I have skin on both sides of the game, I want to look at the most troubling contention in Smith's piece, which is that Goldman Sachs bankers cared little about their clients and spoke about them with contempt. (To be honest, I am not sure what to make of "muppets" as an insult... I have always liked Kermit and have nothing but respect for Miss Piggy's self reliance...) After all, it is one thing to be cast as a ruthless money machine (a critique that has often been leveled at Goldman) and an entirely different one to be accused of ripping off your clients.

    Do investment banks put their interests over the interests of their clients? I would not be surprised if they do, but before you are overcome by moral indignation, I would hasten to point out the following:
    1. The typical client of an investment bank is more likely to be a corporation, hedge fund or institutional investor than an individual. So what? These entities are not exactly shy about promoting their self interests and I will wager that, given a chance, they would not only exploit mistakes made by investment banks but also mistakes made by their own clients.
    2. The relationship between investment banks and their clients strikes me as mutually exploitative, and neither side can exist without the other's acquiescence. Let me use one example of the disfunction that is created as a consequence. There is strong evidence that many large M&A deals are value destructive for acquiring company's stockholders. While it is true the valuations from investment banks grease the wheels for these deals, it is also true that the managers of the acquiring firms are just as much to blame as investment bankers. Intent on spending stockholder money to gratify egos and build their corporate empires, these managers are less interested in honest advice from investment banks and more so in their deal-making prowess. In fact, I think that many corporations use investment banks as shields against having to take responsibility for bad decisions, with "It was not our fault, since the investment bank told us it was okay" becoming the post-failure refrain. 
    Has this always been true? It was perhaps less so, four decades ago, when investment banks were almost all partnerships and catered to clients who did not shop around and stayed with their in-house banks. Before you become too nostalgic for the old times, remember that this was just as ruthless a world, where new competition was squashed quickly and becoming an investment banker was difficult to do, if you were not born into the right family, had the right connections or went to the right school.  The "old rich" were just as greedy as the "new rich" but they did do a better job of maintaining appearances. 

    Rather than invoke the past or rail against the present, I would like to pinpoint at least three reasons why investment banks have become less client focused over time:

    1. Deal shopping: As Goldman gets excoriated for not being client focused, it is worth remembering that loyalty is a two-way street. In a world where clients play investment bankers off against each other, hoping to get the best deal for themselves, these same clients cannot point fingers at investment banks for playing the same game with them.
    2. Specialization: I do think that finance has become too specialized in both academia and practice, with experts and traders who know everything there is to know about narrower and narrower slices of finance or securitization. As a result, the people designing and trading new financial products/services have little sense of where these products fit into the larger scheme of things, and, as a consequence, when it makes sense to use them (or not use them).
    3. Compensation: I do not begrudge investment bankers their income or wealth, but I do think that investment banks have tied compensation too closely to deal making and trading success. By doing so, they have encouraged their employees to get the deal or trade done, often at a cost not only to clients but also to the investment banks in the longer term.
    So, in case investment banks are interested in my advice on how to be more client focused, here is what I would suggest:

    a. Hiring: Investment banks have always focused on hiring the best and the brightest and they should continue to do so. Some people, though, are better at seeing the big picture than others (think Magic Johnson on the basketball court or Joe Montana on the football field) and investment banks need to find more of these generalists to balance the specialists.

    b. Incentives/ Compensation: Tie incentives and compensation more closely to maintaining long term client relationships and getting good deals/trades done. I know that this will be more difficult to do than the existing system, but it will healthier.

    c. Clients/Customers: This may perhaps be the hardest part of the process, but investment bankers may need to be more picky about their customers, saying no to some, even at the expense of substantial profits. 

    Not practical, you say! Well, someone has to start the ball rolling and that someone has to profitable and powerful enough to set the trend. Wait! I do have a nominee! How about Goldman Sachs? This may be the perfect time for the firm to announce a revamp of hiring and compensation structures and see if others follow. 



    Apple: Thoughts on bias, value, excess cash and dividends

    Apple is hitting or is close to hitting two significant landmarks. Its market cap exceeded $ 500 billion yesterday (2/29) and its cash balance is at $ 100 billion. The twin news stories seem to have set investors, analysts and journalists on a feeding frenzy.  I think it is ironic that a company doing as well as Apple is right now, in terms of operations and stock price performance, is receiving this much unsolicited advice (split the stock, pay a dividend, buy back stock, do an acquisition, borrow money) on how it should fix itself. As we look at these prescriptions being offered to one of the healthiest companies in the market today, we should heed the Hippocratic oath, which is to do no harm.

    I am biased
    I have to start with a confession. It is impossible for me to be objective in my analysis of Apple and it is not just because the stock has done so well for me over the last decade. My first computer was a Mac 128K that I bought in the early 1980s and I have bought every Apple model since (even the ill fated Lisa and the not-so-great Powerbook Duo). Why should you care? One reason that the debate on Apple is so heated is that people have strong preconceptions about the company and those preconceptions drive their suggestions about what the company should do. As you read the rest of this assessment, you should recognize that my substantial positive bias towards Apple does affect my analysis. To structure my thoughts about what Apple should do, here is how I see the choices for the company:


    Is Apple's cash hurting its stockholders?
    The first and most critical question is whether Apple's cash holdings are doing harm to the stockholders. Let's dispense with the reasons that don't hold up to scrutiny:
    1. Cash earns a low rate of return: It is true that Apple's cash balance earns a very low rate of return. It is, after all, invested in treasury bills, commercial paper and other investments that are liquid and close to risk less. It earns less than 1% but that is all it should earn, given the nature of the investments made. Put differently, cash is a neutral investment that neither helps nor hurts investors.
    2. If that cash were paid out, investors in Apple could generate higher returns elsewhere: Perhaps, but only by investing in higher risk investments. Investors in Apple, who were concerned that Apple was investing so much in low return, low risk cash could have eliminated the problem, by buying the stock on margin. Borrowing roughly 20% of the stock price to buy Apple stock would have neutralized the cash balance effect and would have been a vastly more profitable strategy over the last decade than taking the cash out of Apple and searching for alternative investments.

    So, what could be defensible reasons for worrying about cash? Here are a few:
    1. The "low leverage" discount: The tax laws are tilted towards debt and Apple by accumulating $ 100 billion in cash, with no debt, is not utilizing debt's tax benefits.  In fact, the gargantuan cash balance gets in the way of even talking about the use of debt at the company; after all, why would you even consider borrowing at 2 or 3% interest rates, when you have that cash balance on hand?
    My assessment: By my computation, Apple's optimal debt ratio is about 40-50% (download the spreadsheet to check it out yourself) and its current net debt ratio is -20% (using the cash balance of $ 100 billion as negative net debt). Given the risk of the business that Apple operates in, I would not let the debt ratio go higher than 20-30%. Their cost of capital currently is about 9.5% and it could drop to about 9% with the use of debt. That would translate into a value increase of $20-25 billion for the company, not insignificant but that is about a 5% value increase.

    2. The naiveté discount: It is undeniable that legions of investors still use the short hand of a PE ratio, often estimated by looking at an industry average, applied to current or forward earnings to get a measure of whether a stock is cheap or expensive. In the process, they can significantly under value companies that have disproportionate amounts of cash. To see why, assume that the average trailing PE ratio for electronics/computer companies is 14 and that the average company in the sector has no cash. If you apply that PE ratio to Apple's net income or earnings per share, you are in effect applying it not only to the earnings from its operating assets (where it is merited) but also to its earnings from its cash balance (where you should be using a much higher PE ratio). Thus, you will come up with too low a value for Apple.
    My assessment: I would be more inclined to go along with this argument if Apple's stock price had dropped 50% over the last few years. I find it difficult to believe that after the run up that you have seen in Apple's stock price, stockholders are under valuing the company. The counter, of course, is that the PE ratio for Apple, at 16 times trailing earnings or 13-14 times forward earnings, seems low and may reflect a naiveté discount.

    3. The stupidity discount: In a post on Apple more than a year ago, I referred to what I called the stupidity discount, where stockholders discount cash in the hands of some companies because they worry about what the company might do with the cash. If investors are worried that the managers of a company will find a way to waste the cash (by taking bad investments, i.e., investments that earn less than the risk adjusted rate of return they should make), they will discount the cash.
    My assessment: My personal assessment in January 2011 was that, as an Apple stockholder (which I have been for more than a decade), the company had earned my trust and that I was okay with them holding my cash. I am open to a reassessment and I think any disagreement boil down to the answer to the following question: Do you believe that Apple's success and strategy over the last decade was attributable to Steve Jobs or Apple's management? If you believe it was Steve Jobs, you are now in uncharted territory, with Tim Cook, a capable man no doubt, but capable men (and women) have wasted cash at other high profile companies. If you believe that Apple's management team was responsible for its success over the period, your argument is that nothing has really changed and that you see no need to change your views on the cash.


    What if there is no discount?
    If the cash balance is not hurting Apple's stockholders right now, the pressure to return the cash immediately is relieved. However, you still have a follow up question to answer. Does Apple see a possibility that it could find productive uses for the cash? While Jobs never broached that question and preserved plausible deniability, I am afraid that Tim Cook has conceded on this issue, when he said last week that Apple had more "cash than we need to run the company".

    Bottom line: I am inclined to believe that Apple is not being punished right now for holding on to $100 billion in cash. However, I am more concerned than I was a year ago. While I had the conviction that Steve Jobs could never be pressured (by investors, portfolio managers or investment banks) to do something he did not want to do, I am not as sure about Tim Cook. Having seen how quickly markets can turn on high flying companies (Microsoft and Intel in the early part of the last decade come to mind), in the face of disappointment or a misstep, I am worried that Apple may be one misstep away from a discount being attached to cash. Given that even Tim Cook does not think that Apple needs this big a cash balance, I think that it is time that we ask the follow up question: what should Apple do with all this cash?

    What should Apple do with the cash?
    In the broadest sense, Apple can either invest the cash or return it to stockholders and it seems that even Apple does not believe in the first option. Investing the cash internally in more products and projects sounds like a great idea, given Apple's track record over the last decade. In 2011, for instance, the company generated a return on equity of 42% on its investments; if you net the cash out of book equity, the return on equity exceeds 100%. If Apple could invest the $100 billion in cash at 42%, that cash would be worth $350 billion, but put those dreams on hold, because it is not going to happen. First, that high return on equity can be traced back to the blockbuster products that Apple introduced in the last decade, the iPod, the iPhone and the iPad, and those are not easily replicable. Second, there are other constraints (people, technology, marketing, distribution, production) that essentially limit the number of internal projects that Apple can take.

    How about a few acquisitions? I am sure that there are willing and eager bankers who will find target companies for Apple. The sorry history of value destruction that has historically accompanied acquisitions of large publicly traded companies leads me to believe that this path of action will provide justification for those who attached a stupidity discount in the first place. So, to those who are counseling Apple to buy Yahoo!, Pandora, Linkedin or go bigger, please go away!

    If Apple cannot find internal projects of this magnitude and the odds are against value creation from acquisitions, the company has to return the cash to investors and there are three ways it can do this: initiate a regular dividend and tweak it over time, pay a large special dividend or buy back stock. In my view, there are four factors that come into play in making this choice:
    1. Urgency: A company with a large cash balance that has been targeted by an acquirer or activist investors has to return cash quickly, cutting out the regular dividend option. Apple's large market cap protects it from hostile takeovers and its stock price performance and profitability give it immunity from activist investors.
    2. Stockholder composition: When a company that has never paid a regular dividend initiates dividend payments, it attracts new investors, i.e., investors who need or like dividends, into the company. While this "investor expansion" has been used as an argument for regular dividends, I think it should actually be an argument against regular dividends. While some of my best friends are "dividend investors", I think that they are temperamentally and financially a bad fit for Apple, a immensely profitable company that also operates in a shifting, risky landscape. If Apple initiates a dividend, the demands for increases in those dividends in future years will come and the company will find itself locked into a dividend policy that it may or may not be able to afford. 
    3. Tax effects (for investors): The choice between dividends and stock buybacks is also affected by how investors in the company will be taxed as a result of the transaction. While both dividends and capital gains are still taxed at the same rate, that will change on January 1, 2013, when the tax rate on dividends reverts back to the ordinary tax rate (which could be 40% or higher). If Apple drags its feet into 2013, the choice becomes a simple one: buy back stock.
    4. Valuation of stock: Finally, there is the question of whether the stock in the company is under or over valued. A company, whose stock is over valued, should pay a special dividend since buying back  shares at the inflated price hurts the stockholders who remain after the buyback. While I am normally skeptical of the capacity of management to make judgments about the "fair" value of the stock, I decided to take my best shot at valuing Apple using an intrinsic valuation model. Using what I thought were reasonable assumptions (8% revenue growth for 5 years and a 30% target margin, both significantly lower than the numbers from recent years), I estimated a value of $716 $710 per share for Apple. You can download the spreadsheet that I used to make your own judgment. Once you have made your own estimates, please enter them in this shared Google spreadsheet. A buyback at the current price would provide a double whammy: a reduction in a "too large" cash balance and a buyback at a price lower than value. (Update: As many of you have rightly pointed out, a significant portion of the cash is trapped overseas and Apple will have to pay the differential tax rate (between the US marginal tax rate and the foreign tax rate already paid) when the cash is repatriated. I have added the trapped cash input into the excel spreadsheet and factored in the additional taxes.)
    Closing thoughts
    Apple should announce a substantial buy back, but it should use it do so on its terms. First, the buyback should leave Apple with enough of a cash balance (my guess is about $15-$20 billion) to invest in new businesses of products, should they open up. For the moment, I would avoid the debt route, even though Apple has debt capacity. Second, Apple should follow the Berkshire Hathaway rule book and set a cap on the buyback price. While Berkshire Hathaway's cap is set in terms of book value (less than 110% of book value), Apple should set its maximum as a function of earnings or cash flows (say, 16 times earnings). Third, Tim Cook should stop talking about whether Apple has too much cash and get back to business. Make the iPad 3 a success and lets see an iTV, an iAirline, a iUniversity and an iAutomobile (think of any product you use now that is badly designed or a  business that is badly run and think of how much better Apple could do...). Apple did not get to be the largest market cap company in the world by finessing its capital structure or optimizing dividend policy. It did so by taking great investments.




    Governments and Value III: Bribery, Corruption and other "Dark" Costs

    In this last post on the effects of government on valuations, I want to return to the value destructive effects that corruption, bribery and other "illegal" side-payments to government officials can have on value. In many countries, business people know that to keep doing business, they have to grease palms and provide “gratuities” to the gatekeepers of officialdom. A spate of news stories in the last few weeks should alert us all to the reality that the problem is not only still prevalent but that companies everywhere are exposed to its costs.
    1. In a reminder to natural resource companies that the countries where these resources are most abundantly found are often also the ones with the most corrupt government officials, Cobalt International Energy, an energy company backed by Goldman Sachs, saw $900 million of its value wiped out, after revelations that three powerful Angolan officials held concealed interests in the company.
    2. India is the second-largest telecom market in the world, with hundreds of millions of subscribers. The regulatory uncertainty that has always bedeviled companies competing in the sector was augmented to by a tainted telecom auction in 2008, which resulted in the resignation and arrests of a cabinet minister. The saga played out in the Indian Supreme Court's recent ruling taking away licenses awarded to eight companies in that auction; the fact that six of these eight companies were foreign suggested a nativist spin to corruption. Put in blunter terms, the ruling seemed to suggest that bribery of Indians by other Indians was par for the course, but bribery by foreign nationals was an abomination.
    3. Finally, from the other great growth story in Asia, China, came the story of Bo Xilai, a prominent member of the party elite, and his family: his wife, who is accused of murdering a British businessman, and a son, Bo Guagua, who goes to the Harvard's Kennedy School of Government, drives a Ferrari and has the lifestyle of a top notch capitalist. While the story is filled with the kinds of details that tabloid newspapers love, the real story that the Chinese government wants to keep a lid on is that Bo is not alone among government officials, in accumulating wealth out of proportion to his "income" as a government official.
    I am not an expert on corruption but here is what I see as the ingredients that allow it to flourish. First, for official gatekeepers to have power, you need gates: the more licenses, permissions or other official approvals you need to operate, the greater the potential for corruption. Second, it is a lot less risky being corrupt if you have political hegemony (whether it be of the dictatorial variety or one party rule), an ineffective legal system (making it impossible to challenge biased official acts) and an apathetic or controlled media (that either cannot or will not view corruption as a good news story). Third, the odds of corruption increase if the system is designed on the premise that corruption is the rule rather than the exception. Thus, setting the salaries of public employees at well below what the market would pay them, given their qualifications, on the assumption that they will augment these salaries with "side payments", will ensure that you will attract the "most corrupt" people into government and a continuation of the system.

    Rather than debate the basis of corruption and whether culture and history play a role, I want to first focus on “objective” measures of corruption . Transparency International, an organization that tracks corruption globally, releases an annual listing of corruption across the world. Just to provide a summary, the following is a list of the ten least corrupt and the ten most corrupt countries in the world, based on their ranking.
    Least corrupt countries in the worldMost corrupt countries in the world
    1. New Zealand1. Somalia
    2. Denmark2. North Korea
    3. Finland3. Myanmar
    4. Sweden4. Afghanistan
    5. Singapore5. Uzbekistan
    6. Norway6. Turkmenistan
    7. Netherlands7. Sudan
    8. Australia8. Iraq
    9. Switzerland9. Haiti
    10. Canada10. Venezuela
    Just for information, the United States came in as the 24th least corrupt country out of 182 countries, China was 75th and India was 95th on the list. While I am sure that there are countries where you and I may disagree with the rankings, there are clearly regions of the world where operating a business without "paying off" government officials is close to impossible.

    If you are valuing a company that operates in these dens of iniquity, how do you incorporate the costs of corruption into your value? Here are a three alternatives:
    1. Treat bribes as operating expenses: From a valuation perspective, it would be easiest to deal with bribes if they were out in the open and  treated as a separate line item in the expenses. So, in your operating expense breakdown, you could have a line item titled "Bribes and payments to corrupt officials" with the expense associated with it. Perhaps, we can then assess firms on the efficiency of their bribery and treat it as a competitive advantage for companies that are exceptionally good at getting results for their money. Unfortunately, even in countries where corruption is endemic, it remains "under the surface" and unreported.
    2. Treat corruption as an implicit (and unreported) tax: In the more likely scenario, where corruption exists but is not explicitly reported, it may make sense to consider the expenses associated with it as an implicit tax levied by the government. The fact that this tax revenue goes to the government officials and not to the taxpayers is deplorable, but that makes little difference to the company paying it. While this idea may seem farfetched, PWC did exactly this in an "opacity index" that they computed for dozens of countries and converted into tax rates. In 2001, for instance, they estimated the added cost of operating in China was the equivalent of facing an effective tax rate of 46%. Unfortunately, this listing is almost a decade old and while the opacity index itself has been updated by others, the effective tax rates no longer seem to be computed by country.
    3. Increase the cost of capital to cover "government" partners: When corruption occurs at the highest levels, you can argue that as a private business owner, you have "corrupt government officials" as partners who provide no capital but get a share of the income. Consequently, you have to generate a higher return on your capital invested to cover the cash outflows to your implicit partners. You can find interesting attempts to quantify this effect here and here.
    There are two complicating factors. The first is that the United States (among other countries) has laws on the books that forbid companies from paying bribes not only to US officials but to officials in other countries . As a consequence, the costs of bribery may be far greater than the actual expenditures incurred and include the penalties that these companies will be face, if the bribery is exposed. The second is that the "right connections in high places" in countries with extensive corruption is a significant competitive advantage in itself. Odious though we may find this proposition, the firms that understand how the system works (or who to pay and how much to pay to make it work) will generate excess returns and higher value than their more virtuous counterparts. 



    Governments and Value II: Subsidies and Value

    In my last post, I looked at the negative effects on equity value of the threat of government expropriation (nationalization). In this one, I want to focus on the more benign (and perhaps positive) impact that governments can have the values of some companies, through subsidies in one of many forms: providing or facilitating below-market rate financing, special tax benefits, revenues or price supports and even forcing competitors to provide direct benefits to a subsidized entity. Note that my intent in this post is not to examine the wisdom of these subsidies and whether governments should be tilting the playing field. While I do have strong views on the topic (and you can guess what they are from the subtext), I want to focus on the mechanics of how best to value businesses that benefit from these subsidies. This post was, in part, triggered by the recent news story on First Solar, where the company announced its intent to both scale back its operations and return a $30 million subsidy it had received from the German government.

    Subsidy Variants
    Governments, through the ages, have played favorites with businesses, either providing help to their preferred companies or, in some cases, handicapping their competition. Broadly speaking, there are at least four ways in which governments can try to benefit a subset of companies:

    1. "Low or no cost" financing:  The cost of borrowing (debt) for a company should reflect its default risk. In some cases, governments can step in the fray and either provide or facilitate "cheap" or "below market rate" financing, ranging from grants (effectively free financing) to low-interest rate loans (Airbus) to acting as a loan guarantor with banks (Tesla). The net effect is the same: the company is able to borrow more money at lower interest rates than it otherwise would have been able to, which, in turns, lowers its overall cost of financing its operations. You can argue that bailouts are a variant on this subsidy, insofar as it offers a financial lifeline to distressed (usually too-big-to-fail) firms that otherwise would have faced default.
    2. Tax holidays, credits and deductions:  The tax code has long been a favored device for the government to bestow benefits on chosen sectors or companies. In some cases, this can take the form of a lower tax rate on income (than the tax rate paid by other businesses) or a tax holiday, and in others it can take the form of more generous expensing and depreciation rules. Fossil fuel companies in the US, for instance,  have been allowed to expense a portion of exploration costs, granted tax credits amounting to 15% of investment costs related to enhanced oil recovery and gas pipelines can be depreciated over 15 years instead of 20 years. These benefits translate into higher after-tax cash flows (from paying less in taxes)  or timing benefits on tax savings (with expensing and depreciation breaks).
    A side note: One oft-used proxy of which businesses get subsidized the most is the difference between the effective tax rate paid by these businesses and the marginal tax rate. I report the average effective tax rates on my website, by sector. However, I think that the dominant factor driving effective tax rates now is not tax subsidization but foreign sales. The more revenues a company (or sector) generates from overseas (where corporate tax rates are lower), the lower the effective tax rate will be.
    3. Revenue or price support (Higher and more predictable revenues): In some cases, governments step in to both stabilize and increase revenues of businesses by providing price support to companies. For instance, the US government, among others, has provided price supports for some agricultural products, such as sugar. In other cases, governments benefit firms by handicapping foreign competition and imposing tariffs on imported goods. Sometimes, government can indirectly support revenues by providing the subsidies to the customers of preferred companies; an example would be credits offered to homeowners for using solar panels on their houses.
    4. Indirect subsidies: Rather than provide benefits directly to a company, the government can also force competitors to sustain the company by either paying a cash subsidy to the company or by buying its products at an arranged price. The Zero Emissions Vehicle Program, a California state mandate requiring that auto manufacturers failing to produce a certain number of zero emission vehicles buy credits from those who did, resulted in Tesla receiving millions of dollars in payments from other auto companies.

    Ways of dealing with subsidies
    There are two ways of dealing with subsidies. One is to build them into your discounted cash flow valuation inputs and let them flow into your estimated value. The other is to ignore subsidies in a DCF valuation and to value subsidies separately and add them on.

    1. Build into valuation 
    Each of the subsidies, described above, can be incorporated into a DCF valuation input:
    a. "Low cost" financing: Enter the subsidized cost of debt and/or the subsidized debt ratio into the cost of capital, which will yield a lower cost of capital and higher value. Thus, if a firm like Tesla that normally would not have been able to borrow money, since it is a risky, money losing company. and would have been all equity financed (say with a cost of equity of 11%) may be able to borrow a portion of its capital at a "low" interest rate (because of implicit or explicit government subsidization) and end up with a cost of capital of 10.8%.
    b. Tax holidays, credits and deductions: Subsidies that take the form of a tax holiday or special tax rate will lower the effective tax rate and increase after-tax cash flows. To the extent that the tax subsidized operations can be kept separate from non subsidized business, the company may be able to still get the full tax benefits of borrowing. More generous expensing and depreciation rules don't increase the nominal tax benefits across time but the value of the tax benefits will increase because they occur earlier in time.
    c. Revenue or price supports: These subsidies can show up in two places. First, the price support increases revenue to producers who can sell at the support price, which is higher than the market price. Second, to the extent that these subsidies make revenues more stable, they may reduce the operating risk in the business and increase value.
    d. Indirect subsidies: The transfer payments from competitors will boost revenues and cash flows and increase the value of the subsidy-receiving company.
    The advantage of this approach is that the subsidies then get baked into the valuation, with no need for post-valuation garnishing or augmentation. The disadvantage of this approach is that it is easy to forget that subsidies don't last forever and that the firm will eventually lose them, either because governments cannot afford them anymore or because the company loses its preferred status.
    If you do decide to go this route, keep in mind at least two issues. If you build subsidies into your DCF valuation, think through how long these subsidies will last. For instance, the "low cost" financing subsidy may cease to be one, if your company becomes a larger, more profitable entity. In addition, check to see what the value of the company would be, with no subsidies. In other words, break the company's value down into its operating value and its subsidy value.

    A valuation of Tesla
    To illustrate the process, let me try to value Tesla Motors, the electric car company founded by Elon Musk, one of the co-founders of Paypal. Tesla Motors got a subsidy from the US government, in the form of a Department of Energy loan facility that it utilized to borrow about $250 million in 2011, at an interest rate of 3%. (You can download my excel spreadsheets, with the valuations, if you want):
    Step 1: I valued Tesla Motors, with the subsidized financing. The company's borrowing gives it a debt ratio of about 10%, which with its subsidized interest rate, results in a cost of capital of about 10.8%. The valuation, where I do assume that Tesla's revenues will climb to about $ 5 billion in 10 years and that the pre-tax operating margin will converge on 12% (much higher than the average margin of 7% across automobile companies in 2011), yields a value per share of $10.40/share.
    Step 2: I valued Tesla Motors without the subsidized financing, by assuming that the firm would have to raise the debt at a market interest rate of 9% (instead of the 3% subsidized rate). The resulting value per share is $9.60.
    Step 3: The interest rate subsidy can be valued at $0.80/share, the difference between the valuation with the subsidy and the valuation without.
    This is the narrowest measure of the subsidy. If we expand the subsidization to include tax credits for future investments (reducing reinvestment needs for the future) and perhaps less risk (if the government supports revenues or requires competitors to pay Tesla), the value per share would increase (and so would the subsidy value). In this final valuation, I expand the Tesla valuation to include broader subsidies and generate a value per share of $18.17/share.

    2. Separate valuation
    In this approach, the discounted cash flow valuation is done with inputs that the firm would have had in a non-subsidized world, and the value of the subsidy is assessed separately. Thus, in the case of Tesla, you would value the company using the 12% cost of equity (or capital) that the firm would have had in a non-subsidized world, and then value the effect of the low cost financing separately. Thus, if Tesla is able to borrow money at a lower rate, as a result of the government support or backing, the savings each year from the subsidy amount to the difference between the market and the subsidized interest rates. Taking the present value of these savings over time should generate a value for the subsidy, which can then be added on to the value obtained using the non-subsidized cost of capital.
    While this approach requires more detailed information on the nature of the subsidy and what the firm would have looked like in its absence, it has two benefits:
    a. The analyst can value the subsidy for only the period that he or she thinks it will be offered and discount it at an appropriate rate. Thus, if Tesla has $250 million in debt at a 3% subsidized rate, when it should have been paying 9%, it is saving $15 million a year because of the subsidy (9% of 250 - 3% of 250). Assuming that the subsidy is likely to continue for only 10 years and that the only risk of not getting it is if Tesla defaults, the present value of $15 million a year for 10 years, discounted back at the unsubsidized cost  of debt of 9%, yields a value today of $96.26 million.
    b. If the subsidy from the government requires the company to offer something in return (build a manufacturing plant with higher cost labor), separating the effects of the subsidy from the valuation allows you to assess the costs and benefits of taking the subsidy. If the net benefit is negative, the company may be better off rejecting or returning the subsidy to the government.

    Implications for investing/valuation
    A company that gets significant subsidies from the government will have a higher value, in most cases, than one that does not. In some sectors, say green energy, the subsidies can account for a significant portion of the overall value of the firm (and its equity). As an investor, I have always been uncomfortable investing in these companies at prices that require the continuation of subsidies to justify the investments. Governments, especially in these times of budget constraints and sovereign defaults, are both fickle in their choice of favorites and unreliable subsidizers. Thus, if I can buy Tesla at a price that is less than its unsubsidized value, I will do so, and view the subsidies as icing on my investment cake. If, on the other hand, making money on Tesla requires me to count on the government's continuing indulgence, you can count me out. In this case, I am spared the choice, since Tesla at the prevailing stock price of $ 30 looks overvalued, even relative to the most generous subsidized value.



    Governments and Value: Part 1 - Nationalization Risk

    I have been writing about valuation for a long time and for much of that time period, I chose to ignore the effects, positive or negative, that governments can have on the value of businesses. Implicitly, I was assuming that governments could affect the value of a business only through the tax code and perhaps through regulatory rule changes (if you were a regulated firm), but that  a firm's value ultimately rested on its capacity to find a market for its products and generate profits from these products. The last five years have been a wake-up call to me that governments can and often do affect value in significant ways and that these effects are not restricted to emerging markets.

    The news story that brought this thought back to the forefront was from Argentina, where Cristina Fernandez, the president, announced that the Argentine government planned to nationalize YPF. The ripple effects were felt across the ocean in Spain, where Repsol, the majority owner of YPF, now stands to lose several billion dollars as a consequence. Not surpringly, the stock price of YPF, already down about 50% this year, plunged another 21% in New York trading. If you own YPF stock, my sympathies to you, but it is too late to reverse that mistake. However, there are general lessons that we can take away from this sorry episode about how best to incorporate the possibility of government capriciousness into what you pay for shares in a company.

    1. Intrinsic value and nationalization risk
    There are three components to intrinsic value: cash flows (reflecting the profitability of your business), growth (incorporating both the benefits of growth and the costs of delivering that growth) and risk. If you have to value a company in a country where nationalization risk is a clear and present danger, the obvious input that you may think of changing is the risk measure. After all, as investors, you face more risk to your investments in countries with capricious heads of state or governments, than in countries with governments that respect ownership rights (and have legal systems that back it up).
    There are three options that you can use to incorporate the effect of this risk on your value:


    Option 1- Use a "higher required return or discount rate": If you are using a discounted cash flow valuation, you could try to use a higher discount rate for companies that operate in Argentina, Venezuela or Russia, for instance, to reflect the higher risk that your ownership stake may be taken away from you for less-than-fair compensation. The problem that you will face is that discount rates are blunt instruments and that the risk and return models  are more attuned to capturing the risk that your earnings or cash flow estimates will be volatile than to reflecting discrete risk, i.e., risks like survival risk or nationalization risk that "truncate or end" your investment.


    Option 2: Reduce your "expected cash flows for risk of nationalization: You can reduce the expected cash flows that you will get from a company incorporated in a "nationalization-prone" market to reflect the risk that those cash flows will be expropriated. While this may be straight forward for the near term cash flows (say the first year or two), they will be much more difficult to do for the cash flows beyond that time period.

    Option 3: Deal with the nationalization risk separately from your valuation: Since it is so difficult to adjust discount rates and cash flows for nationalization risk (or any other discrete risk), here is my preferred option.
    Step 1: Value the company using conventional discounted cash flow models, with no increment in the discount rate or haircutting of the cash flows. The value that you get from the model will be your "going concern" value.
    Step 2: Bring in the concerns you have about nationalization into two numbers: a probability that the firm will be nationalized and the proceeds that you will get if you are nationalized.
    Value of operating assets = Value of assets from DCF (1 - Probability of nationalization) + Value of assets if nationalized (Probability of nationalization)

    To illustrate, consider Dominguez & Cia, a Venezuelan packaging company, which generated 117 million Venezuelan Bolivar (VEB) in operating income on revenues of 491 million VEB in 2010. A discounted cash flow valuation of the company generates a value of 483 million VEB for the operating assets. Assuming a 20% probability of nationalization and also assuming that the owners will be paid half of fair value, if nationalization occurs, here is what we obtain as the nationalization adjusted value:
    Nationalization adjusted value = 483 (.8) + (483*.5) (.2) = 435 million VEB
    Subtracting out the debt (291 million) and adding cash (68 million) yields a value for the equity of 212 million VEB. At its traded equity value of 211 million VEB, the stock looks fairly priced. If you download the valuation, you can see that I have incorporated the high operating risk (separate from nationalization risk) in Venezuela with a higher equity risk premium (12%) and the higher inflation/interest rates in Venezuela with a higher risk free rate of 20%. In particular, play with the nationalization probabilities and the consequences of nationalization to see how it plays out in your value per share.

    Note, though, that my 20% estimate of the probability of nationalization is a complete guess, in this case. If I were interested in investing in Venezuelan (Russian, Argentine) companies,  I would spend more of my time assessing Hugo Chavez's (Vlad Putin's, Cristina Fernandez's) proclivities and persuasions than on generating cash flow estimates for companies. Since my skill set does not lie in psychoanalysis, I am going to steer away from companies in these countries.

    2. Relative value and nationalization risk
    How would you bring in the concerns about nationalization, if you value companies based upon multiples? One is to use multiples extracted from the country in question, on the assumption that the market would have incorporated (correctly) the risk and cost of nationalization into these multiples. To an extent, this is reasonable and it is true that companies in countries with high nationalization risk trade at lower multiples.
    Note that while Russian and Venezuelan companies trade at a discount to their emerging market peers (and my guess is that Argentine companies will join them soon), you have no way of knowing whether the discount is a fair one.

    The problem, though,  becomes more acute when you are not able to find enough companies in the sector within that country to make your valuation judgment. With Dominguez & Cia, for instance, you have the only publicly traded packaging company operating in Venezuela. If you decide to go out of the market, say look at US packaging companies in 2011, the average EV/Operating income multiple is about 10.51 in January 2012. Applying this multiple to Dominguez's operating income would generate a value of  1230 million VEB, well above the market value of 211 million VEB. However, you have not incorporated the higher operating risk in Venezuela (separate from the nationalization risk) and the risk of nationalization.

    The bottom line with multiples is simple. If you do not control for nationalization risk, companies in countries which are exposed to this risk will often look absurdly cheap on a PE ratio or an EV/EBITDA basis. But looking cheap does not necessarily equate to being cheap..

    Implications
    While it is too late to incorporate the risk of nationalization in the value of YPF, you can adjust the estimated values of other Argentine companies. While the government of Argentina may argue that YPF was unique and that they would not extend the nationalization model to other companies, I would operate under the presumption of "fool me once, shame on you... fool me twice, shame on me" and incorporate a higher probability of bankruptcy into the valuation of every Argentine company. The net effect would be a drop in equity values across the board: that is the consequence of government action. There are other repercussions as well. A government that is cavalier about private ownership is likely to be just as cavalier about its financial obligations: no surprise then at the news that the default spreads for Argentina have surged after the YPF news.

    In closing
    While this post is about the "negative" effects of government intervention, it is possible that the potential for government intervention can push up the value of equity in other companies. In particular, the possibility that governments may "bail out" companies that are "too large or important to fail" may increase the value of equities in those companies as will the potential for government subsidies to "worthy" companies. I will come back to these questions in subsequent posts.

    Returning again to the Argentina story, Ms. Fernandez was quoted as saying, "I am a head of state, and not a hoodlum". Someone should remind her that the two are not mutual exclusive, and the problem may be that she is both.



    Google splits its stock and spits on its stockholders


    I have talked about Google in prior posts on its voting share structure and the increasing cost it is paying for maintaining growth. Well, the company had a big news day yesterday, starting with an impressive earnings report (earnings growth of 60% & revenue growth of 24%) and ending with an announcement that they would be splitting their stock, with a twist. I will focus on the stock split but use it to also make a couple of points about corporate control and earnings growth.

    Stock splits and stock dividends are empty gestures from an intrinsic value standpoint because they change none of the fundamentals of a company. The value of a business rests on its capacity to generate high returns (and cash flows) from existing investments, its potential for value creating growth and the risk in its operations. Splitting your stock (or its milder version, stock dividends) change the number of units in the company without affecting value. Thus, in a two for one stock split, you, as a stockholder, will end up with twice the number of shares, each trading at half the intrinsic value per share that they used to.
    The Google split: Google’s intrinsic value does not change as a result of the stock split. If you are interested, here is my estimate of the intrinsic value per share of Google,, pre-split. At $630/share, the stock look a little over valued (by about 10%). After a two for one stock split, they will still be over valued (by about 10%)... 

    There are two areas where stock splits or dividends can affect prices, either positively or negatively.
    a. Price level effects: By altering the price level, a stock split can affect trading dynamics and costs, and alter your stockholder composition. The “splits are good” argument goes as follows: when a stock trades at a high price (say $800/share),  small investors cannot trade the stock easily and your investor base becomes increasingly institutional. By splitting the stock (say ten for one), you reduce the price per share to $80/share and allow more individuals to buy the stock, thus expanding your stockholder base and perhaps increasing trading volume & liquidity.  The “splits are bad” argument is based upon transactions costs, with the bid-ask spread incorporated in these costs. At lower stock price levels, the total transactions costs may increase as a percent of the price. The effect has been examined extensively and there is some evidence, albeit contested, that the net effect of splits on liquidity is small but positive.
    The Google split: Since the split is a two for one split at a $650 stock price, there is not much ammunition for either side of the price level argument. At $325/share, Google will remain too expensive for some retail investors and the transactions costs and trading volume are unlikely to change much. As one of the largest market cap companies in the market, I don't think liquidity is the biggest problem facing Google stockholders.

    b. Perceptions: A stock split may change investor perceptions about future growth potential in both good and bad ways. The “splits are good” school argues that only companies that feel confident about future earnings growth will split their shares, and that stock splits are therefore good news. The “splits are bad” school counters that splits are empty gestures (and costless to imitate) and that companies resort to these distractions only because they have run out of tangible ways of showing growth or value added.
    The Google split: I would find it odd that a company that just reported good growth in earnings and dividends would use a stock split as a signal. In fact, I am looking forward to seeing the full filing. Perhaps, there is “bad” news hidden behind the healthy growth that Google does not want me to pay attention to.. Or, Google is looking down the road at the oncoming competition (from Facebook and its social media allies) and does not see good things happening. Or, maybe a split is sometimes just a split (with no information about the future)... 

    The twist in this stock split, i.e., that the shares that will be created in the split will have no voting rights, is the more intriguing part of the story. In talking about the rationale for the split, here is what Larry Page said:
    "We have protected Google from outside pressures and the temptation to sacrifice future opportunities to meet short-term demands." Talk about chutzpah! What outside pressure? And to do what? And what temptation is Page alluding to? Brin and Page think that you (as stockholders) are too immature to know what’s good for you in the long term, and they want to make these decisions for you.  I think it is absurd to make the argument that Google would somehow have been stymied in its long term decision making, if it did not have the shareholder structure that it has now. I will wager that there is not a single decision that Google has made over the last decade that they would not have been able to make with a more democratic share voting structure (one share, one vote). The difference is that they would have had to explain these decisions more fully, which is a healthy thing for any management in a publicly traded company to do. In fact, what the stock split signals (to me) is that Google is planning more controversial (and debatable) big decisions in the future and they do not want to either explain these decisions or put them up for a fair vote.

    As the Google model for control becomes the rule rather than the exception, at least in the technology sector, here are the three responses you can adopt to the "Googlers":
    a. Sit it out: If as a stockholder, you are becoming part owner (and partner to the current owners) of a business, I would not blame you, for refusing to buy stock in Google-like companies, because you are not being treated as a full partner. Consequently, you could decide to avoid being investors in any company that has a dual-class structure for voting. The problem, of course, is that you might end up with no investments in an entire sector (social media and young technology) that is the fastest growing segment of the market.

    b. Price it in: The logical response to the loss of control is to price it in, effectively discounting the price you pay for low-vote or no-vote shares, relative to full-vote shares. Conceptually, it is not difficult to do and I have a paper on how you can go about estimating the discount on non-voting shares: you have to build in the expectation and likelihood that managers will misbehave in the future, and that you will not be able to stop them.  In practice, though, investors often value low-vote shares  based upon recent management performance/behavior, paying too high a price when managers are behaving and performing well and pushing down the price too low, after managers disappoint them. 

    c. What, me worry? There are investors who argue that  owning shares, with or without voting rights, gives you little say in the management or corporate governance of most companies and that the dilution of voting rights should therefore have no effect on what you should pay. My response to this karmic view of corporate governance is two fold. First, the fact that you may not be able to change managers with your shareholding (because it is small) does not necessarily imply that stockholders collectively cannot make a difference; in fact, we know that they often do. Second, if you buy into this view, you have effectively lost the right to complain about your lack of say in decision making. Thus, for those institutional stockholders in Google who were quoted in the news stories yesterday as being disappointed that your counsel was not heard, I have little sympathy for you. Google and all of its imitators in the technology sector (with Facebook being the most prominent recent member of the “spit in your stockholder’s face club) have been clear about where control lies. Buying stock in Google or Facebook and then complaining about the autocratic tendencies of Page/Brin or Zuckerberg is like getting married to one of the Kardashian sisters and then complaining about your in-laws or loss of privacy. (Let's call this the Kardashian rule and codify it....)



    Emotions, Intrinsic value and Dividend Clienteles: The Apple trade postscript

    Now that I have read some of the reactions to my post on "folding" on Apple, I would like to respond to at least three issues that were raised in these responses. The first was that my sale of Apple seemed to be grounded more in emotional than in fundamental reasons. The second and related point was that the sale of the stock at a price that was below my own estimate of intrinsic value was not consistent with intrinsic value investing. The third was a more general question of whether or when I would return to the fold of Apple stockholders.

    1. The "emotional" trade
    To those who have charged me with being "emotional" on this trade, rather than "rational", I plead guilty, but I do think that I made clear in both my posts on Apple that I was incapable of being rational in my decisions on the stock. In fact, I will go further and argue that if the sale of Apple was partly driven by emotional factors, the original investment in Apple was also not entirely a "rational" one. It is difficult for those who have grown up with Apple as the dominant player in the smart phone and tablet market to visualize Apple as it was in early 1997: a company that seemed to have run out of ideas, with new products that no one wanted to buy, facing  a dominant player (Microsoft) that was threatening to eat them as a snack. I would love to tell you that I did an intrinsic valuation of Apple in 1997, saw the miraculous recovery in my crystal ball, and bought the stock but I did not. The truth is that I bought Apple for three reasons and the first two could only be classified as emotional.
    1. The first was the "pity" factor. I bought Apple stock because I felt sorry for the company and was perfectly willing to write off my investment in the stock as my charitable contribution for the year, if it did not make it. Having enjoyed its products for its lifetime, I felt I owed the company that much. 
    2. The second was the "protest vote" factor. I bought Apple in 1997 for the same reason that some Russians voted against Vlad Putin a few weeks ago in the Russian presidential election. While I saw little chance (then) that Apple would beat Microsoft, I wanted to go on record my opposition to what I saw as the Evil Empire. 
    3. The third and only financial reason for buying Apple in 1997 was that the optionality that I saw in Apple. At the time, notwithstanding its troubles some of the best design people in the world were still employed by Apple and the company still had the best operating system in the world (in my biased view). If they could get their act together, I felt that they could still find a way to get back to the big leagues. It was a deep out-of-the-money option and I was open to the possibility that it would never pay off. I am glad that it did, big time, but I would attribute it more to luck than my stock picking skills. After all, I have made similar option plays every year for the last 20 years and quite a few of them did what out of the money options tend to do: end up worth nothing. (My Eastman Kodak bet did not do so well...)

    Will the Apple trade change the way I invest?  I don't think so, but the lesson that I  take out of my experience is to pay more attention to the one option play I make each year. I have started my search for a company that has significant competitive advantages (that it has wasted) and is down on it luck (and price). Perhaps, I can find the next Apple in the debris...


    2. A betrayal of "intrinsic value" investing
    One puzzling aspect of my "sell decision" on Apple was the intrinsic valuation of the stock; at my estimate of $710/share, the stock continues to be under valued. Some of you took me to task for ignoring my intrinsic value and selling a stock at a price below that number, just because I am uncomfortable with the changing stockholder composition. I think your criticism is merited but you and I may disagree on the essence of intrinsic value. While we probably are in agreement that the intrinsic value of a firm is determined by its business acumen and operating decisions, I also believe that attracting the wrong type of stockholders to your company can reduce your intrinsic value. To back up my claim, let me start with two facts.

    (a) Companies vary widely on dividend policy
    Looking at 2011 data for US companies, for instance, here is what I see. Of the 5897 firms in my sample, 4435 paid no dividends and the distribution of dividend yields among companies that did pay dividends is captured below:
    The median dividend yield among companies that pay dividends is about 2% but there is wide variation in yields across companies. (With its proposed dividends, Apple would be in the 40th percentile of dividend paying stocks in terms of yield.)

    (b) Investors pick stocks based on dividend policy: Investors form dividend clienteles and buy stock in firms that have the "right" dividend policy. Thus, companies that pay no dividends tend to attract investors who care little about dividends, but have a much higher attraction for growth and price appreciation. Companies that pay high dividends attract dividend seeking investors who like price appreciation, but view dividends as the central to equity investing.  

    There is a link between where companies are in the life cycle and what they pay out in dividends, with young, growth companies that face uncertain earnings and high reinvestment needs paying no dividends and mature companies that can count on earnings paying much higher dividends. If the investor make up (in terms of dividend preference) matches the company make up (in terms of where it views itself as being in the life cycle), you have stability, where firms with different dividend policies can co-exist, with little or no punishment being meted out for paying too much or too little in dividends. Each company has its own dividend clientele and tailors its investment, financing and dividend policies to keep the clientele happy.

    There are three possible problem areas, where this stability can be put to the test:
    1. A company/clientele mismatch: You can get mismatches at both ends of the spectrum. A young, growth company that is held by "dividend seeking" stockholders will face unrealistic demands to pay dividends, even as it runs a cash flow deficit. At the other extreme, a mature company that is held by "growth seeking" stockholders will find itself under pressure to grow, when it has few growth opportunities. 
    2. A transitional company: Growth companies do transition to become mature companies and during that transition, the composition of their stockholders has to change as well. (In rare instances, you can have mature companies transition back to being growth companies...) In some cases, this change in stockholder composition happens gradually and relatively painlessly over time. In other cases, it can be tumultuous, but as the evidence of the transition mounts in the numbers (as declining growth rates, higher cash build up, more stable earnings), the "growth" seekers move on and leave the field to the "dividend" seekers.
    3. A mixed clientele: It is also possible that neither the company nor its stockholders is clear about whether the company is transitioning from one phase of the life cycle to another. In many ways, this is the most dangerous of the scenarios. It is made worse, if the evidence that comes out is contradictory (higher growth and more cash build up, at the same time) because each group sees in the evidence what it wants to see, forecasts out what it would like to see and pays a price based upon its view of the future. Eventually, a day of reckoning will arrive but neither group will give up without a fight.

    So, where is the link to intrinsic value? There may be none, if management is secure, resilient and makes the right calls for the company. The problem, though, is if management gets stampeded or panicked by a mismatched stockholder group into acting in ways that hurt the company's value. The managers of a mature company that is held by growth investors may seek to buy that growth at any price (by doing acquisitions or taking value destroying investments), thus lowering its intrinsic value. A company with a mixed clientele may try to keep all groups happy and reap the whirlwind. Remember Lucent, the company that AT&T created to house the research powerhouse that was Bell Labs, and then saddled with old Ma Bell stockholders who wanted Lucent to pay large dividends (a payout policy that was at war with its status as a technology company that was seeking growth). Lucent paid the dividends (to keep its dividend seeking stockholders happy), took its risky, growth investments (because it wanted to be a growth company) and paid for them with borrowed money, a toxic mix that ultimately devastated the company.

    So, what does this have to do with Apple? Apple's dividend announcement could represent one of three possibilities. The first and most benign one is that Apple's managers see less growth ahead and that they are readying the company for a transition to mature company status. That will undoubtedly be a harsh surprise to those growth stockholders in Apple who continue to see another decade of innovation and profitability like the last one, but they will move on. The second and more disquieting possibility is that Apple is unsure about whether it is a growth or a maturing company right now and wants to attract both groups of stockholders.  To keep both groups happy, Apple will have to go through contortions, lurching from growth-oriented actions (announce a new product) to cashflow-oriented ones (increasing dividends). The third and most damaging possibility is that Apple instituted dividends because it felt pressure to do so, from some analysts and institutional investors, and not because of its view of the future. Think about  it. If it bends so easily to pressure when things are going well, how will it react to the ratcheting up of demands that will inevitably come, if things start to go badly? 

    A battle between growth and dividend players in Apple would have had no effect on Apple three years ago, because Steve Jobs was immune from stockholder pressures (and that was both his strength and weakness). I don't see Tim Cook occupying the same position of strength. Thus, my concern is not that Apple will not react enough to investor demands but that it will become too reactive: acquiring companies it should not be (in response to the growth seekers demands), splitting its stock or increasing dividends (to keep the dividend seekers happy).

    3. A return to Apple
    It is possible (and maybe even likely) that I have over estimated the tensions between Apple's different stockholder groups and under estimated the resilience of Tim Cook and the current management team at Apple. The next few months will provide evidence on both fronts, as will Apple's reaction to its first big setback (which will come).  I will keep revisiting my intrinsic valuation, checking the price and looking at how Apple's management handles the pressure. I have a feeling that I will be a stockholder in Apple again one day, perhaps sooner rather than later. For the moment, though, I am in the strange position of not having any shares in Apple and being a recent addition to the  Microsoft stockholder base. I feel like I have lost my Jedi credentials and joined Darth Vader and Stormtroopers of the Empire!!!



    Apple: Know when to hold 'em, know when to fold 'em..

    In my last post on Apple, I made two confessions. The first was that I have loved the company’s products for almost three decades and am thus incapable of being unbiased in assessing value or marking judgments on its quality as a business. The other was that I am an Apple stockholder of long standing. At least one of these statements is no longer true, since I did sell my holdings of Apple in the last week. Since the issue of whether Apple is going to $1000/share or to $ 200/share still seems to actively debated, I wanted to explain why I chose to fold, rather than hold.

    Before I list my reasons for selling, it is important that I list the justifications that I will not offer:
    1. I don’t consider Apple to be over valued: I did not sell Apple because I consider it an overvalued stock. In fact, the discounted cash flow valuation that I had my last post, where I valued Apple at $710/share still holds. The only difference is that Apple, which was under valued by about 23% when I looked at it a few weeks ago (at $545/share) looks a little less under valued today (about 13% at $620/share). 
    2. I don't buy the signaling stories: In the weeks since my post, Apple did decide to return a modest portion of their mammoth cash balance to stockholders, partly in a stock buyback of $10 billion and partly in the form of a regular dividend of about $10/share (which works out to a dividend of about $ 10 billion at least for this year). There are some long time Apple watchers who have viewed these actions as signals that the company no longer has the investment opportunities that it did and thus as a negative. I don’t buy this signaling story. The rate at which cash has been accumulating in Apple is evidence aplenty that they don’t have enough investment opportunities to invest this cash in. Thus, their decision to return some of that cash reinforces what is already obvious. 
    So, why did I choose to sell Apple? It is because my fellow-stockholders in the company are making me a little nervous. As I look at Apple's current stockholders, here is what I see:
    1. Apple has become a momentum play: Much as I would like to believe that everyone who has been jumping on the Apple bandwagon in the last year is investing for the right reason, i.e.. because they see good value in the stock, Apple has become the ultimate momentum play. In effect, the biggest reason Apple’s stock price is going up now is because it has gone up in the recent past, not because of any news stories or information coming about about the company. Don’t get me wrong. Momentum is a powerful force in markets and I had a post on the power of momentum investing strategies. As an intrinsic value investor, though, it is not only not my cup of tea but it also delinks price from intrinsic value; put differently, I don't have a competitive edge in the momentum game. 
    2. Institutional favorite: Apple is now an institutional favorite, taking center place in almost every large institutional investor’s portfolio. Note that this is related to the first point, since institutional investors are creatures of momentum, buying stocks that have gone up and dumping stocks that have dropped. So, what is my problem with this? First, institutional investors are a fickle crowd, who can quickly turn on stocks that they love.... Second, as a contrarian, my instinct tells me that if institutional investors collectively think that a stock is good, it is time for me to reassess. 
    3. Mixed Dividend Clientele: Apple was a momentum stock and an institutional favorite the last time I posted as well.  For me, the tipping point was Apple’s decision to institute a dividend. Can they afford it? Of course, but I think it was a tactical error at two levels. First, it represents a break from its recent and mostly successful past. For  the last 15 years, Apple has been held by stockholders who were comfortable with its policy of no dividends and high quality growth, and were willing to claim their rewards in price appreciation. By paying a dividend, Apple has opened it doors to a “dividend seeking” clientele, who not only want to see dividends paid out but want to see growth in these dividends. In fact, many of the investors who are new to Apple stock in the last few months are from this group. The clash between what the “old price appreciation” stockholders in Apple think is best and what the “new dividend” stockholders is not significant at the moment, but it will rise to the surface when things don’t go well. We are a bad earnings report or a botched new product away from a full fledged battle between these groups, with Apple's managers in the middle. Second, in my earlier post, I noted  that it would be in Apple’s best interests to put this cash issue behind them decisively by announcing a shockingly large buyback and getting back to business. In many ways, what Apple has done (in announcing a small stock buyback and a dividend) will ensure that the cash question will be a major distraction for the long term. 
    Put in blunt terms, I am selling my Apple stock because I am worried about my fellow travelers in the stock. It is not that I have a problem with any of these groups individually, since I invest in other stocks where I co-exist with momentum investors, institutional investors, growth seeking investors or dividend seeking investors. In Apple, though, they are all in the mix, with different and contradictory views about what makes the company a good investment and what it should do, as a company, going forward. Each group is expecting its best case outcome: continuing price increases for the momentum group and institutional investors, high growth and a stream of new products for the price appreciation crowd and growing dividends for the dividend seekers. Perhaps, Apple can be all things to all these investors, but that is asking for a lot, and perhaps the impossible.

    I bought my Apple shares in April 1997 and I have the price appreciation (and a potential tax bill) to show for it. It has been a wonderful ride, but as the old country song would put it, I have to know "when to hold 'em, know when to fold 'em”, and my gut (strange thing for an intrinsic value guy to admit to..) tells me that it is time for me to move on. Could I regret this decision? I hope I do. Nothing would make me happier than see the stock goes to new heights and have Apple become the first trillion-dollar market cap company. I love the company and its products far more than I care about any bruising my ego and pocketbook may take.



    How much is growth worth?

    In my last post, I looked at the price being paid for growth by valuing the assets in place in a business. To make this judgment, I assumed that the business would pay its entire operating income to claim holders (as dividends to stockholders and interest expenses to lenders). The value of assets in place then becomes the value of the earnings in perpetuity, discounted back at the cost of capital.

    So, what is the effect of growth on value? To grow in the long term, you have to reinvest some or a big portion of your earnings back into the business, and the amount you have to reinvest will depend upon the return on capital you earn on your new investments:
    Reinvestment Rate = Expected Growth rate/ Return on Capital
    Thus, a firm with a return on capital of 15% that wants to grow 3% a year will have to reinvest 20% (= 3%/15%) of its operating income back each year. Investors will thus get less in cash flows up front but have higher cash flows in future years.

    Consider an example. A firm that generates $ 10 million in after-tax operating income, and has a cost of capital of 10%, will have a value of assets in place of $100 million, if it pursues a "no growth" policy:
    Value of assets in place = $10 million/ .10 = $100 million
    If it decides to pursue a 3% growth rate and invest 20% of its after-tax income (based upon the return on capital of 15%), its value can be computed as follows:
    Value of firm = 10 million (1-.20) / (.10-.03) = $114.28 million
    The difference between the two values then becomes the value added by growth:
    Value of growth = Value of firm – Value of assets in place = $114.28 - $100 = $14.28 million

    Determinants of the value of growth
                If you accept the proposition that growth creates a trade off of lower cash flows today for higher ones in the future, you have the three ingredients that determine the value of growth. The first is the level of growth, with higher growth rates in the future generating higher earnings over time. The second is how long these high growth rates can be sustained before the company becomes too big to keep growing (at least at rates higher than that of the economy). The third and most critical is the return on capital you generate on new investments.

    To see why the last ingredient is so critical, revisit the last example and make the return on capital = cost of capital. If you do so, the reinvestment rate has to be 30% to sustain the expected growth rate of 3%. The value of growth then becomes zero:
    Value of firm = 10 million (1-.30) / (.10-.03) = $100 million
    Value of growth = Value of firm – Value of assets in place = $100 - $100 = $ 0
    In fact, if the return on capital generated on new investments is less than the cost of capital, growth can destroy value.

    The process of valuing growth does get a little more complicated when you set higher growth rates, but the logic and conclusions do not change. If the return on capital > cost of capital, the value of growth will increase as the growth rate increases and the length of the growth period expands. If the return on capital = cost of capital, neither the growth rate nor the length of the growth period affect value and if the return on capital < cost of capital, the value will move inversely with the growth rate and the length of the growth period. If you want to take this concept out for a trial run, this spreadsheet can help you. 

    Comparing the value of growth to the price paid for growth
    If you are paying a price for growth, it is always useful to know the value of this growth. If you accept the reasoning in the last section, it follows that it is not growth that you should be paying a premium for but “quality growth”, with quality defined as the excess return you generate over and above the cost of capital. To illustrate this concept, we compute “intrinsic” PE ratios at varying growth rates for three firms, all of which share a cost of capital of 10% but vary in the returns on capital that they earn on new investments (one has a return on capital of 8%, the second has a return on capital of 10% and the third has a return on capital of 12%).
    The PE ratio for just the assets in place is 11.63 and remains unchanged, even if you introduce growth, for a firm that earns its cost of capital. For the firm that generates a return on capital < cost of capital, the PE ratio decreases as growth increases, reflecting value destruction in action. For a firm that generates a return on capital > cost of capital, the PE ratio does increase (the growth premium) as growth increases. It is this premium that you would compare to what you actually pay to make a judgment on whether the added PE you are paying for growth is justified.

    Price of Growth versus Value of Growth
    Using the spreadsheet on growth as a device for deconstructing growth (and its value), I looked at Microsoft, Kraft, Google and Linkedin. In the table below, I have listed my base assumptions for each company and the value of assets in place and expected growth in each one:

    This table can be used to address several issues relating to growth:
    a. Price of growth versus value of growth: You can compare the price you are paying for growth with the value of growth, and you come to different conclusions. For Microsoft, where the value of assets in place covers the market price you are paying, the value of growth is a pure bonus. For Kraft, the value of growth is negative, since the firm earns less than its cost of capital, and the price you are paying for growth is therefore too high. For Google, the price of growth is almost exactly equal to the value of growth, making it the only fair priced stock in this grouping. Finally, for Linkedin, the price paid for growth is more than twice the value of that growth, making the stock over valued. For investors who believe in growth at a reasonable price (GARP), this is the statistic worth watching.
    b. Implied growth rates: An alternative approach is to solve for that growth rate (Look at the spreadsheet and follow the instructions), holding the return on capital and length of growth period fixed, that would yield the price you paid for that growth. Linkedin, for instance, would have to maintain a compounded growth rate of 73% a year (instead of the estimated growth rate of 60% a year) for the next ten years to justify the price you are paying for the growth. (The spreadsheet provides instructions on how to back out the implied growth rate using the Goal seek function in Excel.)

    Growth, in summary, does not yield itself easily to rules of thumb or broad generalizations. In some firms, it can be worth nothing, as is argued by strict value investors, whereas in others, it can be worth a great deal, lending credence to the arguments of growth investors. 



    How much are you paying for growth?

    The debate about Facebook’s valuation is interesting on many dimensions, but one that is worth focusing on is how much growth is worth, and what you are paying for it. At one extreme are some value investors who argue that growth is “speculative” and that it is  worth very little or nothing. At the other are those who argue that growth is priceless and that you should therefore be willing to pay a “fortune” for it. Both groups seem to be in agreement that valuing growth is pointless, because it requires estimates that will be wrong in hindsight.  I had a series of posts on growth a few months ago looking at the limits of growth, the scaling up of growth, the value of growth and how management credibility affects that value. In this post, I offer a simple technique for assessing how much you are paying for growth in a company. In the next one, I address how to value that growth.

    Growth Assets and Assets in Place
    To provide a perspective on how growth and value interact, it is best to start with what I would call a financial balance sheet.

    While it is structured like an accounting balance sheet, it is different on two counts. First, rather than break assets down into fixed, current and financial assets, as accounting balance sheets do, assets are broken down into two categories: “assets in place”, representing the value of investments already made and “growth assets”, measuring the value added by expected future growth. Second, accounting balance sheets are rooted in the past, with numbers representing capital originally invested in assets, whereas financial balance sheets are forward looking, with the values of these assets being based on their capacity to generate cash flows or on market values.

    The value of assets in place
    To understand the price you are paying for growth, consider a simple experiment. A business that has existing assets that are generating earnings has two choices. It can pay the entire income out to claimholders (as dividends to stockholders and interest to lenders ) and forsake future growth. Alternatively, it can reinvest some (or all) of its earnings back into new investments and generate growth for the future. If you adopt the no growth alternative, your earnings from the most recent period will be your cash flow each year in perpetuity.  The value of these cash flows can be computed by discounting back at a cost of capital to yield a value for assets in place:
    Value of assets in place = After-tax Operating Income from most recent period/ Cost of capital
    Note that the depreciation & amortization from the most recent period is reinvested back into the business to keep its earnings power intact.

    There are only three estimation inputs that you need to derive this value. The first is the operating income. While it is convenient to use the operating income from the most resent year as the base value, you may choose to use an average over a few years for cyclical and commodity companies. The second is the tax rate. Again, while the effective tax rate is the easiest to access, you may decide to replace it with a marginal tax rate, if you feel that the company will revert to that rate over time. The third is the cost of capital. While you can compute the cost of capital for the firm in question, it may be far simpler to use the average cost of capital for the sector in which the firm operates. There is one variant worth considering. If you feel that the assets of the face obsolescence, you may decide to assume that the earnings from these assets will be available only for a finite period rather than forever. The equation for value of assets in place has to be modified to be an annuity, instead of a perpetuity.

    Price paid for growth: DCF
    Once you have derived a value for assets in place, you can estimate what you are paying for growth by looking at the traded value of the firm, computed as the enterprise value of the business (market value of equity plus debt minus cash). The difference between the traded enterprise value and the value of the assets in place can be considered the price paid for growth.

    In the table below, we look at four firms, Microsoft, Kraft, Google and Linkedin, to illustrate this concept.

    For each firm, we report the after-tax operating income and the cost of capital used to derive the value of the assets in place. By comparing this number to the enterprise value of the firm, we then compute, on a percent basis, the proportion of the price that goes towards growth.  What are we to make of these numbers? For Microsoft, you can justify the entire market value of the firm with the value of just assets in place.  For Kraft and Google, about 40% of the price paid is for expected future growth. For Linkedin, it is almost 99% of the value. Does the fact that Microsoft's entire value is justified by assets in place make it  a better investment than Linkedin? Not necessarily, since we have not valued growth explicitly and growth can destroy value. In my next post, I will look at the value of growth at each of these companies and consequences for investors who have paid much higher prices.

    Note that this entire analysis can also be done in purely equity terms, with net income divided by cost of equity to derive the growth value in equity in assets in place. If you do so, you can compare the market capitalization (rather than enterprise value) of the firm to the assets in place. The difference will be the price paid for growth.

    Price paid for growth: Relative valuation
    High growth companies often trade at high multiples of earnings, book value or revenues and the “premium’ is usually justified as the price for growth.  This premium can be in enterprise value multiples, such as EV/EBITDA, EV/Sales or EV/Invested capital:
    EV growth premium = Actual EV multiple - EV multiple for assets in place
    With Google, for instance, the EV/EBIT multiple for just assets in place can be computed to be 7.90, obtained by dividing the intrinsic value of assets in place ($92,761 million) by the operating income ($11,742 million). It's actual EV/EBIT multiple is 13.01, estimated by dividing the actual enterprise value of $152,784 million by the same operating income. The growth premium in the EV/EBIT multiple is therefore 5.11 (13.01- 7.90).

    The premium can also be stated in terms of price earnings ratios, as the difference between the PE ratio that you actually pay compared to the PE ratio that you would pay for just the assets in place.
    PE premium = Actual PE ratio - PE ratio for assets in place
    You can estimate the PE ratio for assets in place, either from the cost of equity directly (PE ratio for assets in place = 1/ Cost of equity) or by backing the equity value from the intrinsic value of assets in place (and subtracting out the debt and adding back cash). Using Google as an example again (with debt of $4,204 million, cash of $44,460 million and net income of $9,737 million):
    Intrinsic value of equity in assets in place = $ 92,761 - $4,204 + $ 44,460 = $132,818
    PE for assets in place = $132,818/ $9,737 = 13.64
    Actual PE = $192,840/$9,737 = 19.80
    Growth premium in PE = 19.80 - 13.64 = 6.26




    Facebook: Sowing the wind, reaping the whirlwind

            Last Thursday, about 24 hours prior to the initial public offering, I posted on what I thought would happen on the opening day. I argued that this was the most pre-priced IPO in history, with transactions in the private share market providing information on what investors would be willing to pay for the stock. That was the basis for my view that those expecting a large jump on the opening day were likely to be disappointed and that this would be the Goldilocks IPO, with a 10-15% bump at open. I also felt that the stock was overvalued by about a third and that what happened on the opening day would be revealing not just for Facebook, but for all social media companies. The stock did open up about 12% and faded very quickly to the offering price by the end of the day. In fact, without active support from the investment banks, it would have dropped below. In the last few days, the stock has cratered, declining to about $32 at the time of this post. Here are the lessons I am taking away from this process:

    Pricing versus Valuation
    Pricing is an exercise of gauging demand and supply, reading investor moods and determining what people will pay for an asset, rather than what it is worth. Valuation is about estimating what an asset is worth, given its earning potential, growth and risk. You can tell whether an investor or analyst is a “pricer” or “valuer” by looking at the tools that he or she uses. The tools of choice for most pricers are relative valuation (multiples such as PE or EV multipes), where you assess how much you will pay for an asset by looking at what others are paying for similar assets (usually other companies in the same business), and technical analysis (where you use charts and indicators to gauge shifts in demand). The tools of choice for “valuers” are either discounted cash flow (DCF) or accounting based (building off book value) models.

    A great deal of what passes for valuation in corporate board rooms, investment banks and portfolio management is pricing, not valuation, and the evidence is clear, especially with Facebook. In the weeks leading up to the IPO, an army of banks, led by Morgan Stanley, was working on setting an “offering” price for Facebook. While I am sure that there was an intrinsic valuation done somewhere along the way, I will also wager that it was done to preserve appearances and that it had little or nothing to do with the price that was eventually set. To set that price, my guess is that the banks used two variables: the prices at which investors were transacting in the private share market for Facebook (in the mid-40s) and the feedback that they were getting from institutional investors on how much they would be willing to pay for the stock. Much of the chatter about whether Facebook was a good buy or not was framed in terms of pricing, with the optimists arguing that it was a bargain because you were paying less per user than you were at other social media companies and the pessimists arguing that it was expensive because it was trading at a much higher multiple of earnings or revenues than Google or Apple. Any attempt at full-fledged valuation, where you confronted the uncertainty and attempted to make estimates, was viewed as an exercise in speculation and guesswork.  I also think that this is why the conspiracy theories, where Morgan Stanley fed inside information about future growth to institutional investors prior to the IPO and where the poor retail investors were the last ones to know, are misplaced. I am convinced that the growth rate and the prospects of the company were never key drivers in how this stock was priced and that if there is a story here, it is one of ineptitude and arrogance, rather than malice.

    Momentum is fragile and requires illusions
    Momentum is a strong force in markets but it is one that we don’t understand yet and don’t believe that we ever will. It is after all not only the basis for the madness of crowds and behavioral finance, but also of that most feared phenomenon in markets, the dreaded bubble. Not only is momentum driven by market moods and perceptions, but it is fragile and based ultimately upon an illusion. After all, most momentum investors don’t view themselves as such, and choose to rationalize their behavior using “fundamental’ factors. Thus, in the midst of every bubble, investors delude themselves that it is not a bubble by looking for a good reason: that tulip bulbs would become scarcer in the future, that dot com companies would dominate every business that the operated in and that the demand for real estate would always outstrip supply.

    In their ideal scenario, I am sure that the investment banks hoped that the momentum that they were detecting in the private share markets and in their conversations with institutional investors would continue into the opening day and the weeks after. So, what happened on the opening day? I believe that the momentum shifted and that the hubris of the company and the bankers in the days leading up to opening day contributed significantly to it happening. Rather than maintain the illusion that the offering price was justified by fundamentals, nebulous though they might have been, the parties involved seemed to completely abandon any illusions about value and made it a starkly momentum game. This was manifested in the hiking of the offering price to $ 38 on Thursday evening and in insiders in the company publicly bailing out at the offering price. Even the maddest of crowds, when constant confronted with proof that they are being viewed as suckers, will wake up, and to the dismay of the company and the banks, it happened an hour into the offering.

    What now?
    Much as I would like to believe that what has happened in the last couple of days to Facebook stock is a vindication of valuation, I am a realist. There is no fury that matches that of a disillusioned crowd and I believe that what you are seeing is momentum investors, who were promised quick riches if they bought Facebook stock, bailing out. Will they stop selling at fair value? Since they have no idea what it is, why should they? If momentum shifts in the past are any indicator, you should see the price of Facebook drop not just to its intrinsic value (you have mine, but yours may be different), but to below that value. Since the company is the poster-child for the “social media” sector, I think that you will see this momentum shift play out on other social media companies.

    Would I buy Facebook, Linkedin, Groupon or any other social media company? Social media is an umbrella under which you have diverse firms, some with more clearly defined business models than others and some with stronger barriers to entry than others, and when momentum shifts, investors tend not be discriminating. In the words of that eminent philosopher, Justin Bieber, you “never say never” and some of these stocks are likely to be bargains, sooner rather than later. If you are a value investor, you should be ready.



    Facebook and "Field of Dreams": Hoodies, Hubris and Hoopla

    In mid-February, I posted my valuation of Facebook and my thoughts on what would happen at the IPO. Since the actual offering date is tomorrow and the frenzy mounts, I thought it would make sense to revisit those posts.

    1. Valuation Update
    In my February 16 post on the company, I attached my valuation of the company, based on the S-1 filing as of that date. Quickly reprising that valuation, I valued the equity in the company at $29/share (assigning an overall value of about $72 billion for Facebook's equity), with the following key assumptions:
    a. Revenues growing to $44 billion in ten years, with a compounded revenue growth rate of 40% for the next 5 years, fading down over time
    b. A pre-tax operating margin of about 35%, higher than Google's 30% and on par with Apple
    c. Reinvestment (in internal projects and acquisitions) that generate a $1.50 in revenue for every dollar in capital.
    d. A cost of capital of 11.42% initially, fading down to 6.50% in steady state

    So, what have we learned about Facebook in the last three months that may change this valuation?
    a. Facebook wants growth and will pay for it: Facebook has acquired three companies in the last couple of months, Instagram, Tagtile and Glancee. While the Tagtile and Glancee deals were a continuation of a long term strategy of buying small firms with technologies that augment the Facebook experience, Instagram represented a new front: a "more" expensive acquisition of a company that brought with it potential "new users". My guess is that a publicly traded Facebook, with access to far more capital, will continue making acquisitions with the intent of delivering promised revenue growth and that the pace (and the size) of acquisitions will pick up if (or as) internal growth slackens. That is mixed news for investors: the good news is that it increases the odds that the predicted growth in revenues will be delivered but the bad news is that Facebook may pay more for this growth than anticipated.

    b. Mark Zuckerberg is lord and master of this company: While there has never been any doubt about the autocratic power structure at Facebook, the last three months have brought home that this is Zuckerberg's company. If news stories are to be believed, the decision to buy Instagram (at least at the final price) was made by Zuckerberg, with little input from the board. If you are going to be a stockholder in Facebook, you should get used to this scene being played out in small and big ways over the next few years.

    c. The "Field of Dreams" business model: Finally, Facebook's value still lies in its promise, rather than in actual numbers. Remember the line from the movie, "Field of Dreams", where Kevin Costner wanders through a corn field and hears a voice that tells him that "if you build it, he will come". With Facebook and other social media companies, this line can paraphrased as "if you get the users, they (products, advertising) will come". While I do not want too much of a single story, the news story of GM abandoning its Facebook advertising should provide a cautionary note to the optimistic view that Facebook can easily convert its monstrously large user base into advertising fodder.

    Bottom line: Revisiting the valuation, there is not a great deal I would change as a result of news over the last few weeks: a higher revenue growth rate (45% compounded with revenues growing to $ 56 billion) accompanied by lower margins (30%) and more reinvestment ($1.25 of revenues for every dollar invested) delivers an estimate of value that stays at the $70-$80 billion range. 

    2. Pricing (IPO) Update
    When I labeled this the "IPO of the century" in February, I was speaking tongue in cheek. After all, the century is young and there are other IPOs to come. While there is little that you will learn about the value of the company from the IPO process, there is a great deal that we can learn about human behavior and the ecosystem that feeds off big deals.

    a. The bankers will do anything to be part of a "big deal": As you track the news stories, it is quite clear that the bankers need the Facebook deal more than Facebook needs the bankers. In fact, I am quite surprised that Facebook did not follow the Google model and bypass the investment bankers entirely and set up an auction. I think that the only reason that they chose to follow the conventional route is because investment banks are essentially doing this deal at cut rate prices and bending to Facebook's will at every turn..

    b. And Mark Zuckerberg know it:  As someone who has never been comfortable wearing a tie or a suit, I must confess that I found the brouhaha over Zuckerberg's hoodie to be hilarious. I don't particularly care for Zuckerberg's corporate governance, but I, for one, have never believed that your professionalism is determined by what you wear. I am sure that Bruno Iskil, who lost billions for JP Morgan, wore a very expensive suit, while making his trades. I think Zuckerberg, in addition to mimicking one of his idols, Steve Jobs, was sending a message to Wall Street about who has the upper hand in this game.

    c. Investors are replaying an age-old phenomenon: Individual investors are clearly caught up in the mood of the moment, lining up to get allotments of Facebook shares. Is it a bubble? Who knows? If those who forget history are destined to repeat it, it sure looks like a replay of events from the past, and for those who do no remember them, I have a reading suggestion.

    d. The insiders: While I don't assume that insiders are infallible, it is telling that they are heading for the exits at the same time as individuals are piling in. Is it possible that they think that the stock is being priced at the top end of the value range? Do they not trust Mark Zuckerberg? Inquiring minds want to know and i guess we will find out as events unfold.

    Bottom line: I don't think that there has ever been an IPO where investment bankers have had more information (from private share market prices to institutional investor feedback) to work with, when pricing the stock, than this one. I would be very surprised, if the stock were overpriced; the bankers and the company have too much too lose. I would be equally surprised if the stock were dramatically under priced; a pop of 50% or even 25% would reflect very badly on the bankers' pricing skills. In short, this is shaping up to be a Goldilocks IPO, at least in the initial hours: a pop of about 10-15% (just right for both the bankers and the company). The question is how long the pop will last. This company is too big and too public to stage manage in the weeks after the IPO. If the pop fades quickly, perhaps even by the end of trading tomorrow, I think it is a very bad sign for the momentum game in all social media stocks. 

    3. Investment strategies
    So, what should investors do about Facebook? You can play the IPO game, and I have described some of the ways you could do it, in an earlier post.  Generically, here are the four strategies you can adopt:
    a. Short term buy: It may be too late for you to get in at the offering price, but if you believe in the short term momentum story, you can buy right as the market for Facebook opens tomorrow morning, hope to ride the crest of the price move up as other investors doing the same and exit before they do.
    b. Short term sell: If you think that the hype is overdone and that disappointment will set in very soon, you can sell short right after the market opens tomorrow, especially if it does not open with a significant pop, with the intent of covering in the next week or two.
    c. Long term buy: You may be a believer in Facebook's potential and its capacity to dominate the advertising market and to sell products to its users. If so, you should buy sometime in the near future and hold for the long term. How long will you have to wait to see profits? It depends on how quickly Facebook converts its potential to large revenues and profits... could be a year.. could be five..
    d. Long term sell:  If you do buy into my "Goldilocks IPO" scenario and come up with an estimate of intrinsic value close to mine, though, the investment with the best odds of success on Facebook would be a "long term, short" position on the stock.

    Bottom line: I think that the hype is overdone, that disappointment will set in sooner or later and that the stock has far more downside than upside. You can put me in the last group (long term sell) though I am still searching for the most efficient (and least costly) way to execute this. 

    4. Broader implications
    Does the Facebook IPO have broader implications for the overall equity market? I have heard arguments that a successful Facebook IPO will lead to a rebirth of faith in equities among investors and be a shot in the arm for financial service firms. I think that is nonsense.

    • If Facebook does launch successfully tomorrow and the stock price goes up 10%, 20% or even 30%, I don't see how it will cause risk averse investors to come back to stocks. In fact, it will probably feed into their suspicion that the stock market has become a casino that they cannot trust their savings in. 
    • As for investment banks, a successful Facebook IPO may bring in some fees and commissions but it will not be a reflection of their skills at pricing or deal making. This is a stock that priced and marketed itself, with little or no help from the investment bankers.
    In the same vein, a failed IPO (and I will leave you to define what failure means) will have implications for the pricing of social media companies but not much more.

    Bottom line: Facebook, in spite of its ubiquitous presence in our lives, is just one company and not a very big one (at least in terms of revenues and earnings) yet. The market will obsess about it tomorrow but it will move on very quickly to the next worry, fear or fad.  






    Lessons learned, unlearned and relearned: A semester of online class

    In January, I posted of my intent to put my valuation and corporate finance classes online. As I finished my last sessions in both classes today, I thought it would be a good time to take stock of what the experience taught me about the future of education and how online education can evolve.

    A quick review. I teach corporate finance and valuation classes to MBAs at the Stern School of Business at NYU and have done so for 26 years. While I have put my webcasts and material online for many years, I decided to both formalize and organize the online class this year, using a start up firm called Coursekit. It has since been able to attract more funds and has a new name, Lore.

    The site allowed me to place the resources for the class (lecture notes, assignments, handouts and exams) and the webcasts of the class in one place, together with a social media add-on where anyone (me or any student registered in the class) could post links, thoughts or questions about the class. Here are the links to the classes:
    Valuation: Link to Lore Valuation class
    Corporate Finance: Link to Lore Corporate Finance class

    I had a lot of fun, teaching these classes, and I am glad I did it, but I did get some valuable lessons in online learning.
    1. Discipline is critical on both sides. I had to learn to be disciplined and organized, posting lectures on the site, as soon as I had the links, as well as any other resources I used in my regular class. On the participant side, I recognized how difficult it is for someone (often several time zones away), with a regular job and family commitments, to spend 80 minutes twice a week, watching lectures and then spending more time preparing for the class. While I don't have the statistics, I am sure that of the 2500+ people signed up for the corporate finance class and the 1900 people in the valuation class, relatively few will finish the class on time (today) and that many will not finish the class at all.
    What I plan to do about it 
    (1) I plan to leave the class online for at least the summer and perhaps longer. Hopefully, that will allow those whose constraint is time to catch up on the lectures and even do the projects for the class.
    (2) I also plan to create a shorter (20 minute) version of each 80-minute lecture, delivering the high points of the session for those who really cannot spend the time needed for the full lecture.

    2. Diverse backgrounds/experiences: I know that some people struggled more than others, partly due to language differences and partly because of diverse backgrounds (some were more well versed in statistics and accounting than others). I feel badly for those who struggled and wish I could have done more to help.
    What I plan to do about it
    (1) I am looking for online resources that I can direct people who are in search of basic accounting/ statistics classes to. If I cannot find anything, I will attempt to create my own makeshift versions.
    (2) Next semester, I hope to rope in a  few people who have been gracious enough to offer their help and start a tutorial component to the class. Together, we may be able to fill the gap.

    3. Technology:  Technology is still evolving and that there were roadblocks, on both sides. On my side, there were at least two sessions in my corporate finance class where the recording system failed, and I had to make recordings to fill in. On the other side, those users who tried to watch the webcasts on Google Chrome were stymied (Don't even ask...) and some had trouble with bandwidth.
    What I plan to do about it
    (1) Fix the recording system at Stern so that there are no recording failures. Improve the audio and video quality.
    (2) Use more conduits for the lectures (iTunes U, YouTube) to allow those who have trouble downloading to be able to go elsewhere to get the material.

    In short, there is a great deal that I can do to make the online learning experience a richer, more interactive one, and I plan to keep working on it. For those of you who were and are part of this experiment, thank you for giving it a shot. For those of you who were disappointed in it, I am sorry and I will work on making it better.

    As a final point, for those who would rather take your classes in person, I am preparing for two executive valuation seminars that I will be delivering during the next month.
    a. The first is a two-day valuation seminar in Mumbai, India, on May 24 and 25. You can get details about the seminar by clicking here.
    b. The second is an open-enrollment three-day valuation seminar that I teach every year at the Stern School of Business in New York. This year, it will be on June 4, 5 and 6. While it is intense, I manage to cover almost all of the material that I teach in my regular MBA class (which lasts 14 weeks). You can get details about it by clicking here.




    Value Investing: Where is the beef?

    In my first post in this series on value investing, I noted that value investing is a broad brush that covers a range of different approaches, ranging from screening for cheap stocks to looking for bargains in the "loser" bin to being catalysts for change in poorly managed, mispriced companies. There is one characteristic that some value investors seem to share, which is that they are the grown-ups in the investing world, and that investors with different views of the world (a belief in momentum, hope for growth or that markets are efficient) are deluded. Implicit in this view is also the belief that value investors are the long term winners in markets, but is this a belief that is backed up by the evidence? Or as one of my favorite commercials of all time would put it:


    Does spending more time researching a company’s fundamentals generate higher returns for investors? More generally, does active value investing create value? A simple test of the payoff to the "active" component of value investing is to look at the returns earned by active value investors, relative to a passive value investment option. In the figure below, I compute the excess returns generated for all US mutual funds, classifed into small cap value, mid cap value and large cap value, relative to index funds for each category. Thus, the returns on small cap value mutual funds are compared to the returns on index fund of just small cap, value stocks (low price to book and low price to earnings stocks).

    While the average returns earned by small cap and large cap value funds did beat their respective indices over a 5 year period, the active value funds underperformed the indices in every other comparison, with small cap value funds delivering almost 2% less than the small cap value index over the last ten years. These results are not due to negative returns at a few really bad funds, either, since 55% of large cap value fund managers, 64% of mid cap value fund managers and 56% of small cap value fund managers  under performed their respective indices between 2002 and 2011. In fact, even over the 2007-2011 period (the most favorable period in the comparison), using the median return rather than the average return across value funds makes the excess returns negative. Lest you attribute this to the time period of the analysis, you can look at this study from 1992-2001 and this one from 1971 to 1991 to see that the findings apply over time.

    If you are an individual value investor, you may attribute this poor performance to the pressures that mutual funds managers operate under to deliver results quickly and their tendency to drift from their core philosophies, and argue that disciplined individual value investors do better. Since it is difficult to track the performance of individual investors, the question of whether individual value investors deliver better results than mutual funds has no clear empirical answer. However, there are some intriguing findings in the literature.
    1. In a study of the brokerage records of a large discount brokerage service between 1991 and 1996, Barber and Odean concluded that while the average individual investor under performed the S&P 500 by about 1% and that the degree of under performance increased with trading activity, the top-performing quartile outperformed the market by about 6%.
    2.  Another study of 16,668 individual trader accounts at a large discount brokerage house finds that the top 10 percent of traders in this group outperform the bottom 10 percent by about 8 percent per year over a long period.
    3. Studies of individual investors find that they generate relatively high returns when they invest in companies close to their homes compared to the stocks of distant companies, and that investors with more concentrated portfolios outperform those with more diversified portfolios.
    While none of these studies of individual investors classify superior investors by investment philosophy, the collective finding that these investors tend not to trade much and have concentrated portfolios can be viewed as evidence (albeit weak) that they are more likely to be value investors.

    Faced with this evidence, some value investors fall back on the old standby, which is that we should draw our cues from the most successful of the value investors, not the average (or the median). Arguing that value investing works because Warren Buffett and Seth Klarman have beaten the market is a sign of weaknesss, not strength. After all, every investment philosophy (including technical analysis and charting) has its winners and its losers. A more telling test would be to take the subset of value investors, who come closest to the meeting the purity standards of value investing, and see if they collectively beat the market. Have those investors who have read Ben Graham's investment tomes generated higher returns, relative to the market, than those who just watch CNBC? Do investors who trek to the Berkshire Hathaway annual meeting every year have superior track records to those who buy index funds?

    I don't think we will ever know the answers to those questions, but I am willing to hazard a guess. I don't think that value investors as a group, no matter how tightly that group is defined, beat the market. I also think that some value investors do beat the market consistently, and that their success cannot be attributed to luck. I would go further and argue that they share some common characteristics:
    1. Core investment philosophy:  A good value investor has a well thought through view of how markets work and how they correct themselves, honed not only through experience but backed up with empirical evidence. 
    2. Competitive edge: At the risk of repeating myself, you do need a competitive edge to succeed over the long term. Since that edge can no longer be access to data or analytical tools (both of which have been democratized), it may have to come from you having a longer time horizon, a lower need for liquidity or a different tax status than the typical investor. It could also come from your capacity to deal with information overload or use information across different markets (globally and in terms of asset classes) better than the typical investor.  
    3. Discipline: If there is a finding that studies have in common, it is that too much activity, even with the best of intentions and by the smartest of investors, is damaging to portfolio returns. Having the discipline to not deviate from your core philosophy (based upon whims or emotion) seems to be a key component in long term success.
    4. Lack of hubris: There is no reason why value investors cannot borrow and adapt pieces of momentum and growth investing or even from academia to augment their returns. To do so, they have to be open to the possibility that every investment philosophy has its strengths and weaknesses, and that no group of investors has a monopoly on investment virtue (and success).
    This is the last in a series of posts that I have on value investing. You can read the paper that I have on value investing (see link below) and I did make many of these points in a presentation (Warning: It is a little caustic...) in Omaha this year at a value investing conference, just before the Berkshire Hathaway meeting.
    The Value Investing Series



    Activist Value Investing: Be your own "change" agent

    My last two posts looked at two strains of value investing. In the first, passive screening, you look for mismatched companies that trade at low prices, while not being burdened with high risk, low growth or low quality growth. In the second, contrarian investing, you focus on companies whose stock prices have gone down the most, on the assumption that markets overreact to news and consequently have to adjust. While both approaches are backed up by empirical evidence, you still face a problem as. Without a catalyst in the market, causing the stock price to move to what you think is a "fair value", you can be right in your assessment of value, and go bankrupt being right. In activist value investing, you remedy that problem by acting as the agent of change in the companies you target, and thus have a bigger say in your investing destiny.

    Structuring the discussion
    To structure the discussion of activist value investing, let me begin be offering three measures of value for a publicly traded company: The first and most observable measure is the market price of the stock and the resultant market value of the company, set by demand and supply, and driven by the moods, perceptions and expectations of investors. The second is what I will term "status quo value", reflecting the intrinsic value of the company, run by its existing management team, with all of its strengths and weaknesses. The third is the "optimal value", capturing the intrinsic value of the same company, run by the "best" possible management team. To the extent that a firm is not being optimally run (and what firm ever is?), the optimal value will be higher than the intrinsic value. Unlike the market value, both the status quo and optimal value will require you to make subjective judgments and estimates, with all of the noise that comes with that process.

    There is one final factor to consider, and that is the likelihood that the existing management will change, either as a result of internal pressures (from stockholders and the board) or external ones (a hostile acquisition). The expected intrinsic value of this firm can then be written as:
    Expected Intrinsic Value = Optimal value (Probability of change in management) + Status Quo value (1 - Probability of change in management)
    While there are multiple factors that go into determining this probability, including the composition of stockholders, insider holdings and the existence of multiple share classes (with different voting rights), it is a convenient shorthand for the quality of corporate governance of the firm; good corporate governance should translate, other things remaining equal, into a higher probability of management change.

    Bringing it all together, here is the big picture of how the three measures play out in the real world:

    Both passive and contrarian value investing are focused on finding stocks that have a pricing gap, i.e., trade at a market price less than the expected value, though some strands of contrarian investing incorporate expectations of control changing (and the resulting increase in value). In contrast, activist value investing attempts to provide catalysts to close both the pricing gap and the value gap, by changing the probability of management change at companies (and thus increasing the expected value of the company) and getting the market to recognize its mistakes in pricing the stock.

    The expected value of control
    If you buy into this framework, to assess the value of control in a firm, you have to value it not once but twice, and be able to trace out the effects of changing the way a company is run into the value. Since we know the determinants of value, that is a relatively simple task. In the figure below, I list out the four determinants of the value of operating assets of a firm and the questions that give rise to potential value creation:


    In summary, there are three pathways to value creation.
    - Generate more cash flows from existing assets : You can manage your existing assets more efficiently and generate higher cash flows from those assets. To the extent that cost cutting and more efficient operations are not buzz words, this is the place where you will see the results.
    - More valuable growth: Since it is not growth, per se, that creates value, but growth with excess returns, a firm that is pursuing value destructive growth (by investing in assets that earn less than the cost of capital) can increase value by reinvesting less, whereas a firm that has lucrative investment opportunities (earn more than the cost of capital) can increase value by reinvesting more. The choices made on this dimension will affect dividend policy, since less (more) reinvestment will translate into more (less) cash available for return to stockholders.
    - Cost of funding: To the extent a firm can reduce its cost of capital by changing its financial mix (debt and equity), altering the debt it carries to better match its assets or reduces it operating risk can reduce cost of capital and increase value.
    If you are interested, I have an extended discussion of the expected value of control in this paper. I also have a simple spreadsheet that you can use to assess the status quo and optimal values for a firm. I have entered the numbers for Kraft Foods in here, and based on my assessments, Kraft Foods has a status quo value of $59 billion and an optimal value of $ 65 billion, leading to a value of control of about $ 6 billion.

    For an activist value investor to be a catalyst for value change, he or she has to first identify a firm that is poorly managed, relative to it's potential, and then has to follow up by figuring out what aspect of value creation offers the most promise in the identified firm. Cookbook restructuring, where the same remedy (borrow money, divest asset, pay dividends) is employed for every "troubled" firm, can easily destroy value at some firms. Finally, the investor has to try to alter the probability of management change. At the extreme, this can take the form of a "hostile acquisition", where the activist investor accumulates a majority stake in the company and puts in place a new management team. It can also take lesser forms, including proxy fights and forming coalitions with other investors to change the composition of the board of directors.

    The pricing gap
    Assume that you have what you feel is a reasonable assessment of the expected value of a firm, based upon your status quo and optimal values. Could the market price deviate from this value? Sure, and there are three possible reasons:
    a. Wrong side of momentum: As I have noted in earlier posts, market momentum can be a strong force, pushing prices away from fair value over extended periods. Thus, a stock that has fallen out of favor may see its stock price get pushed down well below its status quo value, as investors flee, and one that is in favor can see its stock price increase increase well above even its optimal value.
    b. Market mistakes: Even the firmest believer in efficient markets will concede that markets can make mistakes in assessing and incorporating information into prices. If that occurs, the price can deviate from value, in either direction.
    c. Market misunderstanding: Some companies are so complex in terms of organizational structure and business mix that even diligent investors may be unable to price them correctly. During periods of crisis, it is not uncommon for investors to reduce what they will pay for these assets, i.e., attach a complexity discount on value.

    As an individual investor, you or I have little chance of stopping momentum, getting the market to correct its mistakes or clearing up misunderstandings, but activist investors may be able to provide a counterweight to the market. First, they can bring enough resources to bear on the market to shift momentum. Second, the news that a well-known (and savvy) value investor has bought (or sold short) a stock may lead investors to reassess the price and remove or reduce market mistakes. Finally, activist value investors with enough heft may be able to get companies to remove some of the sources of market misunderstanding, pushing for (and getting) companies to spin off or divest non-core assets and increase accounting transparency.

    Activist value investing
    As the description should make clear, activist value investing requires significant resources (to acquire large stakes in publicly traded companies) and persistence (it takes time to get management to change its ways). By its very nature, it also requires concentrated portfolios, since you cannot contest managers at dozens of companies at the same time.

    Most institutional investors are ill suited for activist value investing, since they do not have the time horizon to wait for activism to pay off or the stomach to challenge incumbent managers. It is ironic, therefore, that some of the first attempts at activism in recent decades came from institutional investors like CALPERS, the California Public Employee Pension fund. While activist institutions remain the exception, there are still mutual funds (mostly small) that play the activist game. The early eighties also saw the coming to age of "corporate raiders", who targeted what they saw as bloated corporations and demanded change. That tradition remains alive in the individual activists such as Carl Icahn and Bill Ackmann, among others, who publicly target firms for change. Finally, the last two decades has seen some hedge funds and private equity investors (with KKR and Blackstone being leading examples) that have made activism the centerpiece of their investing strategy, often using leverage as their way of bridging the funding gap.

    While all three groups of activist investors start with the same core premise, i.e., that you can make money by targeting the right firms and acting as catalysts for change, they do vary on who they target, what they do at these targets and how much excess return they generate from their investments. In the table below, I summarize what studies of the three groups have uncovered on each of these dimensions:

    In summary, institutional investors have pushed primarily for changes in corporate governance and seen little payoff to their activism. Individual activists have targeted unprofitable, poor performing companies, agitated for deploying assets to more profitable uses and higher dividends, and the survivors have generated superior returns (though the unsuccessful ones drop out quickly). Hedge fund activists have behaved more like passive value investors in the companies that they target, often fail at getting companies to change and if there are excess returns on average, they accrue to a  few investors at the top of the pile.

    Strategies for the rest of us
    Given that most of us do not have the resources to be activist value investors on our own, is there a way to still make a play with this approach? Here are two alternatives:

    a. Follow the activists: You could invest in companies that have been targeted by activist investors and try to ride their coat tails to higher stock prices. Since the bulk of the excess returns are earned in the days before or on the announcement of activism, there is little to be gained in the short term by investing in a stock, after it has been targeted by activist investors. In the long term, you can perhaps make money by focusing on the right activists, looking for performance cues (improved operations) at the targeted firms and hoping for hostile acquisitions. Overall, though, a strategy of following activist investors is likely to yield modest returns, at best, because you will be getting the scraps from the table.

    b. Lead the activists: You can try to identify companies that are poorly managed and run, and thus most likely to be targeted by activist investors. In effect, you are screening firms for low returns on capital, low debt ratios and large cash balances, representing screens for potential value enhancement, and low insider holdings, aging CEOs, corporate scandals and/or shifts in voting rights operating as screens for the management change. The first part should be easy to do but the second part will be more challenging, requiring a mix of quantitative and qualitative assessments. To help on the first, I did a preliminary screening to arrive at a list of 25 companies that trade at less than 8 times EBITDA, have returns on capital <7.5%, book debt to capital ratios <10%, cash as % of value>10% and insider holdings <10%. The rest is up to you!




    Contrarian Value Investing - Going against the flow....

    Nokia came out with an awful earnings report yesterday, with warnings of more bad news to come, and its stock price, not surprisingly, plummeted.

    While investors are fleeing the stock and a ratings downgrade looms, is it a contrarian play? What about JP Morgan Chase? Or Research in Motion? Netflix or Green Mountain Coffee, anyone? By focusing on stocks that other investors are abandoning, contrarian value investing is the "anti-lemming" strategy, but it takes a unique personality and a strong stomach to pull off successfully.

    The basis for “contrarian” investing
    The core belief that underlies contrarian investing is that investors over react to both good and bad news, pushing prices up too much on the former and down on the latter. If you carry this view to its logical conclusion, it then follows that prices will reverse in both cases as investors come to their senses.

    While you may believe that investor overreaction is the norm, is there evidence to back up the claim? The statistical and the psychological evidence is mixed and contradictory. On the one hand, there is significant evidence that investors under react to news stories (earnings reports, dividend announcements), leading to momentum (and drift) in stock prices, at least over short periods. On the other, there is also evidence that investors over react to information, with price reversals occurring over longer periods. In behavioral finance, as well, there are two dueling "psychological" characteristics at play: the first is that of "conservatism", where individuals, faced with new evidence, update their prior beliefs (expectations) too little, thus creating under reaction, and the second is "representativeness", where individuals over adjust their predictions, based upon new information. To reconcile the co-existence of the two, you have to bring in two factors. One is time, with under reaction dominating the short term (days, weeks, even months) and over reaction showing up in the long term (years). The other is the magnitude of the new information, with over reaction being more common after big events. 

    Contrarian investing strategies
    Within the construct of contrarian investing, there are at least four variants. In the first,  you invest in the stocks that have gone down the most over a recent period, making no attempt to be a discriminating buyer. In the second, you focus on sectors or markets that have been hard hit and try to identify individual companies in these groups that have been "undeservedly" punished. In the third, you look at companies that have taken hard hits to their market value but that you believe have underlying strengths which will help them make it back to the market's good graces. In the final approach, you buy stock in beaten up companies with the same intent (and expectations) that you have when buying deep out of the money options. You know that you will lose much of the time but when you do win, your payoff will be dramatic.

    1. The Biggest Losers

    If you believe that investors tend to over react to events and information, the effects of that over reaction are most likely to be seen in extreme price movements, both up and down. Thus, stocks that have gone down the most over a period are likely to be under valued and stocks that have gone up the most over a period are likely to be over valued. It follows, therefore, that if you sell short the former and buy the latter, you should be able to gain as the over reaction fades and stock prices revert back to more "normal" levels.

    In a study in 1985, DeBondt and Thaler constructed a winner portfolio, composed of the 35 stocks which had gone up the most over the prior year, and a loser portfolio that included the 35 stocks which had gone down the most over the prior year, each year from 1933 to 1978. They examined returns on these portfolios for the sixty months following the creation of the portfolio and the results are summarized in the figure below:
    An investor who bought the 35 biggest losers over the previous year and held for five years would have generated a cumulative abnormal return of approximately 30% over the market and about 40% relative to an investor who bought the winner portfolio.

    Looks good, right? Before you rush out and load up on the biggest losers of the last year, a few notes of caution:
    1. Watch out for transactions costs:  There is evidence that loser portfolios are more likely to contain low priced stocks (selling for less than $5), which generate higher transactions costs and are also more likely to offer heavily skewed returns, i.e., the excess returns come from a few stocks making phenomenal returns rather than from consistent performance.
    2. Timing is everything:   Studies also seem to find loser portfolios created every December earn significantly higher returns than portfolios created every June. This suggests an interaction between this strategy and tax loss selling by investors. Since stocks that have gone down the most are likely to be sold towards the end of each tax year (which ends in December for most individuals) by investors, their prices may be pushed down by the tax loss selling.
    3. Time horizon matters: In a test of how sensitive the results were to holding period, Jegadeesh and Titman tracked the difference between winner and loser portfolios by the number of months that you held the portfolios and their findings are summarized in the figure below.  There are two interesting findings in this graph. The first is that the winner portfolio actually outperforms the loser portfolio in the first 12 months. The second is that while loser stocks start gaining ground on winning stocks after 12 months, it took them 28 months in the 1941-64 time period to get ahead of them and the loser portfolio does not start outperforming the winner portfolio even with a 36-month time horizon in the 1965-89 time period. 

    If you feel that, in spite of these caveats, this strategy may work for you, you can take a look at a list of the 50 companies that have gone down the most (in percentage terms) over the last 52 weeks (June 2011-June 2012). I have added a stock price constraint (to ensure that you don't end up with low-priced stocks) and reported the dollar trading volume per day (as a red flag for trading costs).  I have compiled the list for the US (with price>$5), Europe (with price>$5), Emerging Asia (with price>$1), Latin America (with price>$1) and global (with price>$5). Your timing is off (since it is not January) but you can still browse for bargains. You can also adapt the screening plus strategy that I talked about in my post on passive screening and subject the companies on these lists to follow up analysis (intrinsic valuation or qualitative assessments)>

    2. Collateral Damage
    It is not uncommon for markets to turn negative on an entire sector or market at the same time. In some cases, this is justified: a big news story that affects an entire sector, or a macro economic risk that hurts a market. In others, it may represent either an over reaction by investors to the idiosyncratic problems of an individual company in a sector or a failure to consider that companies within a market/sector may have different exposures to a given macroeconomic risk. As an example of the former, consider how banking stocks were punished on the day that JP Morgan Chase reported its big trading loss. As an illustration of the latter, you can look at the Spanish stock market, where investors have punished all companies (though some are less exposed to Spanish country risk than others) over the last year.

    About a decade ago, I penned a paper on measuring company risk exposure to country risk that argued that we (as investors) were being sloppy in the way we assessed exposure to country risk, using the country of incorporation as the basis for measuring risk exposure. With this view of the world, US and German companies are not exposed to emerging market risk, an absurd argument when applied to companies like Coca Cola and Siemens that derive a large chunk of their revenues from emerging or risky economies. By the same token, all Brazilian companies are equally exposed to country risk, though some (such as the aircraft manufacturer, Embraer) derive most of their revenues from developed markets. This laziness in assessing country risk does provide opportunities for perceptive investors during crises. This was the case when Brazilian markets went into a tailspin in 2002, faced with the feat that Lula, then the socialist candidate, leading in the polls, would win election to lead the country. As Embraer fell along with the rest of the Brazilian market, you could have bought it at a "bargain basement" price. If you are interested in following this path, here is my suggestion. Start putting together a list of companies like Embraer, i.e., emerging market companies that have a significant global presence and then wait for a crisis in the emerging market in question. When there is one (it is not a question of whether, but when....), and your "global" company drops with the rest of the market, you are well positioned to take advantage.

    It is trickier, though, playing this game within a sector. Consider the JP Morgan Chase case. While the trading loss was clearly specific to JPM, you could argue that the event affected the values of all banks at two levels. The first is by increasing the chance that the Volcker rule, barring proprietary trading at banks, would be adopted, it affects future profitability at all banks. The second is the fear that in response to the loss, the regulatory authorities would require higher capital ratios be maintained at all banks. If those are your concerns, you should focus on banks that do not make have a large proprietary trading presence and are well capitalized. If investors have over reacted across the board, those banks should be trading at attractive prices.

     3. Comeback Bet
    When stock prices drop precipitously for an individual stock, there is usually a reason. If the drop reflects long term, intractable problems, there may be no reversal. If the drop reflects temporary or fixable problems, you are more likely to see prices reverse. As you look at the reasons for the price drop, you should keep in mind your overriding objective, which is to find a company whose price has dropped disproportionately, relative to its  value.

    Here are some possible reasons for a stock price collapse, with the ingredients for a comeback:
    a. Unmet expectations: When expectations are set too high or at unrealistic levels, it is inevitable that investors will be confronted with reality not matching up to expectations. When that happens, they will abandon the stock, causing stock prices to drop. (Netflix and Green Mountain Coffee, both of which make the list of biggest losers over the last year are good examples of what happens to high flyers when they disappoint...)
    Ingredients for a comeback: Expectations have dropped not just to realistic levels but below those levels. Investors have over adjusted.
    b. Corporate governance issues: Events that lay bare failures of managers and oversight by the board of directors shake investor faith and, by extension, stock prices. A case in point would be Chesapeake Energy, where the CEO, Aubrey McLendon, stepped down after evidence surfaced that the board of directors had allowed him to use $800 million in personal loans to acquire stakes in company-operated oil wells.
    Ingredients for a comeback: (a) A new CEO from outside the firm, (b) with a full cleaning out of management team and revamping of board of directors, and (c) an activist investor presence.
    c. Accounting fraud/ manipulation: As investors, we start with the presumption that financial statements, while reflecting accounting judgments that may work in the company's favor, are for the most part true. Any suggestion of accounting fraud can lead to a meltdown in the stock price, not to mention open the company up to legal jeopardy.
    Ingredients for a comeback: (a) Full reporting of all accounting misstatements, with (b) removal of top management, and (c) no legal jeopardy.
    d. Operating/Structural problems: Operating problems can range from problems with a key product (see Dendreon, on the list of biggest losers last year) to deeper structural problems, where the company's products just don't match up well to consumer demands or to the competition.
    Ingredients for a comeback: (a) Management that is not in denial about operating problems and (b) a realistic plan for dealing with operating problems.
    e. Financial problems: When operating problems combine with significant debt burdens, you have the seeds of distress, which can spiral very quickly out of control, as suppliers, employees and customers react pushing the company deeper into trouble.
    Ingredients for a comeback: (a) A clear debt restructuring/repayment plan, (b) Solid operating performance.

    Whatever the reason or reasons for a price collapse, investors have to follow up by asking and answering three questions:
    1. Is "it" a one-time or continuing problem? While the line between one-time and continuing can be a shade of grey, the answer is critical. One time problems tend to have much smaller impact on value than continuing problems, and are easier to deal with and move on.
    2. How fixable is the problem? Some problems are more easily fixable than others. In making this judgment, you should look at three factors. The first is whether the problem is entirely an internal problem or whether it is partly or mostly due to outside or macro factors. Internal problems are easier to remedy than external ones. The second is whether the solution can be "quick" or will take "time". Thus, a firm with significant debt may be able to restructure that debt quickly, whereas a firm that has deep-rooted structural problems will need more time. The third is whether the managers of the firm seem to have both a reading of the problem and a solution in hand.
    3. Is the market decline disproportionately large? To make this assessment, you have to work through the consequences of the problem for the determinants of value: its effect on current cash flows, the expected value of growth (both the level and the quality) and the risk in future cash flows.

    Using this framework, let's look at JP Morgan Chase. At first sight, it looks like a slam dunk. The trading loss was reported to be $2 billion at the first announcement and it seems like a fixable problem in the short term, with better risk management in place. The fact that the market capitalization went down by more than $30 billion on the announcement of the loss seems to suggest an over reaction, but there is more to this story than meets the eye. The first is that the trading loss of $ 2 billion is an estimate and the actual losses may be higher (the rumor mill suggests that they could exceed $5 billion). The second is that the loss will reduce the current regulatory capital and may increase the target regulatory capital ratio that JP Morgan aspires to reach over time; the combination of a lower current capital ratio and an increasing target capital ratio will translate into lower returns on equity, going forwards, and lower cash flows available to stockholders in the future (in the form of dividends or buybacks). To make a judgment on whether the stock is a bargain at the current price, I used a simple test. The price to book ratio for a mature bank can be written as:
    Price to book ratio = (ROE - Expected growth)/ (Cost of equity - Expected growth)
    Conservatively, if you assume a growth rate of 1.5% in perpetuity and a cost of equity of 9% (about 1% higher than the cost of equity for an average risk company), the return on equity implied at the JPM's current price to book ratio of 0.73 is about 7%:
    0.73 = (ROE - 1.5%)/ (9%-1.5%)
    Implied ROE = 6.98%
    The ROE in the most recent year for JPM, prior to its loss, was 10.34%. Even allowing for higher regulatory capital requirements (which will increase book equity) and lower profits (perhaps from the Volcker rule), the adjustment seems like an over reaction.  I know that there are other fears hanging over large banks, but I have a spreadsheet that I think contains a a conservative valuation of JPM that yields a value of about $46/share, well above the current stock price of $35. You can use it to make your own judgments for JPM or any other bank.

    4. "Long odds" option
    There is one final scenario: a company whose stock price has collapsed, with good reason and where a turnaround is neither anticipated nor expected. In other words, the stock looks fairly priced, given its prospects and problems today. However, let's assume that the firm has proprietary assets is in a risky business, where technology shifts could make today's winners into tomorrow's losers and vice versa. You could consider investing in this company's shares, for the same reasons that you buy an out of the money option.

    In effect, you are leveraging the fact that equity in a publicly traded company has a floor of zero and that your losses are therefore restricted to the prevailing market value of equity. For your option (equity investment) to have a big payoff, though, you will need  the value of the firm's assets to increase significantly from existing levels (because of a new product, market shift or an eager acquirer) and that will require that your firm have a proprietary technology/product/license and operate in a  shifting, risky business. While the value of the assets could drop just as precipitously, you care less about downside because you don't have much to lose (since your equity value is so low).

    Nokia (NOK) and Research in Motion (RIM) come to mind as potential option plays. They both have proprietary technologies and patents (though the market does not think that either technology looks like a potential winner in the market today) and operate in a risky business where the landscape can shift dramatically over night. While the Blackberry technology is a more reliable cash provider for RIM, there are three factors that tip me towards Nokia. The first is Nokia's stock price has dropped far more than RIM's over a shorter period, reducing the cost of my option. The second is that Nokia's debt burden is a mixed blessing: it could cut my option game short, if Nokia defaults, but it also leverages any upside in value. Small changes in Nokia's asset value will translate into big changes in equity value. The third is that the turmoil in the Euro zone adds to the value of my option. Put differently, I like Nokia because it is riskier than RIM, but risk is my ally, not my enemy, with an option. If you plan to invest in Nokia, do so with the full recognition that you may have to write off the entire investment a few months or years from now, but if the stars align, watch out!!!


    The Value Investing Series



    Passive Value investing: Screening for bargains

    As long as there have been markets, I am sure that investors have used screens to find good investments. It was Ben Graham, however, who systematized the process in his books on investing, by laying out the ten criteria (screens) that could be used to find cheap stocks. 
    1. An earnings to price yield > Twice the AAA bond rate (At the AAA bond rate of about 3.6% today, that would work out to an earnings to price ratio > 7.2% or a PE< 14)
    2. PE ratio today < 40% of the highest PE ratio for the stock over the previous 5 years
    3. Dividend yield > 2/3 or the AAA bond yield (At today's AAA rate, yield >2.4%)
    4. Stock price < 2/3 (Tangible book value of equity per share), where tangible book value of equity = Total book value of equity - Book value of intangible assets
    5. Stock price < 2/3 (Net Current Asset Value), where Net Current Asset Value = Current Assets - (Total Liabilities + Preferred Stock)
    6. Total debt < Book Value of equity
    7. Current ratio > 2, where current ratio = Current Assets/ Current liabilities
    8. Total Debt < 2 (Net Current Asset Value)
    9. Earnings growth in prior 10 years > 7%
    10. No more that two years in the prior ten, where earnings declined more than 5%.
    While we can debate the efficacy of these screens (I, for one, find that the fixation on net current asset value is too restrictive), it is quite clear what Graham was looking for: cheap companies with low leverage & stable and growing earnings, with liquid assets acting as a backstop and providing a margin of safety for investors.

    Do screens work?
    Graham had three pricing screens among his ten criteria: PE ratios, a modified version of price to book ratios and dividend yields. In the decades since, studies (many from academics but quite a few from practitioners as well) have found  that at least two of these screens seem to work, at least on paper. Stocks that trade at low PE ratios and low PBV ratios deliver returns that beat the market, on a risk adjusted basis.

    Let's start by reviewing the evidence. Rather than quote from studies that are at different points in time, I used the raw data (maintained very generously by Ken French at Dartmouth) to compute the differential returns that stocks, in the lowest and highest deciles of PE, PBV ratio and the  dividend yield, earned on an annual basis between 1952 and 2010, relative to the overall market:

    Note that low (high) PE and low (high) PBV stocks have beaten (under performed) the market by healthy margins, before adjusting for risk, over time but that there is no discernible pattern with dividend yields. In fact, over the period, non-dividend paying stocks beat both the highest dividend yield and lowest dividend yield deciles in terms of returns earned. You can find more on past studies by going to my paper on value investing.

    So, what's the catch?
    When it looks like you can make money easily, there is always a catch. Here are the three caveats on the "excess returns" that a low PE, low PBV strategy seems to deliver.
    1. Time horizon matters: The returns are in the long term (five years and longer) and there are time periods (some lasting for years) where the strategies under perform the market. For instance, looking across the entire period, for instance, it looks like while low PE stocks dominate high PE stocks over long periods, the latter group outperforms during periods of low economic growth (where growth becomes scarce).
    2. A proxy for risk? While I did not adjust for risk in my computation for excess returns, most of the studies that have looked at these screens have controlled for risk, using conventional risk and return measures (betas, Sharpe ratio etc.). It is possible that there are other risks in buying these stocks that may not be full reflected in these risk measures. For instance, some stocks that trade at low price to book value ratios have high debt burdens and run a higher risk of default/distress.
    3. Transactions costs & taxes: A lot of strategies that make money on paper perform badly in practice because they expose investors to higher transactions costs and taxes. For instance, many of the stocks in the lowest PE ratio decile are lightly traded companies, with high bid-ask spreads and potential for price impact. Similarly, investing in high dividend yield stocks may expose investors to higher taxes.
    In a testimonial to how difficult it is to convert paper profits to real profits, it is worth noting that the James Rea's attempts to put Graham's principles into practice in an investment fund that he ran from 1982 to the late 1990s was an abject failure, with the fund ranking in the bottom 20% of the fund universe in performance. In a similar vein, Value Line's attempts to convert its screens (that also worked exceptionally well on paper) into a mutual fund also failed.

    Incorporating screens into investing
    If you do buy into the effectiveness of screens at finding cheap stocks, there are two ways to incorporate screens into your investing.
    a. Bludgeon Screening: In this approach, all of the work in picking stocks is done by your screens. Thus, you start with a large universe of stocks and screen your way (using either more screens or tighter screens) down to a portfolio size (in terms of number of companies) that you are comfortable with.
    b. Screening plus: You use the screens to narrow the universe of stocks (which may contain thousands of stocks) to a more manageable number, but you then follow up using one of these approaches:
    • Screening plus intrinsic valuation: You value each of the screened stocks using an intrinsic valuation model (a discounted cash flow model, excess return model or your own variant) and invest in the most under valued companies. You can also incorporate a margin of safety into this approach by only investing in stocks that trade at 30%,40% or 50% discounts on your intrinsic value.
    • Screening plus qualitative analysis: Once you have the screened list, you may be able to apply qualitative criteria that you think separate winners from losers (moats, good management etc.) to find the stocks for your portfolio.
    A blueprint for screening
    In Graham's day, screening was an arduous process, with limited access to the financial statements of companies and no computing power. Today, screening has become easy with many sites offering stock screeners for all, sometimes at no cost: Yahoo! Finance, Google Finance and MarketWatch all offer simple screening tools. In fact, it has become so easy that investors sometimes get carried away, piling on redundant screens on top of each other and sometimes undercutting their effectiveness by doing so.

    Before you start, be clear about your objective
    You want to find a mismatched company, i.e, a company that is priced low, with none of the reasons for being priced low (high risk, low growth, low quality of growth). In other words, you want a stock trading at a low multiple, with low risk, high growth rates and high quality growth. What chance do you have of finding such a bargain? It may be low, but there is no harm looking.

    Step 1 - Screen for price
    The first step is to screen for low . With stocks, this will almost always require that you scale the market price to a common variable (revenues, earnings, book value etc.) to estimate a multiple. Here are your choices:


    In making these choices, you have to be consistent. If your numerator is an equity value (market capitalization, stock price), your denominator should also be an equity value (net income, earnings per share, book value of equity). If your numerator is an enterprise or overall business value (enterprise value, value of firm), your denominator should be an overall firm number (operating income, EBITDA, revenues, book value of invested capital). Should you use an equity multiple or an enterprise value multiple? In some sectors, such as financial services, you have no choice but to use equity, since defining debt is close to impossible. In others, you have a choice, and here is my simple rule. If financial leverage varies widely across the sector (some firms have more debt than others), I would go with an enterprise value multiple. For comparisons across the entire market, enterprise value multiples tend to be more robust.

    Once you have picked a multiple, you then have to choose your screening thresholds. In practical terms, you have to decide how low does a stock's pricing multiple has to be to qualify for your cheap list. There are three ways to find this threshold.
    a. You can use the rules of thumb that seem to be so widely prevalent: an EV/EBITDA less than 6 is cheap, a PE ratio in the single digits is low etc. While these rules of thumb may have made sense when first devised, it is doubtful that they make sense today.
    b. You can derive the "cheap" threshold from intrinsic valuation models. To illustrate, the PE ratio for a firm that pays its entire earnings out as dividends and has no growth should be as follows:
    Intrinsic "cheap" PE threshold = 1/ Cost of equity
    In June 2012, when the cost of equity was computed to be about 8%, the threshold for a "cheap" company would be 12.5 (=1/.08).
    c. You can derive the threshold by looking at the distribution of the values of the multiple across your sample, using the lowest decile (or lowest quartile) as your cutoff for "low". The table below lists the deciles for key multiples for US companies in January 2012:
    Thus, looking for stocks with a PE less than 5 would give you stocks in the lowest decile whereas using a cut off of 10 for the PE would give you stocks in the top quartile, at least in early 2012.

    Step 2 - Screen for risk
    Companies that are very risky can look cheap, without being cheap. To screen for risk, consider first a breakdown of risk into three categories:
    (a) Operating risk, reflecting the risk that your revenues and costs can shift over time, as the market and the sector evolve.
    (b) Financial risk, coming from the use of debt, leases and other fixed commitments that can make your residual stake as the equity investor much more volatile.
    (c) Liquidity risk, that you face as as investor when trading on the stock, manifested as trading costs (bid ask spreads, price impact) and inability to trade at the extreme.

    The screens for risk can broadly be categorized as follows:
    1. Price based screens: While many value investors express disdain for betas, there are other price based screens that are based upon prices (standard deviation, volatility in the stock price) that they may still be willing to use as measures of composite risk. In fact, you can use screen for liquidity risk, using market data, by looking at the bid-ask spread or the trading volume/float in a stock.
    2. Accounting based screens: Accounting statements can provide snapshots of risk, though they are stronger in measuring some types of risk than others. You can measure exposure to financial risk fairly well, using ratios that measure the capacity to make interest or debt payments (interest coverage, fixed charge coverage ratios), operating risk less well (variability in earnings over time) and liquidity risk not at all.
    3. Risk proxies: While this may be applying a broad brush, you may use the sector a firm is in as a proxy for risk; thus technology companies may be viewed as risky companies and utilities as safe companies. Alternatively, you may believe that large companies (measured in market capitalization or revenues) are safer than small companies.
    4. Sector specific screens: If you are screening for cheap stocks within a sector, you may use measures of risk that are specific to the sector. Among bank stocks, for instance, you may look at regulatory capital ratios or exposure to problem assets/businesses; banks with lower regulatory capital or greater exposure to toxic assets are riskier. 
    As with the multiples, you can see the quartiles of the distribution for these variables for US stocks in January 2012 in the table below:


    Step 3- Screen for growth
    If you are a value investor who views growth as icing on the cake, you may not look for  high expected earnings growth but you may still want to screen for companies with moderate growth prospects or at least try to avoid companies with negative earnings growth. In screening for growth, you should stay true to the consistency principle, focusing on growth in equity earnings, if you are using an equity multiple (like PE) or growth in operating earnings, if you are using an enterprise value multiple and you would rather be forward looking in your growth estimates (using expected future growth, if available) rather than backward looking (historical growth). The quartiles of growth measures for US stocks in January 2012 is in the table below:

    Step 4 - Screen for quality of growth 
    If you are employing a growth screen, you also want to ensure that the firm is not spending too much to deliver that growth. To screen for quality of growth, you can employ one of two approaches:
    a. Accounting return measures: Dividing the accounting earnings by accounting book value gives you a measure of accounting returns:
    Return on equity = Net Income/ Book value of equity
    Return on invested capital = Operating income/ (Book value of equity + debt - cash)
    While they are aggregate measures for the whole firm and accounting earnings/ book value are susceptible to accounting manipulation, you want firms that are able to earn high returns on their growth investments in your portfolio. At the minimum, the returns should exceed the costs (the cost of equity, if ROE, and the cost of capital, if ROIC).
    b. Sector specific measures: You can also measure efficiency of growth using sector specific measures, such as profit margins (net or operating) in retail, capital invested per subscriber (in cable or other subscriber-based businesses) or capital invested per kWh of power produced (for power companies).
    The quartiles for ROE, ROIC, net and operating margin for US companies in January 2012 are reported in the table below:


    Step 5: Rinse and repeat
    Once you run your screens, check the stocks that come through the screens for two potential problems. The first is sample size. If your screens return only a handful of stocks, your screens have been set too tight and you should consider relaxing one or more of your screens (settling for lower growth or higher risk). The second is sector concentration. If you end up with stocks that are in one or a couple of sectors, you may want to consider modifying or adding to your screens to get more diverse portfolios.

    While you can screen for free at Yahoo! Finance and Google Finance, you get far more flexibility in defining your own screens if you have access to a database. For US companies, you can try Value Line or Morningstar, both of which provide real time data for the entire universe of traded stocks and are not unreasonably priced. For screening of stocks outside the US, you can use Capital IQ, Factset or Bloomberg, but the price tag gets higher. There are some innovative sites out there that are offering better screening tools and large databases, such as RobotDough, a site that combines an impressive database with powerful screening tools, AAII and Zacks (which has a combination of free and premium screens).

    Odds of success
    I have always believed that, as an investor, you need to bring something unique to the table to be able to take something away in terms of excess returns. In other words, just as  we look at competitive moats for successful businesses, you have to think about your competitive moats as an investor. With screening, consider the competitive advantages that Ben Graham saw for the intelligent investor in 1951, when he put together his classic screen list. The first was access. With limited access to financial statements and no easy-to-use tools, only a few tenacious investors could use these screens. The second was discipline. Investors had to stay away from distractions and fads and stay true to those stocks that made it through the screens. The third was patience. Investors had to hold the screened stocks in the long term to generate the promised returns. Today, with widespread access to data and analysis tools , the first advantage has dissipated, leaving behind patience and discipline as your potential advantages. It can be argued that an automated screening/investing process, with no human input, is less likely to succumb to emotion than the most disciplined, patient human being. Put more bluntly, if all you have to offer as an active investor is screens, you are unlikely to beat a machine doing the same. With screening plus, whether you make money depends on the quality of what you do after you screen. If you are skilled at intrinsic valuation or qualitative assessment, you may generate excess returns, relative to the market.

    In closing
    To illustrate the screening process, I used Capital IQ data and used two sets of screens to arrive at a list of "cheap" stocks from a universe of 7542 publicly traded companies in the US.
    Equity screen: Low PE (<10.11, in bottom quartile), above-average expected EPS growth rate (>13.50%, above median), below-average book debt to equity ratios (<27.21%, in bottom quartile), high ROE (>13.60%,top quartile)    --> See the  19 stocks that made it through these screens
    Enterprise value screen: Low EV/EBITDA (<4.51, bottom quartile), above-average expected revenue growth (>7%, above median), below-average book debt equity ratio (<27.21%, below median), above-average ROIC (>9.41%, top quartile)   --> See the 13 stocks that made it through these screens
    I would not be rushing out to buy all of the stocks on either list, but I think it is worth following through and doing intrinsic valuations of these companies. Anyone up for it? If so, you are welcome to use my generic valuation spreadsheet.

    The Value Investing Series
    Where is the value in value investing? (Downloadable paper on value investing)
    Blog post 1: Value Investing: An Identity Crisis?
    Blog post 2: Value Investing I: Screening for bargains



    Value Investing: An Identity Crisis?

    Any post about value investing always evokes strong responses, but I thought I would start this one by turning the focus inwards. So, here are a few questions for you :
    1. Would you classify yourself as a "value investor"?
    a. Yes
    b. No

    2. If yes, what makes you a value investor?
    a. I try to estimate the value of a stock before I invest in it
    b. I only buy stocks that trade at attractive multiples (low PE, low PBV etc.)
    c. I do my homework, looking at the fundamentals, before I invest
    d. I don't know. I just am.

    3. Finally, do you think that value investors collectively do better than other investors in the market?
    a. Yes
    b. No
    c. Not Sure
    If yes, what is the source of their advantage? If not, why do you think they fail?

    • On the first question, I would not be surprised if the preponderance of visitor to this site classify themselves as value investors. After all, value investing has become so broadly defined that everyone seems to be in this camp, and when everyone is a value investor, no one is a value investor. For value investing to work as an investment philosophy, it needs foils, preferably in the form of investors who know little about fundamentals and care about them even less. Paraphrasing Warren Buffett, if investing is a game of poker and value investors are the card counters, you need suckers at the table who will supply the winnings.
    • On the second question,  as value investing has expanded well beyond the Ben Graham school of strict (and passive) value investing to include different and seemingly contradictory strands of investing, there is less consensus about what comprises a good "value” stock. In a recent paper on value investing (which, in turn, is closely modeled on a chapter in my book on investment philosophies), I presented my take on these issues.
    • On the third question, it does seem to be taken for granted, at least in the value investing community, that value investors are not only more virtuous than other, more fickle investors (growth investors, momentum investors) but that their "hard work" pays off in the form of higher returns, at least over long periods. It would be vindication of the "ant and the grasshopper" fable, if it were true, but is it?
    What is the key characteristic that separates value investors from the rest of the world? In my view of the world, and I understand that yours might be different, the key to understanding value investing comes from breaking down a business into assets in place and growth assets.

    It is this mechanism that I used to my posts on estimating how much you are paying for growth and how much that growth is worth. If you are a value investor, you make your investment judgments, based upon the value of assets in place and consider growth assets to be speculative and inherently an unreliable basis for investing. Put bluntly, if you are a value investor, you want to buy a business only if it trades at less than the value of the assets in place and view growth, if it happens, as icing on the cake.

    It is how you find investments that sell for less than the value of assets in place that provides a framework to understanding the different strands of value investing, and there are three ways you can go about this mission:
    a. Passive value investing: The oldest strand of value investing traces its lineage back to Ben Graham and his use of screens to find cheap stocks. Reviewing those screens, which combine market and accounting data, from Graham's book on security analysis, you are looking at stocks that trade at low multiples of earnings, pay a high proportion of these earnings as dividends and have a high proportion of assets that can be liquidated for close to their book value. In the years since, investors have added other screens (good management, stable earnings, strong competitive advantages etc.) that are all designed to reduce the potential for downside on the investment.
    b. Contrarian value investing: In contrarian value investing, you adopt a different tack. You look for companies whose stock prices have collapsed for one reason on another. In its least sophisticated variant, you just buy the biggest losers (at least in terms of stock price), on the assumption that markets generally over react and that the portfolio of these losers will bounce back over time. In its more refined forms, you add other criteria to the mix. Thus, you may buy stocks that have gone down but only if they have a strong brand name and/or little debt.
    c. Activist value investing: In activist value investing, you focus on poorly performing companies and look at the value of its assets in place, with better management in place. You then try to change the way the company is run by either acquiring control of the firm or putting pressure on existing management. Activist investing requires far more resources than either passive or contrarian value investing.

    The skills and strengths you need to succeed in each of these value investing approaches is different and it is not clear than an investor who succeeds using one strand of value investing will be comfortable with the others. In the next three posts, I will focus on each of these strands of value investing. In the last post, I will examine the most contentious issue of all, which is whether value investors collectively generate value from their efforts or whether this too is "fool's gold".  



    Earnings surprises, price reaction and value

    The earnings season is upon us and each company’s earnings announcement is eagerly awaited, traded upon and talked about. For widely followed companies like Apple, the obsession with what the next earnings report will deliver overwhelms any sensible assessment of what it means for the company. But is this obsession merited? Do earnings announcements have significant effects on value? If so, why? More importantly, can you make money off earnings announcements? 

    The “Announcement” Process
    To understand how and why earnings reports matter, we should start by looking at the process. Publicly traded companies are required to report on their performance at “regular” intervals. In the US, the reports have to come every quarter, with full financial statements filed with the SEC. The degree of disclosure varies across markets, both on timing (quarterly, semi-annual and annual) and on information (partial reports of performance in some regimes).

    The reporting ritual is highly scripted, at least in the US, in terms of timing (companies report earnings on about the same date every year, give or take weekends, and in the same format to allow for year to year comparisons). The initial report provides the bare bone details (revenue growth, earnings per share and a breakdown of a few extraordinary items) and is followed a few weeks later by the full filing of the quarterly report (10Q) with the SEC.

    Since earnings reports contain information that can affect prices, the SEC does regulate trading and disclosure around the reports. Insiders are restricted from trading before earnings announcements and Regulation FD bars firms from providing information about upcoming earnings reports to subsets of investors (analysts). In theory, at least, the information in an earnings report should be “news” to markets.

    Companies may be restricted from providing information selectively to analysts following them, but this does not prevent analysts from forming and propagating their expectations about what the earnings report will contain to their clients and, by extension, the public. In fact, a substantial portion of a typical equity research analyst’s time is spent on the “earnings forecasting” exercise, and there are services that assess analyst quality by looking at how close the forecast comes to actual numbers. In the US, services such as Zacks and I/B/E/S that track and report analyst forecasts of earnings and you can find them in the public domain (Yahoo! Finance or similar sites)

    The Expectation Game
    When a company does report its earnings, markets will react to the “news” in the report but the way we measure the news has to be relative to expectations. Thus, a company that reports that its earnings went up by 30% may be seen as delivering bad news, if investors were expecting an increase of 40%, and a firm that announces an earnings decline of 30% may be providing positive information, if the expectation was that earnings would decline by 40%. Thus, it is not the magnitude of the earnings change that matter but the “surprise” in the earnings, measured as the earnings change relative to expectations.

    But how do you measure expectations? One obvious answer is to use the analyst estimates of the earnings and news reports like this one generally compare the earnings change to the “consensus” estimate of earnings change to frame the report. A second is to use the “past” earnings growth for the company as a measure of expected earnings growth. With either measure, then, a positive (negative) earnings surprise then becomes an earnings report where the actual earnings per share exceeds (falls below) the expected value (using consensus earnings estimates or historical earnings growth).

    While you can use analysts or history as the basis for estimating expected earnings, the market expectations process is a more nuanced one and more difficult to model. In the last two decades, firms have become more attuned to playing the earnings game, and have become increasingly adept at beating earnings expectations by playing both sides of the game. First, they work on analyst expectations, using selective leaks to bring expectations down, prior to earnings reports. Second, they work to mold the actual earnings, using both accounting choices (earnings management) and operating discretion (timing of R&D expenses, for instance) to deliver results that beat expectations. The problem with this game is that markets catch on and adjust expectations accordingly.

    The Announcement Effect
    If you can measure earnings expectations, an earnings surprise should have an effect on stock prices, with positive (negative) surprises evoking positive (negative) responses. The earliest studies of earnings surprises used historical earnings to estimate expected earnings and found backing for this hypothesis. In more recent studies, consensus estimates of earnings have been used to measure expected earnings. The following graph captures the announcement effect of earnings surprises, categorized from most positive to most negative, with expectations measured as consensus estimate from analysts:


    There are three interesting findings embedded in this graph. 
    1. Pre-announcement drift: There is a mild drift in stock prices before earnings reports that is consistent with the eventual surprise: prices move up before positive surprises and down before negative surprises. I will let you make the judgment on whether this is evidence of insider trading, investor prescience or some combination of the two. 
    2. Announcement effect: The announcement still contains news. On the announcement, the price effect reflects the magnitude and the direction of the surprise, with stock prices going up about 3%, on average, in reaction to the most positive surprises.
    3. Post-announcement drift: The most surprising finding is that stock prices continue to drift after the announcement in response to the surprise. The graph below looks at the price drift in the 30 days after the announcement:


    Differences across firms
    There are studies that indicate that the returns associated with earnings surprises are more pronounced with some types of stocks than with others. For instance,
    1. A study of value and growth stocks found, instance, that the returns in the three days around earnings announcements were much more positive for value stocks (defined as low PE and PBV stocks) than for growth stocks across all earnings announcements – positive as well as negative. This suggests that you are much more likely to get a positive surprise with a value stock than with a growth stock, indicating perhaps that markets tend to be overly optimistic in their expectations for growth companies. 
    2. Earnings announcements made by smaller firms seem to have a larger impact on stock prices on the announcement date and prices are more likely to drift after the announcement. 
    3. As with analyst reports, there seems to be evidence that the market reaction to earnings reports is a function not only of the earnings number reported but also the accompanying management commentary.
    4. There is some evidence that the market reaction to earnings reports is greater at firms with high institutional ownership, with one rationale being offered that institutional investors tend to be more short term in their focus and thus more likely to respond to quarterly earnings reports.
    There is one final aspect of the earnings game that may be affecting stock market reactions. As firms become adept at playing the game, managing expectations and tweaking earnings to beat expectations, investors have adapted. Firms that consistently beat consensus estimates now have to beat them by a "margin" (based upon their past history) to register a positive surprise. This is of course the phenomenon of "whispered earnings". With the Apple announcement due later today (July 24, 2012), the consensus earnings estimate is for earnings per share of $10.35 and the whispered earnings estimate is 67 cents higher at $11.02. The only problem is that Apple has beaten whispered earnings 42 out of the last 56 quarters. It is only a matter of time, I guess, before you have whispers on top of whispered earnings. My head hurts just thinking about the possibilities.

    Playing the Earnings Game
    So, how can investors play the earnings game? Using the earnings surprise graph as the basis for the discussion, here are some of the possible paths.
    a. Predict the surprise: You can try to devise ways of forecasting positive or negative surprises before they occur. I know it is easier said than done, but to the extent that you can stay on the right side of the insider trading law and find advance indicators of upcoming surprises (trading volume changes, price patterns etc.) you can profit.
    b. Trade on the news: To take advantage of the drift after the news, you could buy stocks after exceptionally positive earnings announcements and sell short on stocks after terrible earnings reports. Given that the drift is about 2-3%, don't expect this to do much more than augment returns at the margin. You could of course load up and use options to leverage the profits, but...
    c. Play the earnings momentum game: While the first two strategies are short term, there is a longer term strategy that can be built around earnings reports. Studies indicate that companies that have consistently beat earnings reports over the last few quarters deliver higher returns in subsequent periods. Thus, in addition to screening for high quality growth and low risk, you can also screen for earnings momentum.
    d. Intrinsic value assessment: As a believer in intrinsic valuation, I look for ways to tie the information in earnings reports to intrinsic value. To do that, though, you need to look past the top line news (earnings per share) and at the underlying details (revenue growth, operating margins and return on capital). If you do so, you may very well find  a report that looks positive on the surface (because the actual earnings exceed expectations) but contains enough negative news (lower revenue growth, declining margins and return on capitals) to cause intrinsic value to decrease. If the market misreads the report as "good" news and the stock price jumps up, you have the makings for a contrarian play.

    So, here is the challenge. By the time you read this post, the Apple earnings report will have been made public. Evaluate it and make your judgment on how (if at all) you will incorporate it into your investment strategy for Apple. I have attached my intrinsic valuation of Apple (made before the earnings report came out) with suggestions on how to incorporate the information in the earnings report into value. Take your best shot!



    Equity Risk Premiums: Globalization and Country risk

    The equity risk premium reflects what investors expect to earn on equities, as a class, over and above the risk free rate. Implicit in that definition are two key points. The first is that the equity risk premium is a macro number that applies to all stocks. The second is that the equity risk premium is the receptacle, in intrinsic valuation, for all macro economic fears. In fact, I used the equity risk premium as my vehicle for talking about how economic crises (the US rating downgrade of last summer, the Greece default dance…)

    On my web site, I update the equity risk premium for the S&P 500 every month, with my latest update of 6.17% on June 29, 2012. Even if you accept that estimate as a reasonable one for the US, there are many other estimation challenges. If you are valuing a Brazilian company, what equity risk premium would you use? What if you are valuing a multinational like Siemens or GE, with significant revenues in emerging markets, or an oil company with substantial reserves in Nigeria? More generally, in the face of globalization, valuing any company now requires an understanding of how best to evaluate country risk and convert into appropriate equity risk premiums. If you are working for a multinational, understanding how equity risk varies across countries is central to coming up with hurdle rates that vary across countries and lead to a fairer allocation of capital.

    Should equity risk premiums vary across countries?
    The question of whether equity risk premiums should be different for different countries, at first sight, looks like it has an obvious answer. Of course! After all, Venezuela, Russia and Greece are riskier countries to invest in than Switzerland, Germany or Canada and should have higher equity risk premiums. The answer, though, is not that simple. There are two scenarios where country risk will cease to matter and you will use the same equity risk premium for all companies, no matter which country they operate in. The first is if country risk is idiosyncratic, i.e., specific only to that country, with no spill over effects. If this is the case, diversifying geographically across countries should make this risk disappear in your portfolio, which can be accomplished by companies expanding their reaches across the globe (think Coca Cola or Nestle), or easier still, by investors holding geographically diversified portfolios. The second is to assume that all investors invest in global portfolios, in which case you could compute a global equity risk premium, capturing macro economic risks around the world, and estimate betas for individual companies against a global equity index.

    Both assumptions are difficult to sustain. The assumption that country risk is diversifiable is built on the presumption that the correlation across countries is low and that there is no contagion effect. That may have been true in the 1980s but as investors and countries have globalized, the correlation across countries has risen. Put differently, country risk is no longer diversifiable and requires a risk premium to those exposed to it. The assumption that investors are global is more reachable now than two decades ago, but institutional restrictions (Indian and Chinese investors still cannot invest easily overseas) and investor behavior (there is a substantial home bias in portfolios, where investors over invest in their domestic markets) still stand in the way.

    Bottom line: I think that equity risk premiums do vary across countries, with higher equity risk premiums applying to riskier countries. Applying the same equity risk premiums across companies will lead you to over value companies that have higher exposure to emerging markets.

    How do you estimate equity risk premiums for different markets?
    If you accept the premise that equity risk premiums should be different for different market, the question of how best to estimate these premiums follows. You cannot obtain these premiums using historical data, i.e., by looking at the premiums earned by stocks over riskless investments within each of the markets. Why not? First, there may be no riskless investments in many of these markets, either because governments may have default risk or because government bonds were not issued/traded over the period. Second, these markets are changing so much over the historical period in question that the historical premium you get over the period is not a predicted premium. Third, and more important, equity markets are volatile and the equity risk premiums over 20,30 or even 50 years of data have estimation errors that drown out the estimate.

    Here are three alternatives that can be used to estimate the equity risk premiums for other markets:
    A. Country default spreads: The simplest approach is to start with a mature market premium (say, 6% for the US), and then augment it by adding a country default spread for the country in question. That default spread can be estimated in one of three ways:
    1. Government bonds in US$/ Euros: If the country in question has dollar or Euro denominated bonds, you can estimate the spread over the US treasury bond or the German ten-year bond rate respectively. 
    2. Sovereign rating: Moody’s, S&P and Fitch all assign sovereign ratings to countries. You can estimate a typical default spread, based on the sovereign rating, using a lookup table that I update at the start of each year. Using Peru as an example, the sovereign rating of Baa3 for the country yields a default spread of 2.00%. Here are the latest local currency and foreign currency sovereign ratings from Moody's.
    3. CDS spreads: The Credit Default Swap market is of more recent origin, but it is a market that allows you to buy insurance against default risk (see my earlier post on this market). Thus, if you bought a 10-year Peruvian government bond with an interest rate of 4.5%, and were concerned about default, you could have bought a 10-year Peruvian CDS. The price of that CDS in June 2012 was 2.06%, effectively implying that you would need to pay 2.06% out of your 4.5% each year for the next 10 years to get default protection. If you are interested, here are the ten-year CDS spreads for all of the countries where they are offered as of June 30, 2012
    B. Relative Equity Market Volatility: In this approach, you can scale up the equity risk premium for the US by the relative volatility of the country in question, with relative volatility computed as the ratio of the volatility of that market to the volatility in the S&P 500. Thus, if standard deviation of Peruvian equities is 21%, the standard deviation for the S&P 500 is 15% and the equity risk premium in the S&P 500 is 6%, the equity risk premium for Peru will be
    Equity Risk premium for Peru = 6% (21%/15%) = 8.4%
    Country Risk premium for Peru = 8.4% -6% = 2.4%
    While this approach has intuitive appeal, its weakness is that the equity market volatilities are as much a function of country risk as they are a measure of liquidity, with less liquid markets (which are often the most risky) having higher standard deviations. Here are my estimates for emerging markets as of January 2012.

    C. Scaled Default Spread: In this approach, you combine the first two, by starting with the country default spread in approach 1 and then scaling it for relative volatility, but this time of the equity index in the country to the volatility of the government bond in that country. Again, using Peru as the example, assume that the standard deviation in the Peruvian government bond is 14% and that the standard deviation in Peruvian equities stays at 21%:
    Default spread for Peru = 2.00% (using the rating)
    Country risk premium for Peru = 2.00% (21%/14%) = 3.00%
    Total equity risk premium for Peru = 9.00%
    By staying within the same market for both volatilities, this approach is less susceptible than the prior one to liquidity variations across markets. The standard deviations can be noisy or difficult to estimate and I prefer to use a median value for the ratio across markets, rather than the ratio for any given market. (See my January 2012 update of equity to government bond volatilities.)

    There is one other approach, where you are not dependent upon knowing the mature market premium, historical volatilities or default spreads. You can compute an implied premium for an emerging market, based upon the level of equity prices and expected cash flows. While this is what I do for the S&P 500 each month to get the implied premium for the US, it is far more difficult to use in emerging markets, because of data limitations.

    Where do you use this equity risk premium?
    Equity risk premiums come into play at every step in investing. At the asset allocation stage, where you determine how much of your portfolio you will be allocating to different asset classes (equity, fixed income, real assets) and to different geographical areas, you have to make judgements of which markets you are getting the best risk/return trade off and allocate more money to those markets.

    Once you have made your asset allocation judgments, equity risk premiums come into play, when you value individual companies. In intrinsic or discounted cash flow valuation, you need the equity risk premium to get to a cost of equity and capital. The common approach, among many practitioners, is to attach an equity risk premium to a company, based upon its county of incorporation. Thus, when valuing Peruvian companies, you would use 9.00% as your equity risk premium, thus pushing up your cost of equity/capital and pushing down value, and when valuing US companies, you would use the 6% (mature market premium). I would suggest a more nuanced approach (which will take a little more work): compute an equity risk premium for a company that reflects a weighted average of the countries it operates in, with the weights being based upon an observable variable (revenues seem to work best). Thus, if you are valuing a company with 30% of its revenues in Peru (ERP =9%), 30% of its revenues in Venezuela (ERP =12%) and 40% of it revenues in the US (ERP =6%), you would use the following:
    Weighted average equity risk premium = .30 (9%) + .30 (12%) + .40 (6%) = 8.7%
    If the company breaks down revenues into regions rather than counties, you may have to compute a premium by region (Latin America, South Asia, Eastern Europe, Sub-Saharan Africa etc.) and take a weighted average.

    In relative valuation, the use of country risk is usually implicit or qualitative. Thus, when comparing the PE ratios for oil companies, you may choose not to buy Lukoil, even though it trades at a lower PE than Conoci, because you worry about Russian country risk. If you want to be more explicit about how much to adjust multiples for country risk, download my spreadsheet for computing intrinsic multiples and change the equity risk premium to see how much PE or EV/EBITDA multiples change as the equity risk premium changes.

    My latest update
    I update country risk premiums, by country and region, at the start of every year. Given the turmoil of the last six months, and dramatic changes in country risk (especially in Europe), I have updated the numbers as of June 30, 2012. You can get the latest version of my estimates of country risk premiums by clicking here. If you want a blow-by-blow account of my reasoning on equity risk premiums, you can be a glutton for punishment and download my paper on equity equity risk premiums (the 2012 version).



    Apple's Crown Jewel: Valuing the iPhone Franchise

    If you are a stockholder in Apple, it is time to celebrate again! The last week has been an eventful one for the company. In addition to claiming the title of "largest market cap" ever, when its market value hit $623.5 billion on August 20, the company also won its lawsuit against Samsung on "patent infringement" charges. Samsung will not only be required to pay $ 1 billion in damages but may also have to remove some of it products from the US market as a consequence. To add to the mix, the iPhone 5 will shortly be arriving on the shelves and there is talk again of Apple becoming the first trillion dollar company ever.

    As with my last two posts, I want to set the record straight on my posts on Apple in the last couple of years. In January 2011, I posted on Apple's immense cash balance (of $50-$60 billion at the time). and argued that, as a long-term investor in the company, it has earned my trust after an unmatched decade of success, both in terms of profitability and stock returns, and that I was okay with them holding on to the cash. In March 2012, I returned to the question partly in response to news stories that suggested that Apple may initiate a dividend. Noting that dividends would attract a very different group of stockholders into the company and put them on collision course with the existing stockholder base, I posted that if Apple was intent on returning the cash (as Tim Cook seemed to be), it should do a large stock buyback. I also valued the company at about $710/share (the stock price was about $550 at the time). In April 2012, the stock hit $600 and I bid my farewell to the company as an investment, with much regret and gratitude. I justified my decision to sell not on valuation (since I found the stock to be worth $700+) but on two counts. First, I argued that the company had become a momentum play and that the pricing process had lost its connection to the valuation process. Second, I also felt uncomfortable with the mix of dividend, growth and momentum stockholders, with differing expectations about the company and differing demands of it. Even though Apple’s stock price has gone up about 10% since I sold it, I have no regrets about selling. Since my original case for selling the shares was predicated on a fickle investor base with conflicting views, I believe that the stock price gyrations over the last six months supports that thesis. The stock price dropped as low as $530 and now risen to its high for the year without any dramatic news announcements for the most part driving the price (until the last week). My intrinsic valuation has not changed much in that period and remains over $700, with the updated numbers through the end of last quarter. 

    No matter what your views (bullish or bearish) are on Apple, I think that there can be little disagreement on the proposition that Apple's market value rides more on one product, the iPhone than ever before and that it is worth taking a closer look at the underpinnings of that value. Looking at the numbers, here are three key points worth making about the iPhone franchise (and its value to Apple):
    1. The iPhone is a money machine: In the most recent twelve months, the iPhone generated about $100 billion in revenues and approximately $21 billion in after-tax profits for Apple.
    2. The iPhone is a dominant player in a growing market: The smartphone market grew about 40% last year,  primarily as cell phone users switch to smart phones. During the year,  more than 150 million smart phones were sold, with Apple accounting for about 20% of the units sold. However, with its heftier price tag on the iPhones, Apple had a 43% share of the market, if it is defined in dollar revenues. 
    3. The iPhone has a short life cycle: One of the reasons for Apple's disappointing earnings in the most recent quarter is that customers stopped buying the iPhone 4S, waiting for the iPhone 5 to arrive. Since the iPhone 4 came out in June 2010 and the iPhone 4S was introduced in October 2011, that puts about a two-year life cycle on the product.  So what? Companies like P&G or Coca Cola produce products that have very long life cycles; diapers and sodas have not only not changed much over the last few decades but are unlikely to change by much over the next few. Protected by strong brand names, they can be expected to generate earnings for long periods, with relatively little investment or innovation by the companies in question. With a short product life cycle, a company is faced with two challenges. First, it has to come up with innovations to its product to retain its customers when the cycle is renewed, and that will require investment, especially during the later parts of each cycle. Second, even with these innovations, there will be customers who switch to competitors' products (either because they are cheaper or because their innovations are more attractive) and for a company to maintain it's market share, it has to get more of it's competitors' customers to switch to its products. 
    Given the iPhone's profitability and dominance in the growing smartphone market, I tried to value the iPhone franchise, incorporating the effect of the short life cycle. In assessing the value, I made the following assumptions.
    1. Profitability: Apple will be able to maintain its current after-tax operating margin of 21% on future iPhone sales. 
    2. Smartphone market: The smart phone market will continue to grow at a 6% compounded rate for the next 10 years, with growth tapering down towards the growth rate of the economy in the long term. 
    3. Product life cycle: The life cycle for a new iPhone will continue to be two years and Apple will have to reinvest half its after-tax operating income in the second year of each cycle (this 50% also incorporate the lost sales in the second year, as each iPhone ages and customers wait for the next version).
    4. Switching assumptions: iPhone customers are assumed to be loyal, with only 5% switching to competitors' products at the end of each life cycle. Apple will be more successful at attracting competitors' customers, with 10% switching into iPhones. 
    5. Risk: Needless to say, there is substantial risk in this process and the cost of capital of 11% (at the 90th percentile for US companies) reflects that risk.

    The value that I estimate for the iPhone franchise is $307 billion, working out to a multiple of 3.39 times revenues and about 16.17 times net income on the iPhone. You can download the spreadsheet that I used and change the assumptions, if you so desire. In fact, as with my Groupon and Facebook valuations, I have opened a shared Google spreadsheet for you to enter your estimates of value for the iPhone franchise.

    Here is the larger point, though. About 55% of Apple's business value comes from its iPhone franchise and there are three pressure points that will test this value.

    • The first is Apple's capacity to maintain pricing power and earn its current margins; there isn't a competitor within shouting distance of Apple, when it comes to margins. If the after-tax margin drops to 15% from its current 21%, the value of the franchise drops to $219 billion.
    • The second is that Apple will be able to prevent the life cycle from speeding up further and that it can continue to innovate at a reasonable cost (with this cost in conjunction with the loss in earnings during the second part of the cycle not exceeding 50% of the after-tax earnings during the period). Reducing the life cycle to one year from two almost halves the value of the franchise.
    • The third is that Apple is able to maintain a net positive switching ratio (more of the competitors' customers switch to Apple than vice versa), allowing it to increase in market share in dollar value terms. Assuming a neutral switching ratio (customers switching in = customers switching out), reduces the value of the franchise to $255 billion. 
    There is an internal tension between these three variables, since keeping iPhone prices high (preserving the high margins) and spending less on innovation (reducing the cost of innovation) may increase the risk that more customers will switch away than into the iPhone. Using the "life cycle" model also provides some perspective on why the lawsuit victory against Samsung may have a bigger effect on the value of the iPhone franchise than how the iPhone 5 fares with customers in a few weeks. Samsung's loss will have a deterrent effect on competitors planning an assault on the iPhone kingdom, thus increasing Apple's pricing power (preserving margins) and improving its odds of holding on to its customers (improving its switching ratio).

    With the iPod, iPhone and iPad, the company has been able to count on the unmatched loyalty of its customers, while both attracting customers of less innovative competitors and increasing overall market size. The question that investors face right now is whether Apple can continue its winning streak. The high valuations attached to the company assume that the company can keep doing what it is right now, that the iPhone 5 will not only launch successfully, but be followed by the iPad Mini and the iPhone 6 and so on. The risk that investors have to take into account when investing in Apple is that somewhere along the way, the winning streak may will be broken. Unlike other large market cap companies with long product life cycles or diversified product portfolios, Apple’s value rests on being a Phoenix, constantly reinventing itself every few years.




    Groupon Gloom: Deal of the day or Death Spiral?

    In keeping with this week's theme of revisiting ghosts of valuations past, I decided to take a look at another fallen angel, Groupon. The stock has collapsed to $4.44 from its post-IPO high of $29 and investors and employees seem to be fleeing from the exits. If you are a contrarian with a strong stomach, it would like the stars are aligned for some bottom fishing but is Groupon a buy, even at this discounted price?

    To make this assessment, I decided to take a look at my posts on Groupon from last year:

    1. In my very first post on Groupon in June 2011, I looked at their attempt to move customer acquisition costs from the operating expense to capital expenditures column. While I was sympathetic to the general argument that operating expenses that create benefits over many years (such as R&D, exploration costs and even customer acquisition expenses) should be treated as capital expenditures, I was skeptical in Groupon's case since there was little evidence that Groupon's acquired customers stayed on for long periods and also because Groupon did not follow through fully and treat customers as assets (and amortize or depreciate these assets over time). 
    2. In my second post in October 2011, I looked at Groupon (as well as Google and Green Mountain) with an eye towards potential growth, using four tests: the feasibility of the growth given the overall market served by each company, the capacity to scale up growth (i.e., maintain growth as the companies get bigger), the value created by that growth and the effect of management credibility on how the market perceives that growth.  
    3. In my third post on November 2, 2011, I valued Groupon at the time of the acquisition. Using  "aggressive" assumptions on revenue growth (50% annually for first 5 years, scaling down to mature growth by year 10) and pre-tax operating margin (23%), I estimated a value of $14.62 per share, below the $16-$20 range that investment bankers were touting.
    4. The stock did go public on November 3, 2011, at $20/share, and jumped to $28 by the end of the day. My fourth post on Groupon, on November 4, 2011, looked at the company in the context of a discussion of the value of growth. For growth to add value, I argued that it has to be accompanied by "excess returns", which, in turn, require competitive advantages or barriers to entry. Looking at Groupon's business model, I could not think of any significant barriers to competition that would prevent others from entering the market and eating away at Groupon's margins. Using a simulation, I estimated the following distribution for value/share for Groupon in November 2011 and argued that the stock was more likely to be worth less than $10/share than it was to be be worth $30:



    A year later, it is clear that I under estimated how quickly any competitive advantages that Groupon's first mover status gave them would be eroded. This is clear not only from perusing my email box every morning (and removing the dozen emails from different deal-of-the-day purveyors) but also in Groupon's financial results. As the most recent earnings report makes clear, revenue growth has slowed, profitability has lagged and the stock price collapse is in reaction these changes.

    As I revisited my valuation, as with Facebook, I had to caution myself not to overreact, but the news, as I see it, is far more dire for Groupon than it is for Facebook. While Facebook's results were disappointing in terms of converting potential to profits quickly, the potential (from their vast user base and the information they have on these users) still remains. In Groupon's case, where the business model was clearer at the time of the IPO, the business model has collapsed and it is difficult to see what the company can do to set itself apart from the competition and make money at the same time. As a result, the changes I made in my Groupon valuation are more dramatic than the changes I made in my Facebook valuation. My base year numbers reflect their most recent quarterly filing, with trailing 12-month revenues of $1.965 billion and operating income of $71 million. My forecasted revenue growth rate is 25% (leading to revenues in 2022 of $10.3 billion, as contrasted with my earlier forecast of $25.4 billion), my target margin is 12% (down from my year-ago estimate of 23%) and my sales/capital ratio is now down to 1.25 (from a year-ago estimate of 2.00). The end result is a value per share of $4.07, which makes the stock, at best, a fairly priced stock. In fact, if you bring in the likelihood that the firm may not make it through its growth pains in the spreadsheet, the value per share drops even further. As with the Facebook valuation, you can download my spreadsheet and put your own estimates in... I have a shared Google spreadsheet for those of you who want to share your numbers...

    There are two broader point that are worth making here.
    1. A dramatic stock price drop is not always a buying opportunity: Most young growth stocks are subject to gyrations and it is not uncommon to see growth stocks plummet, when they don't meet the lofty expectations that investors have for them, and we have seen this happen to both Facebook and Groupon. In some cases, investors over react and push the price down far more than they should and that is the basis for my pitch I made for friending Facebook in my last post. In some cases, though, the stock price collapse is well-deserved and that is my rationale for avoiding Groupon. 
    2. Intrinsic valuations can (and should) change over time: There is deeply held belief, at least in some quarters, that intrinsic valuations are stable and don't change over time. While that may be true in many companies and most time periods, there are three exceptions. The first is a dramatic change in the macro environment. My intrinsic valuations for almost all companies changed between August 2008 and October 2008, as the market price of risk (in the form of equity risk premiums and default spreads) increased dramatically in the aftermath of the banking crisis. The second is when accounting fraud is uncovered and key numbers have to be restated. The third is with young growth companies where the premise on which the value of growth is based - that it is scalable, defensible and valuable - is called into question. It is the third exception that applies to Groupon and I feel comfortable lowering the value per share from $14.82 a year ago to $4.07 today. 



    Facebook face plant: Time to friend the company?

    Facebook returned to the headlines on Friday, after it's stock price dropped below $20. At it's closing pricing of $19 on August 17, Facebook was trading at roughly half it's IPO offering price. Investors, analysts and journalists are all looking for the reason for the collapse and some at least seem to have found a ready target: the price drop, they argue, is the result of the "unlocking" of restrictions on insiders selling shares. The problem with this explanation is that it has never been a secret that insiders in Facebook would be able to sell shares starting August 16 and I would wager that no one would have even noticed the end of the lockup period, if the IPO had gone well and the stock were trading at $ 55/share. So, what is going on with Facebook? Why has its stock price plunged over the last few weeks? And is the stock cheap at $19?

    The story so far...
    As we look back at 2012, it is quite clear that Facebook has held us in its thrall (and not always in a good way) through much of the year and my posts over the year on the company reflect that fascination. Rather than cover up my paper trail, let me draw attention to it (warts and all):
    1. S1 Filing (February 2012): In my first post on Facebook this year, right after Facebook filed its financials (S1) with the SEC, I valued Facebook at $28/share (or $70 billion). I based this valuation on the company's immense potential (its vast user base and the information it had about these users), but was concerned about the absence of a clear business plan (to convert users to revenues), the overhang from insiders stockholdings/options (yes, you could see the lock up period ending in February) and the abysmal corporate governance. 
    2. Playing the IPO pop game (February 2012): In response to a wave of articles that seemed to suggest that investing in the Facebook IPO (at the offering price) would be a sure road to profit, I tried to provide some history on the IPO game in my second post on Facebook, noting that while it was was true that investing in the average IPO does generate a pop for investors, this pop is not guaranteed and that the IPO game can be a loser's game. 
    3. The day before the IPO (May 2012): On the day before the IPO, I posted on what I saw as the hubris of those involved in the IPO process - the investment bankers, the company (Facebook) itself and the institutional investors, who all seemed to think that they could lead the market by to wherever they wanted to go. I updated my valuation of Facebook to about $27 a share and contended that the stock would open with a relatively small pop (that the bankers would get the pricing right) but that the stock was overvalued for longer term investors.
    4. The post-IPO assessment (May 2012): The stock opened (late because of the NASDAQ technical problems) at about $42 and very quickly lost ground over the day to end the day at below the offering price.  I posted my rationale for the momentum shift and argued that a great deal of the blame could be laid at the feet of the company and its bankers, who essentially took momentum for granted. I also ended the post by arguing that the switch in momentum could very well lead take the stock in the other direction, from over valued to under valued.
    An updated valuation
    If Facebook was over valued at $38, relative to the estimated value of $27/share, is it under valued at $19? To address this question, I revisited my Facebook valuation from May and looked at what I have learned about the company (for the better or worse) since. Has there been enough information that has come out about the firm that could have caused the intrinsic value (at least as I measure it) to drop below $19? The biggest piece of financial information that has emerged on Facebook has been one quarterly earnings report a few weeks ago and it seems to me that not much has changed on either side of the ledger since February. The earnings report was a disappointment to markets, revealing less revenue growth than anticipated and an operating loss, largely as a result of share compensation expenses that were recognized when restricted stock units owned by employees were recognized at the time of the IPO. Facebook remains a company with vast potential (their user base has not shrunk), no clear business plan (is it going to be advertising, product sales or something else) and poor corporate governance. I had not expected any of these issues to be resolved in the one quarterly report and they were not. I did make some adjustments to my valuation: (a) lowering my revenue growth (with my 2022 revenue estimates dropping by about 10%, relative to my May estimates, (b) reducing the operating margin from 35% to 32% to reflect the higher expenses and (c) reducing my sales to capital ratio from 1.50 to 1.20 to incorporate the higher cost of acquisition driven growth. With these changes,  my intrinsic value for Facebook with the updated information is $23.94, a drop of just over 10% from my May 2012 estimate.

    So, why did the price drop so much? There are several possible reasons. The first is that my estimate of intrinsic value is completely wrong, that the true value for the company has always been in the low teens and that the market is correcting its initial mistake. The second is that most investors in Facebook don't know what the value of the company is and don't care a hoot about it. Instead, they are pricing (rather than valuing) the stock, reacting to the "surprise" in each news story and to how other investors in the market are responding to that story. This, after all, is the nature of momentum investing, with positive surprises getting magnified by the crowd into unrealistic price jumps and the negative surprises into catastrophic drops. I know that analysts have turned bearish on the stock but since many of these analysts assured me that Facebook was a steal at $38/share, I am not inclined to put much weight on their prognostications. In fact, they very fact that they are turning against the stock may be a positive indicator.

    Time to buy?
    Now that the stock is at $19, about $5 below my estimate of intrinsic value, would I buy? To make that judgment, I considered three factors.

    1. My value could be over stated: I understand that this is a risky investment and that my estimate of value could be hopelessly wrong. In fact, I followed up my intrinsic valuation with a simulation, where I looked at the distribution of intrinsic value, allowing revenue growth, margins and cost of capital to vary. 

    Based on my assumptions, there is an 80% chance that the stock is under valued at $19 a share and an almost 85% chance that it is under valued at $18 a share.

    2. Management is not going to change: The corporate governance issue is the one that I have the most trouble overcoming. The structure of the voting rights in the company ensure that there is little that stockholders can do to influence how this company is run and that can be a potential problem if it locks itself into a self-destructive path. Calling for Mark Zuckerberg to step down or share power, as an article in the Los Angeles times did, are completely unrealistic. The Russians have a better shot at getting rid of Vlad Putin than Facebook stockholders have of displacing Zuckerberg. For some, this may be a deal breaker, and it came close to being one for me.

    3. Vindication, even if I am right, will not come quickly: Markets know no fury to match that of momentum investors scorned, and these investors tend to turn with a vengeance on the companies that disappoint them. Put in stark terms, it is entirely possible that my valuation of Facebook could be right but that the stock price could continue to keep dropping as investors bail out. Eventually, the "intrinsic" truths will emerge, but it may be a long time coming. 

    My conclusion is that Facebook is not quite at the threshold of being a buy yet, but it is getting close. I have a limit buy order for the stock at a price of $18. I would be interested in seeing where you stand on the stock and you are welcome to enter your estimate of intrinsic value for the stock and your threshold for buying the stock in the shared Google spreadsheet.



    The "dividend tax" cliff approaches: Implications for stocks

    A great deal has been written about the "fiscal cliff" that US taxpayers, investors and companies are faced with at the end of this year. Put simply, all of the tax changes made in 2002 and 2003 expire at that time, and the tax code will, in large part, revert to what it was prior to those changes. I will leave it to others to debate the macro economic implications of going over the cliff but I want to focus on one "segment" of the code that has implications to valuation.

    In 2003, the tax code was altered to bring the tax rate on dividend income down to 15%, to match the tax rate on capital gains. That was, in a sense, a revolutionary move, at least for the US, since dividends had been taxed much more heavily than capital gains for much of the previous century. I did write a paper in 2003 about the potential implications of the tax law change for businesses that you can read. In effect, I argued that the tax change would have a positive effect on stock prices, that the effect would be greater for "high" dividend paying stocks than for non-dividend paying stocks and that corporate dividend policy would be altered by the change. Now that there is the possibility that the law will be reversed, it is time to revisit the issue.

    Dividends, Expected Returns and Stock Prices: Why taxes matter...
    To understand the impact of investor taxes on dividends, let's begin by looking at how  you would price stocks in a world where interest income, dividend income and capital gains are not taxed. Let's assume that the risk free rate is 1.5% and that stocks are collectively paying a dividend yield of 2%. To induce you, as a risk averse investor, to invest in stocks, you would need to be offered a premium (at least on an expected basis) over the risk free rate. Let's assume that you would demand a premium of 4.5%, after personal taxes, to shift from the riskfree asset to risky equities. Thus, you would need to earn a 6% return (1.5%+4.5%), after personal taxes, to invest in stocks. Since this is a world with no taxes, your pre-tax expected return would also by 6%; with a dividend yield of 2%, the expected price appreciation on stocks would have to be 4%.

    Now, introduce a uniform tax rate of 15% on interest income, dividend income and capital gains into this world. Since you need to earn 6% after taxes, you would need to earn 7.06% before taxes:
    Expected pre-tax return = Expected after-tax return/ (1- Uniform tax rate) = 6%/ (1-.15) = 7.06%
    Thus, if stocks continue to pay a 2% dividend, the expected price appreciation would need to 5.06%. The higher required return would mean that stock prices would have to drop, relative to what they were in a world with no taxes. With the existing tax law, we are close to this tax regime (with the only difference being that interest income is taxed at a higher tax rate). This is close to the current tax regime.

    Let's now change to law to reflect what the tax rate will be on January 1, 2013, if we do revert back to pre-2003 levels. The tax rate on dividends, for individual investors, will revert back to the ordinary income tax rate. At the margin, for unmarried (married - joint filing) investors generating more than $ 85,650 ($142,700) and  in income, that rate will be close to 35% (counting just Federal taxes and incorporating the additional taxes that the new health care law will impose on dividends and other investment income) and approach 40% for those with income levels exceeding $178,650 ($217,450). The tax rate on long term capital gains will also go up, but only to the 20% rate that prevailed prior to 2003. If companies continue with a dividend yield of 2% and the price appreciation stays at the 5.06%, investors will earn a much lower after-tax return:
    After-tax return with pre-2003 tax rates = 2%(1-.40) + 5.06% (1-.20) = 5.25%
    If investors risk preferences have not changed, they will have to want to continue to earn 6% after taxes, but the pre-tax return would have to increase to compensate for the higher taxes. In fact, if we assume that the dividend yield stays fixed at 2%, we can solve for the required price appreciation
    2% (1-.40) + X (1-.20) = 6%
    Solving for X, we get a required pre-tax price appreciation of 6% and a required pre-tax return of 8%. That would translate into a significant drop in stock prices.

    Making it real: The dividend cliff and the S&P 500
    To make this less abstract, let's work with some real numbers. At the start of every month, I back out the expected return on stocks from the level of the index (S&P 500) and expected cash flows. At the start of September 2012, when the S&P 500 was at 1406.58, I computed an expected return on stocks of 7.30% (yielding an equity risk premium of 5.75% over the risk free rate of 1.55%). This expected return is what investors are demanding on a pre-tax basis on stocks. Since the current dividend yield on the S&P 500 is about 2.01%, the expected price appreciation on a pre-tax basis is 5.29%. Since both dividends and capital gains are taxed at 15%, under the pre-cliff tax law, the post tax return is 6.21%:
    After-tax return in September 2012 with current tax law = 2.00% (1-.15) + 5.29% (1-.15) = 6.21%
    Now, let's assume that investors will continue to demand this after-tax return in 2013, that the tax laws revert back to pre-2003 levels and that companies continue to maintain a dividend yield of 2.01%:
    2.01% (1-.40) + Expected pre-tax price appreciation (1-.20) = 6.21%
    The expected pre-tax price appreciation would have to be 6.25% and the required return on a pre-tax basis would have to be 8.26% on the S&P 500, yielding an equity risk premium of 6.71% over the riskfree rate of 1.55%. Holding the cash flows the same and changing the equity risk premium to 6.71% yields a value of 1201.22 for the S&P 500, a drop of about 14.60% in the index from current levels. If you don't agree with the assumptions I have made, not a big deal. I have attached the spreadsheet that I used and you can compute your own estimate.

    Differential impact: High dividend versus non-dividend paying stocks
    Note, though, that the effect of the reversal in the tax law will not be uniform, since every company does not have a dividend yield of 2%. Companies with high dividend yields, that continue to pay those dividends, will see expected returns increase more and stock prices drop by a more significant margin. In the graph below, I have compute the percentage change in stock prices you can expect in stocks with dividend yields of 0% to 4%.

    Note that the stocks with the 4% dividend yield, holding all else constant, will see stock prices drop by 18%,, whereas the stocks with the 0% dividend yield will see a price drop of only 7%.  Again, you can use the spreadsheet and alter my assumptions, if you so desire, and compute the effect on any individual stock.

    The Weak Links
    This analysis suggests that a sharp correction is ahead for stocks collectively and especially so for high dividend paying stocks. It is, however, based on a set of assumptions about tax law and markets that may not be correct.   So, what are the weakest links in this analysis?
    1. There is no chance that the fiscal cliff will become reality: This is not the first time that we have faced the possibility of the tax laws reverting back to pre-2003 levels. At the end of 2011, faced with the possibility, Congress and the administration pushed off the day of reckoning at the last moment. It is possible that faced with the catastrophic consequences of going over the cliff, Congress will find a way to avoid it again, but is it guaranteed? Having seen the political dysfunction at both ends of Pennsylvania Avenue over the last decade, I am not as confident as others may be that common sense will prevail and that the cliff will be avoided.
    2. Not all investors pay taxes on investment income: In my analysis, I used the tax rates on wealthy individual investors to make my assessment, but tax rates vary widely across investors. There are two critiques that can be mounted. The first is that about 60-70% of stocks are held by non-individuals: mutual funds, pension funds and corporations and the tax rates that these investors may not be affected (or at least not as much) by the change in the tax law. The second is that companies that pay high dividends attract investors who like those high dividends and it is possible that these investors make less income and face less of a hit from the change in the tax law.  Note, though, that even if we factor in these investors, the basic analysis still holds but the impact will be lightened. In fact, one way to alter the analysis is to take a weighted average tax rate across all investors in the market, which would buffer the impact. The graph below estimates the effect on the market, stocks with a dividend yield of 4% and stocks with a dividend yield of 0% of assuming lower tax rates in the post-cliff period.
    3. Investors may already have built in the expectation that tax laws will change into current stock prices: To the extent that the fiscal cliff has been in the news and widely reported, it is possible that the market has already incorporated the possibility of it coming to fruition into stock prices and the expected return. I would have been inclined to believe this if I had seen the equity risk premium climb, and stock prices drop, over the course of the year, but they have not. In fact, we started the year with a much higher equity risk premium of 6.04% and have seen the premium drift down to 5.75%.
    4. Companies may change their dividend policy: I did predicate my analysis on companies maintaining their dividends at 2012 levels, even if the tax law changes to tax dividends more highly in 2013. In fact, if companies were completely flexible, they could stop paying dividends and largely nullify the impact of the tax law change. History suggests that this is unlikely. If there is a word that best describes dividends, it is that they are "sticky", i.e.. that companies are reluctant to change dividends and especially to cut them. In fact, the 2003 law did not to lead to a surge in dividends (though a few companies pay special dividends in the immediate aftermath) and I don't think that a reversal of the law will lead to a sudden reassessment of dividend policy.

    Bottom line:  I may be overly pessimistic, but the dividend cliff scares me and I am planning for the eventuality that the tax code will change drastically on January 1, 2013. I am and will continue pruning my portfolio, shifting my money from large dividend-paying US stocks to non-dividend paying or low-dividend paying foreign stocks. I won't go overboard and sell short/ buy puts on high dividend paying stocks. After all, the dividend tax effect is one of many forces that will affect equity markets over the next few months and it is possible that one of these effects will drown out the tax effect.



    Inspiration or Insanity? Fed action and Market Reaction


    The big news of last week was the Federal Reserve's announcement of QE3, i.e.,  that it would buy $40 billion worth of bonds each month until the economy was back on its feet again. The fact that the commitment was open ended (unlike  QE2 and Operation Twist, the two prior big moves by the Fed during the last three years) and directly tied to stronger employment/economy was viewed as positive by the stock market, which jumped about 2% in the two days after.  I am sure that I am missing some significant piece of the puzzle, but as I watch the news coverage and market reaction, I am reminded of one of my favorite movies, "Groundhog Day".

    While we can debate the intent behind the Fed move and whether it would succeed at awakening the economy, I would posit three points (all of which I am sure are debatable):
    1. The Fed does not set market interest rates: Much as I would like to buy into the notion that the Fed sets mortgage rates, corporate bond rates and treasury rates, the only interest rate that the Fed actually sets is the Fed Funds rate, the rate at which banks trade balances at the Federal reserve. In fact, if the Fed has as much power over interest rates as we think it has, the US would not have had double digit treasury bond rates in the 1970s.
    2. The Fed’s influence on market rates is greater at the short end than at the long end of the spectrum: It is true that the Fed can influence market interest rates through its actions on the Fed Funds rate, with interest rates falling (rising) on signals of a looser (tighter) monetary policy", but that fall or rise is greatest for short term rates. It is also true, in Operation Twist and continuing into QE3, the Fed is pumping billions into the bond market with the intent of keeping longer term rates low. The bottom line though is that influence does not equate control, and the bond market is far too large for even the Fed to turn the tide (if the tide is running against what the Fed would like to do).
    3. What the Fed wants to do and what it seeks to accomplish with that action seem at war with each other: If I understand what the Fed is doing, its intent is to keep interest rates low to induce higher real growth (and lower unemployment) in the economy. There is an inherent contradiction between the Fed's action and its objective. If the economy starts growing faster, market interest rates cannot and will not stay low, no matter what the Fed does. Thus, the only way the Fed can keep interest rates low for an extended period is if low interest rates do not translate into a stronger economy.   I would argue that the the Fed's earlier moves in this recession (QE1, QE2 and Operation Twist) make this point for me. Interest rates have stayed low, with mortgage rates and corporate bond rates at historical lows, but they have done so, because the economy has stagnated. 
    To address the question of whether the Fed action is good for stock prices/values, I would list three “macro” variables that underlie the valuation of all equities:
    1. The risk free rate: The first corner of the triangle is of course the risk free rate, i.e, the rate you would earn as an investor on a guaranteed investment. Holding all else constant, a lower risk free rate should translate into higher equity values. 
    2. Equity risk premium: The second corner is the equity risk premium, which is the premium that investors demand for investing in stocks as compensation for exposure to macroeconomic risk, i.e., uncertainty about real economic growth and inflation. Holding all else constant, a lower equity risk premium should translate into higher equity values. 
    3. Real Growth: The third corner is real economic growth, with higher real growth, all else held constant, translating into higher equity values.
    If you hold real growth and equity risk premiums fixed, and lower interest rate, the values of all financial assets should rise. But “holding all else constant” is easier said than done.  If the risk free rate is low because real growth is expected to be low and/or because investors are fleeing to safe harbors in the face of crisis, whatever you gain from having the lower risk free rate will be overwhelmed by the increase in the equity risk premium and the lower real growth. Thus, as I noted in an earlier post, a lower risk free rate does not always translate into higher equity values. The most charitable assessment I have of the market's optimistic reaction to the Fed’s action is that the market buys, at least for the moment, into the Fed’s juggling act: that they can keep interest rates low, without increasing macroeconomic risk, while spurring real growth in the economy. I think you could point to a more likely scenario where QE3 does not do much for real growth, while leading to more uncertainty about expected inflation (and higher equity risk premiums) and the net effect on stocks is negative.

    Given high unemployment and an economy stuck in neutral, you may feel that the Fed had no choice. After all, doing something is better than doing nothing, right? That would be true, if QE3 were costless, but it does carry three costs:
    1. The inflation factor: The biggest cost of an expansionary monetary policy is the potential for inflation that comes with it. I know that the low inflation over the last few years has led some analysts to conclude that the inflation dragon has been slain forever.  However, history tells us that inflation is like a deadly virus, harmless as long as we can keep it trapped, but hard to control, once it escapes. Put differently, if the Fed has miscalculated and high inflation does return, the cure will be both long drawn out and extremely painful.
    2. Artificially "low" interest rates create winners and losers: If the Fed's bond buying is keeping interest rates at "artificially" low levels, not everyone wins. Among individuals, spenders are rewarded and savers are punished, a perverse consequence in a nation that already saves too little for the future. Among businesses, you reward those businesses that have to raise fresh capital, and especially those who are more dependent upon debt, and punish more mature and/or equity-focused businesses. Among sectors, you help out those that are more dependent upon debt-funded consumption (housing, durable goods) and do less for service businesses. Thus, keeping interest rates "abnormally" low may create bubbles in some sectors and encourage people to act in ways that are not good for the economy's long term health.
    3. Credibility effect: The powers of a central bank stem less from its capacity to print money (any central bank can do that) and more from its perceived independence and credibility, and I think the Fed has hurt itself on both counts. While I am willing to believe that the Fed acted without political considerations, any major action two months ahead of a presidential election will viewed through political lens, and it is natural for people to be suspicious. In addition, each time the Fed takes a shot at the "real growth" pinata and nothing happens, it damages it's credibility. Much as the market (and some economists) may welcome and justify QE3, but the ultimate test is in whether it will give a boost to real economic growth and if that does not occur, what's next? 
    I was a skeptic on the efficacy of QE2 and Operation Twist and I remain unpersuaded on QE3. If the definition of insanity is that you keep trying to do the same thing over and over, expecting a different outcome, then we seem to be fast approaching that point with the Fed.






    A new semester begins: Valuation class online

    If you are a teacher, you measure your life in quarters and semesters. This is my fiftieth semester teaching, and, as in each of the prior forty nine semesters, I could not wait to get started. Coddled as only tenured faculty at a research university can be, I have only one class to teach this semester. The class is "Valuation", and it is about valuing any asset: stocks, businesses, sports teams and collectibles are all fair game. While the class begins with an extended discussion of intrinsic (DCF) valuation , it will extend to cover multiples/comparables and real options. The first class was Wednesday, September 5, and I will teach it every Monday and Wednesday for the next 15 weeks (with a few days off in the middle) from 10.30 to 12 at the Stern School of Business at New York University.

    At the start of this year, I argued that universities have used their "monopoly" status in the education business to protect themselves from needed change. I also presented my view that "disruptive" changes were coming, largely because technology has undermined the entrenched competitive advantages that have allowed universities to charge premium prices for often below-average products. I also put my class online, using a company called Coursekit, and a few thousand people enrolled in the class. While life got in the way of completing the class for some of these students, I was gratified by the feedback I got on the class and I did learn from some of my mistakes (though I undoubtedly will make more mistakes soon). Symbolizing how quickly this business is shifting, Coursekit has changed both its look and its name (it is now called Lore), raised more capital and is aiming for bigger and better things. I wish them well, but I have decided to broaden the choices available to those who would like to take my Valuation class this semester. So, if you are interested, here they are:

    1. School website: I maintain a website at Stern for the class that includes everything that I do in this class: webcasts of the classes, lecture notes and quizzes/exams. You can find them all by clicking onn the link below:
    http://www.stern.nyu.edu/~adamodar/New_Home_Page/webcasteqfall12.htm
    The plus is that this is my first stop when I add or update anything to the class and it is the one place where you will be guaranteed to find everything to do with the class. The minus is that I am not a master at web design and the look and it shows: things are sometimes difficult to find and it is short on eye candy.

    2. Lore: I will continue to teach this class on Lore, but rather than maintain two separate classes (as I did last semester), I will consolidate the class in one location. Since I will be using Lore to keep track of those who are registered and are taking the class at Stern, you will be auditing the class on Lore, if you choose this option. To join the "audtior" list, click below:
    join.lore.com/c2d550c59a7f
    Note that you will have all of the access to materials and webcasts of the registered students. For the moment, though, you will be able to read posts and comments but you cannot post: I will work on seeing whether I can change that, to allow you to participate in discussions. The plus is that the site is much more polished than mine will ever be, but the minus is that you have to work within the Lore structure, which may not be to your liking. 

    3. Apple iTunes U: As a long time Apple user, I have watched the development of Apple iTunes U with interest. What started as a site with just class videos and no interaction is evolving into something more typical of Apple: beautiful and useful at the same time. The downside, though, is that you need an Apple device to use iTunes U, preferably an iPad. If you do have one, here is what you can do:
    Step 1: Go to the Apple App store and download Apple iTunes U. Don't worry. It is free.
    Step 2: On your Apple device, open your email and click on the link below
    https://itunesu.itunes.apple.com/audit/COK8RVCXTC
    Step 3: Apple iTunes U should open up and the class should be on your shelf.
    Step 4: You may need to wait until I let you into the site. (I am working on making this a public course but there seem to be some barriers in place...)
    The plus is that the site is dazzling in terms of beauty but the minus is that you cannot get to it on your Android or Blackberry device.

    4. YouTube:  I am using a site call Symynd to provide access to the class resources to anyone who is interested in valuation. This site, which aims to democratize education, converts the webcasts into YouTube videos and provides access to the material. You can get to the site by going to:
    For those of you who have trouble downloading the large lecture webcast files (150 GB and higher) that are offered on the other channels, the YouTube videos work much better, since they are compact. There is a Facebook page for the class, where you can post and respond...

    I hope that one of these four channels works for you and that you can come along for the ride. As always, I am interested in finding out not only what works, but what does not. The first session of the class was last Wednesday (September 5) and you have plenty of time to catch up before the next class on Monday. I will post the webcasts on all four channels about an hour after the class ends (between 1 pm and 2 pm, New York Time, every Monday and Wednesday).




    The Yankees' A Rod Problem: Sunk costs and investing

    As any baseball fan knows, the New York Yankees have an A Rod problem. Just in case you have no idea what I am talking about, A Rod is Alex Rodriguez, the third baseman for the New York Yankees, signed in December 2007 to a one of the richest sports contracts in history. The Yankees, dazzled by the the numbers that A Rod posted in 2007 and by the possibility that he could become baseball's home run king (with 500 home runs, he seemed to be on a path to beating Barry Bond's record of 762 home runs), signed the then 33-year old to a ten-year contract worth $275 million (with numerous bonus clauses for breaking home run records). The five years since have not measured up to expectations, with the disappointment building to a crescendo in the 2012 post-season, when A Rod's anemic hitting led to his being benched in the last two games against the Detroit Tigers. Now, the Yankees owe $114 million over the next 5 years to a 38-year old third baseman, who is susceptible to injuries and has seem to have lost his home run power  and his capacity to hit right handed pitching.  

    What should the Yankees do with A Rod? If they follow financial first principles, the contractual commitment of $114 million that they have already entered into should not be part of the calculus in any decision that they make now. Thus, if they feel that A Rod, based upon his current skill level (and age), is worth only $3 million a year for the next 5 years, they should be willing to consider trading him to another team (assuming he okays the trade) that will offer even a little bit more (say $3.1 million/year) in return, and eat the rest of the contract (about hundred million). Will they do it? I don't think so, because any such deal be an explicit admission that they made a horrendous mistake five years ago. Instead, what you are most likely to see is A Rod at third base for the Yankees, to start the next season, with everyone hoping and praying that he discovered the fountain of youth (at least a legal version of it) in the off season.

    The financial principle I was referencing is of course the one of sunk costs and anyone who has taken a basic corporate finance class knows the rule. A cost that you have already incurred or are contractually committed to incur should be ignored in your decision making. That rule, though, is easier enunciated than put into practice and here is a simple exercise to see why:

    1A. Assume that you are the manager of a business that is in ongoing development of a new product that will require spending an additional $100 million to bring to completion. Assume that you have just learned that a competitor has come up with a superior product at a lower cost and will be bring it to 
    the market at the same time as you will. Would you spend the $100 million?
    a) Yes
    b) No

    1B. Now assume that the same facts as in the prior case but also assume that you know that you have already spent $ 900 million on developing this product. Would you spend the additional $100 million?
    a) Yes
    b) No

    For most of you, I am sure that the answer would have been an easy "No" for 1A, since spending an extra $ 100 million on a product that will not compete seems pointless. For some of you, though, was it more difficult to say "No" to 1B? If so, you are not alone since 80% of managers in an experiment that asked exactly these questions were swayed by the sunk costs into investing in a doomed project. Interestingly, there have also been follow up studies that find that if decision makers were responsible for incurring the sunk costs in the first place, they are even more likely to be swayed by those costs.  In behavioral finance, the capacity of sunk costs to affect decisions falls under what is termed the "Concorde fallacy", named after the ill-fated supersonic jet that the British and French governments poured billions of dollars into, even in the face of clear evidence that it would never be a commercial success, partly because they had already spent so many billions in development.

    If you are an investor, you may wonder what this post has to do with you. I think we are all susceptible to the sunk cost problem. To illustrate, let's try a different experiment:
    2A. Assume that you are looking at a stock trading at $10/share and that you have valued the shares at $8/share. Would you buy the stock?
    a) Yes
    b) No

    2B. Now assume that you are looking at the same stock trading at $10/share, but that it already part of your portfolio and you bought it at $50/share. If your value per share is $8, would you continue to hold the stock?
    a) Yes
    b) No

    2C.  Now assume that you are looking at the same stock trading at $10/share, but that it already part of your portfolio and you bought it at $2/share. If your value per share is $8, would you continue to hold the stock?
    a) Yes
    b) No

    I am sure that the answer that you gave to question 2A was an unequivocal "No" but was your answer different for 2B? And how about 2C?  (Remember that holding a stock in your portfolio is equivalent to buying the stock....) If the answers were different, why? After all, on an incremental basis, the choice is exactly the same, and an investor who would not buy the stock in 2A would have also sold the stock in 2B and 2C.

    The problem is that investors seem to have different sets of rules, one for new or marginal investments, and one for existing investments. Rationally, your decision on whether to keep an investment in your portfolio should be based on whether that investment is cheap or expensive, given its price and value today, and not on what you originally paid for the investment or its value then.  (I know that taxes can create a real issue here, but this problem seems to persist even for tax exempt investors.) However, we are human and almost by definition, we are not rational, and behavioral finance chronicles the costs that we bear. In particular, there is significant evidence that investors sell winners too early and hold on to losing stocks much too long, using a mixture of rationalization and denial to to justify doing so.  Shefrin and Statman coined this the "disposition effect" and  Terrence O'Dean looked at the trading records of 10,000 investors in the 1980s to conclude that this irrationality cost them, on average, about 4.4% in annual returns. Behavioral economists attribute the disposition effect to a variety of factors including over confidence (that your original analysis was right and the market is wrong), mental accounting (a paper loss is less painful than a realized loss) and lack of self control (where you abandon rules that you set for yourself).

    So, is there anything that we can do to minimize the disposition effect? I don't have the answer but here are some things that you could consider. I employ the first two in my portfolio and while I cannot quantify how much they have saved me, they have brought me peace of mind.
    1. Regular value audits: The easiest path to the disposition effect is denial, where we refuse to look at the investments that we already have in our portfolio because we are afraid of what we may find. In fact, think about how much time we spend trying to come up with new investments to add to our portfolios (it is always more fun to start anew) and how little time we spend on maintenance investing. One practice that I have instituted for myself is that I have to value every company that is already in my portfolio at least once a year. It forces to me to take a look at the company, as if it were a new investment, and decide whether it deserves to stay in my portfolio another year. Since I have about 40 stocks in my portfolio, it does require some discipline but I think it has been well worth the cost.
    2. A selling rationale: Even with these value audits, I (like most investors) find it difficult to let go of losers, since selling a stock that has gone down is an explicit admission that I made a mistake. So, I provide myself with cover, especially at year end. For every winner that I sell each year (and I do sell one or two that have become over valued, at least in my judgment), I look for a loser (which is also over valued, in my judgment) that I will unload to reduce my tax exposure. Thus, rather than having to admit that I made a mistake, I can pat myself on the back for a savvy tax trade. Delusional, I know, but it helps...
    3. Automated rules: If the first two suggestions don't work, there is a third option, which is to take control of the decision out of your hands. You can put in a stop loss order, specifying that a stock that drops more than X% from your original purchase price, it gets sold automatically. It is a bludgeon, because that stock may very have become a bargain, but you may be saving yourself some bad disposition effect losses.
    4. Decision making separation: If it is the unwillingness to admit to your own mistakes that lies at the heart of the "disposition effect", it may be alleviated (at least in part) if the person making the assessment of whether to hold or sell a losing stock is not the person who made the mistake of buying the stock in the first place. Perhaps, mutual fund managers should work in pairs, with one manager responsible for making new investment picks and the other in charge of monitoring existing investments. Impossible to do for individuals, you might say... but I am considering talking to my wife about splitting the investment management role in our family. She can be the stock picker and I could be the stock assessor or vice versa.... One of us gets to make judgments on the other's mistakes.. On second thoughts, scratch that idea..
    So, as we watch the Yankees tackle their A Rod problem, it is worth remembering that we all have our own versions of the same problem: a reluctance to admit to our past "investing" mistakes and let sunk costs be sunk costs.





    Private Equity: Too disruptive or not disruptive enough?

    From my past blog posts, you should know that I am not a political blogger, but Mitt Romney’s background as a key player at Bain Capital has made private equity a hot topic this political season. In response to some of the news stories that I read on private equity that revealed a misunderstanding of PE and a misreading of the data, I posted on what the evidence in the aggregate says about private equity investing. Reviewing that post, I noted that PE fit neither side’s stereotype. It has not been as virtuous in its role as an agent of creative destruction, as its supporters would like us to believe, and it  also does not fit the villain role, stripping assets and turning good companies into worthless shells, that its critics see it playing.

    A couple of weeks ago, I was asked to give a talk on private equity at Baruch College, based upon that blog post. That talk is now available online (in two parts) and you can get it by clicking below:
    1. https://baruch.mediaspace.kaltura.com/media/Private-Equity+Firm%3A+Friend+or+Foe+of+the+U.S.+Economy%3F+%28Part+1%29/1_fjg9aogk
    2. https://baruch.mediaspace.kaltura.com/media/Private-Equity+Firm%3A+Friend+or+Foe+of+the+U.S.+Economy%3F+%28Part+2%29/1_sagki2jm
    The session is a little long (with the two parts put together running over an hour and a half). So, feel free to fast forward through entire sections, if you so desire. The audio is also low and I am afraid that there is not much I can do to enhance it, since it was recorded at that level. However, the iTunes U versions of these presentations have better audio and you can get them here:
     https://itunes.apple.com/us/itunes-u/zicklin-graduate-leadership/id556092137?mt=10
    I have also put the powerpoint slides that I used for the session for download and you can get to it by clicking here.

    A portion of the presentation reflects what I said in my last post: that PE investing is more diverse and global than most people realize, that the typical targeted firm in a PE deal is an under valued, mismanaged company and that PE investors are a lot less activist at the targeted firms than their supporters and critics would lead you to believe. Here are a few of the other points I made during my talk (and feel free to contest them, if you are so inclined):

    1. Why private equity? 
    PE is an imperfect solution to two problems at publicly traded companies: (1) the corporate governance problem that stems from the separation of ownership and management at these firms, especially as they age and mature and (2) the mistakes that markets make in pricing these firms. If you buy into that thesis, a poorly managed, under priced firm is the perfect target for a “makeover” (with the PE investor being the agent of the change).

    2. Who are these PE investors? 
    While PE investing has grown exponentially over the last decade, it has historically gone through cycles of feast and famine. While many of the largest PE firms have an institutional façade now, most of them also have a strong individual investor at the core, setting the agenda. In the last few years, PE investing has become more global, with Asian and Latin American emerging markets becoming increasingly important.

    3. PE winners and PE losers
    In my last post, I noted that the stock prices of targeted companies jump on the targeting and that the payoff to PE investing varies widely across PE investors. Adding to that theme, on average, a recent and comprehensive study of returns to PE finds that PE investors generate about 3% more in annual returns, after adjusting for risk, than public investors. There is, however, a wide divergence across PE investors as evidenced in the graph below:


    Thus, the top 10% of PE investors beat public investors by about 36% annually but the bottom 10% of PE investors underperform public investors by about 20% annually. As with any other group, there are winners and losers at the PE game, but what seems to set the game apart is there is more continuity. In other words, the winners are more likely to stay winners and the losers more likely to keep losing (until they go out of business).

    4. Is PE a net social good or social bad? 
    There are three critiques of PE investing. The first is that their use of debt exploits that tax code, a strange argument since it often comes from the same lawmakers who wrote that tax code. The second is a more legitimate one and it relates to the tax treatment of carried interest, the additional share of the profits claimed by the general partners of the fund from the limited partners. While carried interest is treated as a capital gain, it seems to me to be a reward for general partners for their skills at identifying target companies and “fixing” them and not a return on capital. If so, it should be taxed as ordinary income. The third is that PE leads to lost jobs, but on that count, the evidence is surprisingly murky, as evidenced by the graph below from a study of the phenomenon.



    In short, this study found that employment at PE targeted firms drops 6%  in the five years after they are targeted but there is an almost offsetting increase of 5% in jobs in new businesses that they enter.

    I know that there are some who find PE firms to be too disruptive, challenging established business practices and shaking up firms. Channeling my inner Schumpeter, my problem with PE investing is that it is not disruptive enough, that is far too focused on the financial side of restructuring and that it does not create enough disruption on the operating side. In short, I want PE investors to be closer to the ruthless, efficient stereotypes that I see in the movies and less like the timid value investors that many of them seem to more resemble. 



    The disclosure dilemma: Why more disclosure has led to less information

    The last three decades have been the golden age of disclosure, as both accounting rule writers and regulators have pushed companies to reveal more and more about their prospects to investors, both in the US and internationally. Some of this push can be attributed to more activist investors, demanding more information from companies, but much of it can be traced to accounting fraud/malfeasance, where companies held back key information from investors, who paid a price as a consequence. In response, legislators, the watchdog agencies (SEC and its equivalents) and the accounting rule-writers (GAAP, IFRS) have all responded by increasing the amount of information that has to be disclosed by firms. That should be good news for investors, but here are the contradictions that I see:
    • If the objective of “disclosure” laws is to prevent the next Enron, Parmalat or Worldcom accounting scandal, it clearly has not worked, since we seem just as exposed as we have always been to these problems. If anything, companies seem to have become more creative in hiding “bad” stuff, in response to disclosure laws, making it more difficult to detect problems. 
    •  If the objective is to help investors value companies better, it has not worked either. To me financial disclosures are raw data, when I do valuation, and I must confess that I find financial statements more difficult to work with today than I did thirty years ago, when disclosure laws were less onerous.
    So, what gives here? Why have these increased disclosure requirements not worked the magic that they were supposed to? While we can point to lots of reasons, including imperfections in the disclosure requirements, I think that the biggest problem is that the disclosure rules have turned financial disclosures into data dumps. To see my point, take a look at the 10K for a publicly traded company, even a small one, and you will see a document that runs into tens or even hundreds of pages. For instance, Procter & Gamble’s most recent 10K runs 239 pages and it is slim next to Citigroup’s most recent 10K which runs more than 300 pages.  If you are interested in valuing Procter & Gamble or Citigroup, you have to work your way through these pages, separating the wheat from the chaff, or more specifically, information from data. Faced with information overload, it is easy to get distracted by the legal boilerplate (you might as well throw out the entire section that discusses risk) and the trivial details that clutter modern disclosures. In my estimate, less than 10% (and that is being generous) of a modern financial disclosure has any value to an investor and to find this information, here are some things to keep in mind: 
    1. Read with focus: Know what information you are looking for, before you start looking for it.  In other words, reading a 10K, just looking for useful information, is equivalent to digging up your backyard, looking for interesting stuff. Your most likely outcome is that you will end up with a mountain of dirt and little to show for your work.
    2. Don’t sweat the small stuff: If you are valuing a $ 60 billion dollar company, you can afford to skip over that section that describes in excruciating detail a $25 million real estate lease that the company has entered into or the $50 million lawsuit filed against the company. 
    3. Don’t cater to your inner accountant: We know that accounting has its fixations and that financial disclosure often cater to these fixations. Thus, there are large chunks of these documents that are dedicated to how intangible assets have been “fair valued” or goodwill has been “impaired” (a mythical asset that exists only in the accounting world). Since I don’t trust accounting fair value judgments to begin with and goodwill has but a peripheral role (if that) in cash flow based valuation models, I can afford to skip these sections. 
    As some of you already know, I do teach a valuation course at Stern and my invite to anyone who is interested in sitting in still holds. Since a key part of doing valuation is learning how to work with financial disclosures, I recently put together a webcast on disclosures, where I used P&G’s most recent 10K to value the company. If you are interested, you can find the webcast with the supporting material (the 10K, my slides and my valuation of P&G). In fact, they are part of set of webcasts I am doing on the nuts and bolts of valuation:
    http://people.stern.nyu.edu/adamodar/New_Home_Page/valuationtools.html

    I am afraid that things will only get worse for investors. The push towards more disclosure, well intentioned though it might be, is unstoppable and  will create more bulk in annual reports and company filings, and more distractions for investors.

    While I am sure that I will be ignored, here are my suggestions to the regulatory and accounting disclosure czars if they truly want to help investors:
    1. Focus on principles, not rules: The principles that govern valuation are simple and robust, but they seem to take a back seat to rules when it comes to disclosure requirements. To provide a simple example, capital expenditures should measure what a company invests in its long term assets, whether those assets are tangible (land, building, equipment) or intangible (human capital, brand name, intellectual property). Not only are the accounting rules governing capital expenditures unnecessarily complex but they are internally inconsistent, with different rules governing tangible and intangible investments. (Prime exhibit: the treatment of R&D expenditures). 
    2. Less is more: My wife, who is the "organizer' in our house, has a very simple rule for everyone in the family. For every new item that any of us buys, one item has to be removed (given away or abandoned) from our closets. It is an excellent rule, since in its absence, we would undoubtedly hoard what we already have, on the off chance that we might need it in the future. I would propose a similar rule in disclosure. When companies are required to disclose something new, an old disclosure requirement of equal length has to be eliminated, thus preventing disclosure bloat.
    3. Target investors, not lawyers: As I browse through financial disclosures, I am struck by how much of the content is written by lawyers, and for lawyers, with the specific intent of shielding companies from lawsuits and/or regulatory backlash. While I understand that companies are gun shy about being sued, and that this protection is necessary,  it may be time to allow companies to file two disclosures, one for lawyers and one for investors. Using P&G as my example, I could construct an investors' 10K, about 20 pages in length, stripped off all the legalese that the full 10K includes.
    4. Let accountants do accounting (and not valuation): I know that "fair value" accounting is here to stay, but  I believe that the push is misguided. By requiring accountants to play the role of appraisers, it asks them to play conflicting roles: provide a faithful recording of what has happened in the past (traditional accounting) while also forecasting the future (a key component of making valuation judgments). In the process, I think that we will end up with financial statements that do neither accounting nor valuation well and that investors will pay the price.
    Looking forward, investors will increasingly be tested on their capacity to separate the data that matters (information) from the data that does not (noise or distraction). There is an interesting twist (and I thank Bill, who commented on this post for this insight). The increasing complexity of financial disclosure does open up the possibility that investors who can navigate their way through these disclosures and separate information from data will have a competitive advantage over other investors, who give up in frustration.



    Winning (losing) by losing (winning): The power of expectations

    If you are a baseball fan, I am sure that you know that both the New York Yankees and the Baltimore Orioles made the playoffs last week. While there was some celebration in New York on the news, it was nothing compared to the jubilation in Baltimore. The reason is not hard to fathom. In the last 16 years, the Yankees have made the playoffs in all but one, and with their payroll and heritage, Yankee fans view the playoffs as an entitlement, rather than a bonus. For Baltimore fans, whose team has not had a winning record (forget about making the playoffs) in a long time and was not expected to have one this year, it is a hugely positive surprise. It reinforces the message that it is now how well you do, but how well you do, relative to expectations, that determines the response.

    Expectations and Outcomes
    The expectations game is not restricted to sports. It spills over into politics, as attested to by the Obama and Romney teams jockeying to set expectations for the presidential debates and it definitely permeates markets. In particular, there are two news stories over the last couple of weeks that illustrate how critical expectations are in determining how we gauge performance.
    • On September 27, 2012, Research in Motion came out with its  earnings report, revealing that revenues dropped 31% and that it lost $235 million in the most recent quarter. Terrible news, right? The company's stock jumped 18% on the news!!
    • A few weeks ago, Apple introduced its newest iPhone, selling more than 5 million iPhone 5s over the first weekend and setting itself on target to beat prior records for smart phones sold. The big story, though, was about a free Map app that Apple was offering with the iPhone, that was misbehaving. The company has lost almost $40 billion in market value in the last two weeks!!
    To a first-time market observer, the market reactions may seem perverse, with the market rewarding a company reporting bad news (RIM) while punishing a company (AAPL) for its success, but bringing in expectations levels the playing field. The news about Research in Motion in the last couple of years has been unremittingly negative, and investor expectations for the company have hit rock bottom. In fact, the very fact that RIM did not see revenues go to zero and operating losses wipe them out may be such positive news that investors bought the stock. Conversely, almost everything that Apple has touched over the last decade has turned to gold, and people seem to expect the company to be perfect in executing everything that it does. Thus, the negative reaction to the Maps fiasco may be more a recognition on the part of some investors that Apple is not infallible and that the next error they make could be much more damaging.

    Playing the expectations game
    The crucial role that expectations play in how markets read outcomes is not a secret and companies try to manage the game, with varying degrees of success. For publicly traded companies, this involves walking a very fine line, where you talk down expectations without talking down the stock price. Yesterday, for instance, Meg Whitman, CEO of Hewlett Packard, told the world that it would take a lot longer for HP to fix its problems. Was she trying to be honest with markets or trying to bring down expectations to the point that she will be able to beat them more easily? It is almost impossible to tell, but whatever her rationale, the stock dropped 13% on the announcement. 

    Why do some companies manage expectations better than others? Here are some factors to consider.
    1. The audience: In providing guidance to markets, companies have conventionally thought of equity research analysts (especially sell side) as their primary audience. Ultimately, though, it is investor expectations that drive the game, and while analysts may influence those expectations, they are (in my view) more follower than leaders. The companies that are best at moulding expectations talk to investors, though they might use analysts as their messengers.
    2. The information: For a company to try to guide expectations, it has to have better information than investors do and be able to convey that information to markets. In particular, rather than just suggest that earnings expectations are too high, providing information on specifics such shipments or margins to back up the guidance will increase the impact it has. Companies argue that the Reg FD, the SEC's rule restricting selectively providing information to analysts, has restricted their capacity to provide meaningful guidance but note that the regulation does not prevent companies from making public disclosures to all investors.
    3. Credibility:  To be credible, companies that try to manage expectations have to be seen as trying to do both manage them down (when they are too high) and up (when they are too low). Too many companies seem to think that managing expectations just implied lowballing earnings and revenue numbers. A study of company guidance statements, the primary device for managing earnings expectations by Factset found that almost 80% of guidance provided by firms in the third quarter of 2012 was negative & designed to lower expectations (rather than raise them). A company that always tries to talk down expectations, while beating expectations each period, is like the boy who cried wolf, more likely to be ignored than listened to.
    4. Results: The game's denouement occurs when the actual news (earnings or other) comes out and investors measure it relative to expectations. If investors feel that companies are fudging the number or cooking the books to deliver actual earnings that beat expectations, they will at some point stop reacting to the news
    It is the fact that information disclosures have become a game that has led some companies to choose not to play the game at all, either because they view it as a distraction from their mission of creating long term value for stockholders or because they think it is futile. In fact, my sense is that the payoff to companies from playing this game is become smaller over time and that more companies should consider the option of not playing.

    Profiting from the investment game
    Can you profit from the game? After all, there are lots of investors who try. In my earlier post on earnings reports, I noted the time and energy expended by analysts and portfolio managers trying to get ahead of the next report.  Without rehashing the evidence, I will draw on my favorite proposition in investing. Success at the investing table requires you to bring something to it, and to win the expectations game, you have to have an edge and here are the possible ones:
    (1) Sector or company specific knowledge: You could invest resources in learning the inner details of companies in a sector (technology, health care) and use that knowledge to make judgments on which companies will deliver positive surprises and which ones will under perform.
    (2) Forensic accounting skills: Accounting statements contain clues about future earnings, and a microscopic examination of current accounting statements may provide clues about the future.
    (3) Inside information: I know, I know. It is illegal, at least in the United States, but that does not stop some from trying to use it to get an advantage.
    I am too lazy to immerse myself into sector specific information, don't care much for delving deep into accounting statements and both too risk averse/outside the circle to get or use inside information.

    Even if you don't want to play the quarter-to-quarter expectations game, you can perhaps turn the game to your advantage in one of two ways. The first is to use it in timing your investments, buying stocks that you think will deliver long term value (and were on your list of "buys" anyway) after they fail to meet expectations. Thus, if you have always wanted to add Apple to your list, you may feel that the Maps debacle is exactly the right time to jump in. The second is to build an investment strategy of buying (selling short) stocks right after "big" expectations failures (successes), on the assumption that investors are likely to be over reacting to the news. That is a strand of contrarian investing, albeit with a shorter time horizon and I posted on this strategy a few month ago.





    HP's Deal from Hell: The mark-it-up and write-it-down two-step

    I don't think that there can be any disagreement that Hewlett Packard (HP) had a terrible day on November 20. In a surprise announcement, the company announced that it was taking a write off of $8.8 billion of the $11.1 billion that it paid to acquire Autonomy, a UK based technology company, in October 2011, and that a large portion of this write off ($ 5 billion) could be attributed to accounting improprieties at Autonomy. Even by the standards of acquisition mistakes, which tend to be costly to acquiring company stockholders, this one stood out on three dimensions:
    1. It was disproportionately large: While there have been larger write offs of acquisition mistakes , this one stands out because it amounts to approximately 80% of the original price paid. 
    2. The preponderance of the write off was attributed to accounting manipulation: Most acquisition write offs are attributed either to over optimistic forecasts at the time (the investment banker made us do it..) of the merger or changes in operations/markets after the acquisition (it was not our fault). HP's claim is that the bulk of the write off ($5 billion of the 8.8 billion) was due to accounting improprieties (a polite word for fraud) at Autonomy.
    3. The market was surprised: Most acquisition write offs, which take the form of impairments of goodwill, are non-news because they lag the market and have no cash flow effects. In other words, by the time accountants get around to admitting a mistake from an acquisition, markets have already admitted the mistake and moved on. In HP's case, the market was surprised and HP's stock price dropped about $ 3 billion (12%) on the announcement. Put differently, the market had priced in an acquisition mistake of $5.8 billion into the value already and was surprised by the difference.
    The blame game
    I am sure that this case will be examined and reexamined over time in books like this one, but at this moment, every one involved in the merger is blaming someone else for the fiasco. So, here is a roundup of the suspects:
    • Meg Whitman, the current CEO of HP, blamed the prior top management at the company, and said that "(t)he two people that should have been held responsible are gone ".
    • Leo Apotheker, the prior CEO who orchestrated the acquisition, claimed to be shocked at the "accounting improprieties" at Autonomy. 
    • Michael Lynch, the founder of Autonomy, said that two major auditors had performed "due diligence" on the financial statements and had found no improprieties at the company. 
    • Deloitte LLP, the auditor for Autonomy, denied all knowledge of accounting misrepresentations and claimed to be cooperating with authorities. 
    • The advisers on the deal (Perella Weinberg & Barclay's Capital for HP, Quatalyst, UBS, Goldman Sachs, Chase & BofA for Autonomy) have all been mysteriously silent, though none have offered a refund of their advisory fees. 
    So, who is telling the truth here and who is to blame? Perhaps, the only way to answer this question is to go back to the original deal, which occurred just over a year ago.

    Building up to an acquisition price: The original deal
    Before we look at the numbers, it is worth reviewing the history of the two companies involved. Autonomy was a company founded at the start of the technology boom in 1996, which soared and crashed with that boom and then reinvented itself as a business/enterprise technology company that grew through acquisitions between 2001 and 2010. Hewlett Packard, with a long and glorious history as a pioneer in computers/technology, had fallen on lean times as it's PC business became less competitive/profitable and due to top management missteps.

    On August 18, 2011, HP's then CEO, Leo Apotheker (who had worked at SAP) announced his intent to get out of the PC business and expand the enterprise technology business by buying Autonomy. While the deal making began on his watch, the actual deal was officially completed on October 3, 2011, with Meg Whitman as CEO. If she was a reluctant participant in the deal, it was not obvious in the statement she released at the time where she said that "(t)he exploding growth of unstructured and structured data and unlocking its value is the single largest opportunity for consumers, businesses and governments. Autonomy significantly increases our capabilities to manage and extract meaning from that data to drive insight, foresight and better decision making."

    One of the perils of assessing "big" merger deals is that the fog of deal making, composed of hyperbole, buzzwords and general uncertainty, obscures the facts. So, let me stick with the  facts that were available at the time the deal was done (a time period that stretched from August 18, 2011, to October 3, 2011):
    1. Acquisition Price: While there have been varying numbers reported about what HP paid for Autonomy, partly reflecting when the story was written (between August & November) and partly because of exchange rate movements (HP paid £25.50/share), the actual cost of the deal was $11.1 billion. 
    2. Market Price prior: Autonomy's market cap a few days prior to the deal being announced was approximately $5.9 billion.
    3. Pre-deal accounting book value: The book value of Autonomy's equity, prior to the deal, was estimated to be $2.1 billion. (Source: Autonomy's balance sheet from its annual report for 2010)
    4. Post-deal accounting book value: After acquisitions, accountants are given a limited mission of reappraising the value of existing assets and this appraisal led to an adjusted book value of $ 4.6 billion for Autonomy. (Source: HP's 2011 annual report, page 99)
    The advantage of working with these numbers is that differences between them are revealing. In the figure below, I attempted to deconstruct  the $11.1 billion paid by HP into its constituent parts:

    You can see the build up to the price paid by HP as a series of premiums:
    1. The accounting "write up" premium for book value: One of the residual effects of the changes that have been made to acquisition accounting is that accountants are allowed to reassess the value of a target company's existing assets to reflect their "fair" value. For technology companies such as Autonomy, this becomes an exercise in putting values to technology patents and other intangible assets and that exercise added $2,533 million to the original book value of equity.
    2. The pre-deal "market" premium over book value ($1.3 billion over post-deal book value): Even if accountants write up the value of assets in place to fair value, markets may still attach a premium for growth potential and future investments. As with any market number, this number can be wrong, too high for some companies and too low for others. Prior to the HP deal, the market was attaching a value of $6.2 billion to Autonomy, $3,833 million higher than the original book value of equity and $1.3 billion more than the post-deal accounting book value of equity. 
    3. The acquisition premium ($5.2 billion): To justify this premium, HP would have to had to believe that one or more of the following held:  (i) the market was undervaluing Autonomy, i.e., that the true value of Autonomy was much higher than the $ 5.9 billion, (ii) there are synergies between HP and Autonomy that have value, i.e., that there are value-enhancing actions that the combined firm (HP+Autonomy) can take that could not have been taken by the firms independently and/or (iii) that Autonomy was badly run and that changing the way it was run could make it more valuable, i.e., there is a control premium. Even without the benefit of hindsight, neither undervaluation nor the control premium seemed to fit as motives in this acquisition. First, Autonomy was being priced by the market richly in August 2011; the market cap of $ 5.9 billion was roughly 6 times revenues and 15 times earnings and neither number looked like a bargain. Second, for a company that had been as badly run as HP to be talking about inefficiencies at other companies (and control premiums) strikes me as absurd.
    The reaction to the deal was negative, a the time that it was done. The analysts and experts were generally down on the deal, but more importantly, the markets voted against the deal by pushing down HP's stock price. Between August 18, 2011 (the date the deal was announced) and October 3, 2011 (when the deal was consummated), HP's market cap plummeted by $15 billion from $58.5 to $43.5 billion. It would be unfair to attribute this meltdown to the Autonomy deal alone, since HP was announcing spectacular failures on so many different fronts, but it would be fair to say that markets did not share HP's hopeful assessments of synergy in this deal.

    The cost of accounting impropriety & breaking down blame
    Let's fast forward to today. In the conference call on November 18, the CFO of HP attributed the write off of $8.8 billion to two primary sources: $5 billion to accounting improprieties at Autonomy and $3.8 billion to a drop in HP's stock price. The latter rationale does not really hold up since it mistakes cause and effect; the stock price went down because of HP's misstep (though it has made so many that I am not sure which one) and is not the cause of the write off. Thus, it makes sense to attribute the entire write off to the deal. Applying HP's write off of $8.8 billion to the acquisition price of $11.1 billion, brings Autonomy's estimated value (according to HP) back down to $2.3 billion (almost equal to the pre-deal book value of $2.1 billion). In effect, HP is arguing that almost all of the premiums in the original deal (the accounting write up, the pre-deal market premium, the acquisition premium) were not justified.

    So, what form did these accounting improprieties take? Based on news reports, HP's contention is that Autonomy was "overstating" and "mis-categorizing" revenues (they were allegedly booking low margin hardware sales as higher margin service/software sales). Assume for the moment that HP is right, and that Autonomy's revenues in 2010 were overstated by 15% and that its true operating margin was the industry average of 31% (and not the 36% that Autonomy was reporting in 2010). Since the accounting misstatements predated the HP acquisition, the pre-deal market value of $5.9 billion should already have been inflated because of the misstatements. Using the pre-deal market value of $5.9 billion as a base, I extracted an expected revenue growth rate of 14.25%. I then substituted in the lower revenues (15% drop) and lower margin (31%) into the valuation and estimated a value for the equity of $4.2 billion. Put differently,  if you buy into HP's story fully, the value effect of the accounting misstatement was $1.7 billion (the difference between the pre-deal market value and the adjusted value)  on the pre-deal value.

    HP's argument would be that the synergy premium of $5.2 billion that they paid was also overstated because of the accounting improprieties. Since we do not have access to the detailed synergy estimates (assuming that they were made), we assumed that the accounting overstatement would comprise the same percent of the synergy value it was of the pre-deal market value ($1.7 billion is 28.81% of $5.9 billion) and that half of this value is Autonomy's share (since synergy accrues to the combined firm):
    Estimated accounting impropriety portion of synergy value =0.5( 28.81% of $5,200) = $749 million
    I know that this may not be fair and that I am going with incomplete information, but here is my breakdown of blame for the $ 8.8 billion write down:


    As I see it, everyone involved in this process owns part of this disaster. Leo Apotheker, the CEO who pushed this deal through, gets the lion's share with $4,451 million, though the investment bankers who advised him were his enablers in the process. To the extent that HP is right in its contention that Autonomy cooked the books (inflating revenues and margins), Autonomy's founder/ managers and its auditor (Deloitte) are responsible for $2,449 million in value destruction. That leaves us still with an additional $1,900 million in write offs, which I can attribute to either a deterioration of Autonomy's business in the eleven months since HP took it over (a form of reverse synergy) or game playing on the part of HP, where taking bigger losses now will allow them to claim improvements and look better in the future. In either case, I would hold HP's current management responsible for that portion ($1,900 million) damage. As HP stockholders, though, don't expect any of these parties to offer to cover their fair share.

    This deal offers important lessons about headstrong CEOs, the ineffectual accounting for acquisitions and the flaws in the acquisition process that allow bad deals like this one to get through, but this post has become too long to expand on these issues. So, more in my next few posts....


    The Acquisition Series
    HP's deal from hell: The mark-it-up and write-it-down two step
    Acquisition Archives: Winners and Losers
    Acquisition Hubris: Over confident CEOs and Compliant Boards
    Acquisition Advice: Big deal or good deal?
    Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
    Acquisition Accounting II: Goodwill, more plug than asset




    Much ado about liquidity? Lockup expirations and stock prices

    Last week shaped up as a big one for Facebook. On Wednesday (November 14), the company faced the steepest of its lockup expiration cliffs so far, with 777 million shares released for sale by insiders. Its two earlier lockup expirations, of 271 million shares on August 16 and 234 million shares on October 29, did cause stock price pullbacks of about 5% and 3% respectively. Consequently, there was concern that Facebook’s stock price would take a beating on November 14, but the stock price climbed 12.6% on that day.


    There are a host on intriguing questions that derive from lockups, their expiration and the market reaction to them, and I think it is worth taking a look at them.

    The mechanics of and rationale for a 'lockup"
                Facebook is not unique. Most initial public offerings (IPOs) have lockup agreements that prevent insiders (which include owners/founders and VC investors) from selling their shares for a period after the offering. These lockups are not mandated by regulatory authorities but are contractual agreements between issuers and underwriters, with the terms disclosed in the IPO prospectus. While the most common lockup period for IPOs in the US is 180 days, there are quite a few firms that stagger their lockup dates (as Facebook did).  So, why do we see lockup periods in initial public offering? There are at least three reasons for the practice.
    1. Skin in the game:  There are many risks that investors face when investing in newly public companies, but one is that the investors and founders of the company will cash out and leave behind a vacuum. Lockup periods ensure that the venture capitalists and owners of a business have skin in the game at least for a limited period after a stock goes public.
    2. Signal of company quality: As a related point, having a lockup period makes the offering price more credible for outside investors, since insiders have to wait to sell their shares (rather than dump them at the offering price). A study of British IPOs found that longer lockup periods are associated with better performing IPOs (both in terms of profitability and stock price performance). In fact, it is worth remembering that Facebook, in its pre-offering hubris cut the lockup period to three months for some holders just before the offering date.
    3. Stage management of offering: Having a lockup period for insiders also ensures that only a small fraction of the outstanding shares  hit the market on the offering date. This, in turn, enables investment bankers to "discount the price" at the offering and allows them to use the initial offering more as a marketing event leading up to the main event (which is the sale of shares when the lockup period expires). As this study notes, there is evidence that investment bankers and insiders both have an interest in underpricing the offering shares to create price momentum, which can then be ridden (hopefully) to the end of the lockup period. 
    Lockup expirations: The insiders' choice to sell (or not)
    When a lockup expires, insiders get the right to sell their shares, though they can choose not to sell. While there may be other motives at play, there are three reasons why insiders may sell at the end of the lockup period:
    1. Need for cash: Some insiders, while wealthy in terms of the market value of their holdings, a can still be cash poor if the bulk of their wealth is tied up in the shares of the company. If they need the cash (to either fund conspicuous consumption or to pay taxes), they may have to liquidate at least some of their holdings.
    2. Diversification : In a related point, the founders and even some of the venture capitalists in a company that has just gone public may find that they have too much of their wealth tied up on that company. Having weighed the desire for control of having a concentrated position against the peace of mind that comes from diversification, some of them may choose to cash out on at least a portion of their holdings and invest that cash elsewhere.
    3. Information: Perhaps the trickiest part of the equation is that insiders do have access to information that the rest of the market does not about how a company's operations are performing. If they feel that the market price is too high (relative to their judgment of value), they will be inclined to sell their holdings.
    The rest of us get to observe the actions (whether insiders sell at the end of the lockup period and how much they sell) but not the motives. Not surprisingly, we still try to find signals in the actions and react to how much insider selling there is, relative to our expectations.

    Lockup expirations: The evidence and analysis
    Lockup periods are therefore par for the course in initial public offerings and insiders have multiple motives for selling when lockup periods end. So, what typically happens when lockup periods end? To understand the market reaction when lockup periods expire, let's look at the effects, both positive and negative, of these events:
    1. Liquidity effect: In the short term, the end of the lockup period releases shares for sale into the market, creating a demand/supply story that goes as follows: the end of the lockup releases news shares into supply, and holding the demand for these shares constant, this should reduce price. In the longer term, the release of the “locked up” shares to the market increases the shares that are available for trading (the float) and may should improve liquidity. 
    2. Information effect: When insiders exercise their right to sell their shares, they are also conveying their views on what they think about the market price. As we noted in the last section, you are more likely to see heavy insider selling, if insiders view the stock to be over valued and less if it is under valued. In particular, markets form expectations about how much insider selling you should observe and if there is less (more) insider selling than anticipated, it is viewed as good (bad) news. 
    3. Backstop effect: While investment banks may be under no legal obligation to provide support services beyond the immediate IPO, there is evidence that issuing banks continue to provide at least partial support for an offering until the lockup date. That support can range from buying shares, if the stock price goes into free fall, to favorable recommendations from the issuing banks’ equity research analysts. The removal of the investment banking support system may have negative consequences for stocks. 
    Looking at the trade off, the net effect should vary then across companies. You would expect the most negative price impact from lockups ending at small lightly-traded firms (where the near term trading imbalance can overwhelm the long term liquidity benefits), where there are few institutional investors or analysts tracking the firm (making insider trading that much more informative) and where issuing banks have been active in providing support (ensuring that the removal of the backstop will have more consequences.  The effect should be more muted with larger firms that are already actively traded by institutions and tracked by analysts. Since these firms are already heavily traded, the liquidity impact is likely to be smaller, the institutional and analyst following should reduce the information impact of insider trading and the size of these firms will make it impractical for investment bankers to provide more than surface level backstop support.


    The studies that have looked at this phenomenon seem to reach consensus on two broad conclusions::
    1. The price impact is negativeWhen lockups expire, stock prices drop. The drop is statistically significant (between 2 and 5%) and there is no rebound from this price drop.  In case you are tempted to try to take advantage of this price drop by selling short prior to lockup expirations, it is too small (relative to transactions costs) and too unpredictable (about a third of lockups end with increases in stock prices) to build a profitable investment strategy around.
    2. The trading volume surges: Trading volume increases  on the expiration of lockup periods, with volume increasing substantially both at the time of the expiration and the periods after.  One study finds that the price impact on the lockup expiration is related to the change in liquidity in the post-lockup period, with more positive (negative) stock price reactions correlating with increases (decreases) in liquidity.


    Looking at Facebook
    Based on the last section, I would argue that analysts who have used the lockup expirations as a rationale for Facebook's stock price performance since its IPO  have been reaching for straws. Facebook is a large market cap firm (market cap > $50 billion), with substantial trading volume and a heavy analyst following. It is not the type of company where you would have expected to see dramatic up or down moves on lockup expirations.

    That is not to say that lockup expirations are non-events, since even at Facebook, there have been sizable price reactions to the first three lockup expirations - negative (-5%) for the first one, slightly less negative on the second one (-3%) and positive (13%) for the third.  Rather than search for elaborate rationale for the different market reactions, I would point to price momentum around each of the expirations. The first lockup period expired in the immediate aftermath of a bad earnings report in August, with the stock price already sliding, and the market reaction was negative. The second lockup period expired after the stock had spiked on the third quarter earnings report but was retracing its steps in the days after. The lockup period that expired last week (on November 14) was after the second earnings report, which was viewed as good news, and when the stock had upward momentum. Looking at this small sample, it seems to me that at least in Facebook, insiders have behaved like other momentum investors, selling when everyone is selling and holding if the prevailing sentiment is positive.  If there is a broader lesson to be learned from these experiences, it is that we attribute too much wisdom and knowledge to insiders, at least at young growth companies.  Rather than being ahead of the market in their assessments of value, insiders at these companies are often just as uncertain as the rest of the market and just as likely to follow the crowd. As a stockholder in Facebook now (my limit order did come through), I am less inclined to pay attention to what Zuckerberg thinks or does about the company and more to the fundamentals that will drive its value over time.



    Storms and Stocks: Dealing with Disruptive Shocks

    Sandy, the super-storm that terrorized New York and its environs is now history, but it left a trail of destruction. As communities around the city and New Jersey dealt with power failures, gas shortage and transportation chaos, I was thinking about the lessons that I learned from the experience and their application to financial markets, which have been buffeted with their own storms for the last five years.
    1. Once is an accident, twice is bad luck, but three times is a pattern: For much of the time that I have lived in the United States, power failures were not only unusual but when they did occur, lasted at most for a few hours. However, in 2011, we lost power for several days twice, once after Hurricane Irene and once after a freak ice storm, and this year, we lost power again for a week. While it is entirely possible to attribute these occurrences to chance, it is also possible that weather systems have changed and that the last two years may be more the rule than the exception going forward. The last five years in financial markets have been characterized by “unusual” macro events (banking crisis, Greece, Spain etc.) but they are unusual only because we are viewing them through the lens of recent history (the prior six decades in developed markets). As with the weather, it is possible (and I think it is likely) that these macro crises are not an aberration but are part and parcel of markets for the foreseeable future, and that investment strategies and risk management systems have to be adapted accordingly.  
    2. History provides little guidance: When there is a disruptive shock (and the storm definitely qualified), it is human nature to use past history to fill in the gaps, even if it does not quite fit. Thus, my neighbors argued that since train service was up and running a couple of days after the storm last year or the terrorist attacks in 9/11, it was likely to be back up after this one too. In financial markets, investors have used the crutch of historical data (equity risk premiums from the past, PE ratios over time) to evaluate when and where to invest these last five years. In both cases, extrapolating the past would have yielded poor predictions. 
    3. Misinformation fills the news vacuum: In the immediate aftermath of the storm, there was an information vacuum where the power and transportation companies had no useful guidance to customers and rumors filled in the gap. With each macro crisis over the last few years, we have seen the same phenomenon in markets, where rumors of deals made and unmade have moved markets substantially. 
    4. It is good to have back up systems: About 15 months ago, none of the houses in my neighborhood had back-up generators, as the cost of installing one seemed to be well in excess of any potential benefits. After this storm, I would not be surprised to hear generators starting up at a third of the houses the next time we lose power. The problem, though, is that these generators are themselves dependent upon fuel (natural gas or gasoline) to work and may end up being idle in their absence. Risk managers (at companies and financial service firms) have devised their own back up systems to protect themselves against the “last” crisis but these systems may themselves break down, in the face of the next crisis. 
    5. But it is better to design resilient systems: One reason that this portion of the East Coast was hit so hard by the storm was that it was never designed to withstand it. In particular, large power-dependent houses with finished basements, power stations that are close to the ocean or rivers and overhead power lines are all rich targets for storms like Sandy. If these storms are the new norm, we have to think about building houses that are livable without power (those older houses have lower ceilings, unfinished basements and fireplaces for a reason) and a more defensible power system. In investing we have to think about a similar redesign of how we invest, with dynamic asset allocation (reflecting the constant shifts in the macro environment) and a stock selection process that is less dependent upon rules of thumb (many of which were constructed for a past that no longer applies). 
    More generally, in the face of the increasing frequency of disruptive shocks, I would pick:
    (a)Simpler over more complex systems: Over the last few decades, lulled by the growth of technology and access to data, we have built more and more complex systems (in both day-to-day living and investing) that are dependent upon both. Since disruptive shocks cut off both technology and data, simpler systems will survive and bounce back faster in the face of these shocks. I am glad that my investing strategy is based on intrinsic valuation and that I can value a company with an annual report and a calculator (or even an abacus) and that I am not dependent on access to real time data or computerized trading for investments. I am even happier that I could go two weeks without tracking either the market or looking at the investments in my portfolio, without fear of a meltdown. 
    (b) Decentralized over centralized systems: The “hub and spoke” system, where you centralize resources does have its advantages, primarily related to efficiency, at least in normal times. The problem with these systems is that failures at the system’s center can shut the entire system down, as passengers on United and Delta discovered, when their hubs (Newark for United and LaGuardia for Delta) shut down during the storm. Decentralizing these systems may create more coordination headaches during normal time periods but allow for faster recovery after disruption.

    I am glad that the storm has passed, that I have power and that I am able to type this post on my train ride home from work. At the same time, I realize that as an investor, there are more storms coming, both from within (the fiscal cliff) and from outside (Asia’s slowdown and the EU’s future) and that I need to become more agile to weather these storms. Time to get to work….



    Death and Taxes at year end: Unpredictable Certainties

    There is one trading day left in the year and thus one last day for last-minute tax planning. More than any year in living memory, this one is unsettled simply because no one knows what the tax code will look like for either corporations or individuals next year. As a consequence, I have found that taxes have dominated my thoughts about investing for the last couple of weeks and that makes me uncomfortable, since some of the least sensible investment choices I have made in my lifetime have come about when tax considerations have been preeminent. To ground my thinking and actions for these last few weeks, there are three propositions about taxes that I have had to remind myself about repeatedly over the period.

    1. The objective in investing is not to minimize taxes paid but to maximize after-tax returns
    If you hold pre-tax returns constant, your objectives when it comes to taxes are simple: you want to pay less taxes rather than more, and later rather than sooner, and that is precisely what most tax advantaged investments offer as their selling points. The catch, though, is that you generally have to accept lower pre-tax returns in return for these tax advantages and it is often the case that these tax advantaged investments generate lower after-tax returns than conventional alternatives. An investment strategy built around minimizing taxes can lead to bad choices. Do you want an investment strategy that ensures that you pay not taxes next year? That's easy!  Just buy non-dividend buying stocks that go down over the course of the year!!

    I was reminded of this simple proposition as I was considering the coming changes on capital gains taxes, the one aspect of the tax law where we know what next year will bring. The long term capital gains tax rate, which was 15% for the last decade, will jump to 20% for all investors on January 1, 2013, and to 23.8% for those investors who have more than $200,000 in income; the additional 3.8% is the tax on investment income that was part of the Patient Protection & Affordable Care Act of 2010. Thus, if you have $100,000 in capital gains on a stock, selling it on December 31, 2012 will result in a $15,000 capital tax, but selling it later in 2013 will generate $20,000 ($23,800) in taxes. While my first reaction was that I should sell my big long-term (held > 1 year) winners this year and save on taxes, I had to caution myself to go slow, since the savings in capital gains taxes have to be weighed against the value lost by selling early, if the holding in question is still undervalued.  I ranked the investments in my portfolio, based upon absolute capital gains and then revalued each of the five stocks at the top of the list, using updated information. The three stocks that were still under valued (based on today's price and updated valuation) by more than 5% remained in my portfolio, whereas the two stocks that were under valued by less than 5% or were fairly valued (or over valued) were sold. If you don't have the time or the inclination to do a full fledged valuation, you can still ask yourself a question about your big winners: Would you buy the stock at today's prices? If the answer is yes, you should be hold back on selling the stock, even though capital gains taxes are going up next year.

    I know that next year will bring more of these trade offs. With dividend taxes, where there is more uncertainty,  the worst case scenario is that they revert back to being taxed as ordinary income. For investors making over $250,000 in income, this could translate into a tax rates as high as 43.4% (assuming that the higher income tax rate reverts to 39.6% plus 3.8% in healthcare taxes). While my first reaction again is that if this scenario unfolds, I should avoid stocks that pay large dividends, I know that that reaction may not be a sensible one. After all, the prices on these stocks could fall to make their returns attractive enough that even with the higher taxes, they are good investments.

    2. Look for value first, think about taxes afterwards
    When valuing companies, I believe it is best to keep personal taxes out of the analysis, since it is not your tax status or mine that is the determinant of the intrinsic value of a company. That value should be estimated from the perspective of the marginal investors in the company, i.e., investors who own large proportions of the stock and trade it, rather than your own. That is why we measure risk as perceived by those marginal investors (who we assume have diversified portfolios) and that is also why it is their perception of taxes that will determine intrinsic value. Thus, if the marginal investors in P&G and Coca Cola are pension funds (and thus unaffected by dividend tax law changes), it is possible that the intrinsic value of these companies may not change, even in the worst case scenario where the tax rates double on dividends.

    Having estimated the intrinsic value of these companies, I can bring my tax status into the mix, when making my choices. Thus, if I have to pay a 40% tax rate on dividends and a 20% tax rate on capital gains, and I have to choose between two equally undervalued companies, one with a high dividend yield and one without, I would pick the latter. If the higher dividend paying stock delivers a higher pre-tax return than a stock of equivalent risk that does not pay a dividend, I will then have to work out the after-tax returns that I will get from each to make my final judgment. For example, if I expect to generate a pre-tax total return on 10% on a stock with a dividend yield of 2% and 9% on a stock that has no dividends, the after tax returns on each would be as follows (with a 20% tax rate on capital gains and a 40% tax rate on dividends):
    After-tax return on a stock = (Total return - Dividend yield) (1- Capital gains tax rate) + Dividend yield (1- Dividend tax rate)
    After-tax return on dividend paying stock = (10%-2%) (1-.20) + 2% (1-.40) = 7.6%
    After-tax return on non-dividend paying stock = 9% (1-.20) = 7.20%
    For the last decade, I was able to skip this step as the tax rates on capital gains and dividends converged, but it is a step that I cannot ignore if the tax rates on dividends and capital gains diverge again.

    3. Having a long time horizon is the best protection against taxes
    As investors look for ways to reduce the tax drag on their investments, they will be tempted by complex products that will claim to save them taxes. For some of the very wealthy, these products may make sense, but for the rest of us, they often create more costs than benefits. I may be simple minded when it comes to taxes but I think that the most effective tax management strategy for most investors is to have a long time horizon. Investors with short time horizons generally pay more in taxes for two reasons: (1) their holding periods are too short to qualify their gains for long term capital gains, thus converting their price appreciation in ordinary income (with higher tax rates) and (2) the high turnover in their portfolios makes it impossible to have a cohesive tax strategy.

    The link between turnover and taxes is most easily seen when you look at returns on mutual funds, where Morningstar keeps track of the pre-tax and after-tax returns on funds. The figure below provides the statistics for the tax drag for funds broken down by turnover ratios (total trading volume/ value of the fund) for a five year period (2006- 2010):


    While the returns on all funds were depressed by the poor market returns during this period, what is noteworthy is the tax drag (the different between pre-tax and post-tax returns) as a function of turnover ratios. The funds with the lowest turnover ratios (and the highest time horizons) had the lowest tax drag, whereas those fund that had short holding periods and high turnover ratios paid much more in taxes.

    In closing
    At this point in the fiscal cliff debate, I am resigned to the fact that taxes will go up on January 1, 2013 and the only question is by how much. I have done all I can with my existing portfolio to reduce the impact of the tax law changes, but I have had to restrain myself from over reaching. It is possible that we will know what the tax code will look like before close of trading on December 31, 2012, and the market reaction to those changes will play out over the next few days. For my part, I am done with investing for the year and will spend tomorrow on more important concerns- friends, family and faith. Death and taxes may be unavoidable, but life is too short to be spent obsessing about either. So, have a happy new year and may it bring you health and happiness!!



    The year in review: Apple's universe?

    As the year winds to a close, I don't think that there can be much debate that this was Apple's year, for better or for worse. In my view, no company has dominated the financial news and the cultural landscape in any year as much as Apple did during 2012. Not only were Apple's earnings announcements greeted with mass hysteria, but Apple's products were bigger news than any celebrity on Hollywood. At the risk of adding to the heated discussion that accompanies almost any mention of the company, here is my attempt to pull together what happened to the company this year.

    January 2012: How much cash is too much cash?
    The year began with a great deal of breast beating, at least among some of the pundits & portfolio managers about how big Apple's cash balance was, as well as ill conceived arguments about why the cash was hurting Apple's stockholders. In my post on Apple's cash balance on January 19, 2012, I took on the argument that cash is a bad investment simply because it earns a low rate of return, and presented my thesis that a large cash balance can have a positive, neutral or a negative effect on assessed value, with the judgment depending upon how much you trust the management of the company holding the cash. With Apple's impeccable track record on both internal investments and stock price performance over the last decade, I argued that as an investor, I was comfortable with the company holding my cash for me and that the market was not punishing Apple for accumulating cash. In a later post on trapped cash in August 2012, I took note of the fact that a significant portion of Apple's cash was trapped in foreign markets and that returning the cash to the US would generate a significant tax bill.

    March 2012: Dividends or Buybacks?
    By March 2012, Apple's cash balance was approaching $100 billion, creating a second round of debate about whether it should return the cash to its stockholders. Rather than leave well enough alone, Apple opened the door to much greater pressure to do something with the cash, when Tim Cook, its CEO, conceded that Apple had more "cash than we need to run the company". Once that admission was made, I argued in a post on March 1, 2012, that Apple had no choice but to take action and return cash to its stockholders. Looking at the choice between paying dividends and buying back stock, I argued that there were four considerations that came into play in making this decision: (1) whether urgent action was necessitated by the presence of acquirers or activist investors, (2) whether stockholders in the company were more motivated by dividends or capital gains in buying the stock, (3) what the tax consequences to investors were from receiving dividends/capital gains and (4) whether the stock was under or over valued. By my assessment, Apple's market cap made it invulnerable to outside pressure, its existing stockholders had generated all their returns from price appreciation and the stock was under valued (my value per share was approximately $ 710). I argued for a stock buyback of roughly $60- $ 70 billion, with a cap set on the buyback price.

    April 2012: The Clash of Investor Clientele
    Apple did make a decision to return cash to its stockholders, but far less than I had argued for ($20 billion, rather than $60 billion) with half as a regular cash dividend. In a post on April 3, 2012, I explained a personal decision that I had made to sell Apple and laid out my reasons, though they were still misunderstood. After explaining how much I loved the company and how grateful I was for the returns that the stock had made for me from my original investment in 1997, I also was categorical that at $600+ a share, I felt that the stock was still a good value (based upon my assessment of value at $710/share). However, there were two forces at play in my decision to abandon the stock. First, the stock's incredible ascent over the previous decade had made it a large portion of my personal portfolio, making my wealth vulnerable to swings in the stock. Second, the decision to pay dividends, in my view, opened the door to a new group of "dividend" stockholders investing in the stock, with very different expectations of what the company should do in the future than the "growth seeking" stockholders who already held the stock. If you added the "momentum" investors who had joined in the mix, drawn by the large market cap and price surge in the stock, you had an investor base that was at war with itself. Every news story and corporate action, I felt, would be scrutinized and found wanting by one or more of these groups, which, in turn, would lead to wild price swings that I could not afford in my portfolio.

    That post exposed me to a fair amount of backlash (including anonymous voice mails on my office phone) and the critique that I was being emotional and not staying true to my intrinsic value roots. While I have a thick skin, I did feel the urge to follow up with a post on April 6, 2012, where I pleaded guilty to both charges, by admitting that my original investment in Apple in 1997 was an emotional one (I felt sorry for the company) and arguing that being right on intrinsic value was only half of winning the investment game. In fact, this tension between intrinsic value and price became a theme that I returned to repeatedly, during the rest of the year.

    August 2012: The iPhone Launch
    In late August, the world was agog (and I am not using hyperbole) with the coming of the iPhone 5. As I listened to my youngest (thirteen) tell me about every new rumored feature that the phone was going to have, I did my part by valuing the iPhone franchise in a post on August 29, 2012, based on five value drivers: (a) an after-tax operating margin of 21% on the product, (b) a 6% growth rate in the smartphone market, (c) a product life cycle of 2 years, (d) only 5% of iPhone users would switch to competitors, whereas 10% of competitors would switch to the iPhone and (e) a risk level commensurate with the top decile of US stocks. The resulting value for the franchise that I obtained was $ 307 billion.

    The iPhone franchise valuation did point to a danger that Apple investors need to be aware of. Since half or more of Apple's value comes from the iPhone, the short life cycle for the product will inevitably create an ebb and a flow to the stock, with each new version of the product being scrutinized for signs of slippage, just as the iPhone 5 has.

    October 2012: The Maps fiasco
    The iPhone did launch and while it was the most successful smartphone launch in history, what happened in the weeks following provides an illustration of the power of expectations. The assumption that Apple could do no wrong had become such an entrenched part of investor beliefs that every misstep on the iPhone put under the microscope. In a post on October 9, 2012, on expectations, I noted the contrast in market reactions to Research in Motion reporting that revenues dropped by 31% (its stock price jumped 18%) and to Apple's mishandled free Map app (which was associated with a drop in Apple's market cap of $40 billion).

    While the expectations game has worked against Apple for the last few months of 2012, the perceived disappointments in Apple's financial and operating results may carry a silver lining, insofar as they lead to lower expectations for the future. So, I would not be surprised if Apple's first quarter earnings beats expectations and the game goes on...

    December 2012:  Blame the fiscal cliff?
    As the end of the year approached, Apple seemed to go into a tail spin, starting with a disappointing earnings report in November but with the price drop accelerating as the year end approached.


    Not surprisingly, analysts and pundits were looking for something or someone to blame and the fiscal cliff became a favored target. Apple's stock price was collapsing, they argued, because capital gains taxes would increase in January 2013 and investors in Apple were therefore booking their capital gains in 2012. While I have argued that stock prices would be negatively affected if  we go off the fiscal cliff, I don't see it as the primary factor behind Apple's fall. While the initiation of dividends in March 2012 has increased the exposure of Apple's investors to the tax law changes coming in January 2013, large dividend paying companies such as Coca Cola and P&G should have seen much worse carnage than Apple did, if the fiscal cliff is to blame.

    Looking forward to 2013
    So, what now? As Apple's stock price tests the $500 level, is it now a buy? Is the new year likely to bring changes to the company? I don't claim to be a pundit or a financial advisor, but here are some suggestions I would have for anyone thinking about investing in Apple now or in the near future:

    1. Absolute versus Percent: When a company has a market capitalization of $500 billion and its stock price is $500, small percentage changes in the stock will translate into large absolute values. While that is stating the obvious, there is a psychological component that any investor in Apple has to deal with. A $25 drop in Apple's stock price will feel like a bigger drop than a $1.50 drop in Facebook's price, though both amount to roughly 5% of their respective prices. Put differently, Apple will feel more risky or volatile than it truly is, simply because investors are unused to $500 shares.
    2. Momentum shifts will continue to be the name of the game: Notwithstanding the 'psychological' effect of higher absolute price changes, the sudden shifts in momentum that we saw with Apple stock through 2012 will continue into 2013, as the different investor groups fight over the future direction of the company. Eventually, one or more of these disparate groups will abandon the company and move on to better targets, but that will not happen overnight. If you are an investor in Apple, be clear about what you see in the company and which group you attach yourself to.
    3. Don't get distracted by small details: I subscribed to a news site that aggregates opinion pieces about Apple as an investment and I was flabbergasted at how many of these pieces were based upon non-news. The process hit a climax, for me, when a unsourced blog post/news story/tweet that there was only one person outside the Apple Shanghai store when the iPhone 5 was introduced there caused the stock to lose $15 billion in market value. Much of what you will read about Apple (the size of the iPad mini screen, whether the Google maps app is better than the Apple Maps app, when the next iPhone is coming out) matters little in the big picture.
    4. Focus on Apple's value and its value drivers: The drivers of Apple's value are not difficult to decipher and I have attempted to make them transparent in my updated valuation of Apple. If you download the spreadsheet, you will note that my estimate of the value per share has dropped to $609 per share (from my March 2012 estimate of $710/share). While my revenue and margin numbers (the growth rate in revenues is lower, but the dollar revenues over time are similar) in the new valuation are very close to my March 2012 estimates, I have reassessed the cost of capital to reflect Apple's increasing dependence on Asia for future growth: that growth will come with higher risk (which shows up as a higher risk premium). I have also been conservative in assuming that the trapped cash will be subject to an immediate tax penalty of about $18.4 billion (when, in fact, it will be paid over a long period of time or perhaps not at all). If you are investing in Apple stock, you should make your own assessment of the company rather than trust mine (or anyone else's).
    5. Ignore the experts/analysts: During the last year, equity research analysts collectively have never been ahead of the curve on Apple's share price. Every increase in the stock price seems to lead analysts to increase their estimated value for the stock and every drop precipitates a drop in assessed values. So, ignore the buy, the sell and the hold recommendations from analysts, since they are agents of momentum rather than oracles of change.

    Bottom line: At $500/share, in my view, Apple is under valued and I believe that my assessment of value is a sober one, with little built in value added from future game changers. Apple reinvented the personal music player business (with the iPod), inspired the smart phone business (with the iPhone), created the tablet business (with the iPad), reconfigured the entertainment retail business (with iTunes and the Apple stores) and there is no reason why it cannot change other businesses and generate additional value for its investors. I am still nervous about my fellow travelers in this stock and how they may cause the price to deviate from value, but I am more sanguine than I was in April for two reasons. First, many of these investors are fickle and I would not be surprised to see the same momentum investors, who jumped on the bandwagon when the stock was going up, abandon it now. Second, l can live with the price noise if Apple were a smaller portion of my portfolio and I can make that choice. So, I have a buy limit order for Apple at $500 and I may or may not be an Apple stockholder this new year, depending on what the stock does in the next two days. I am okay either way!



    Acquisition Alchemy: Creating value from deals

    By now, it should be no secret that I am not a fan of acquisition-driven growth. I have argued in my previous posts that acquirers often pay too much, that many acquisitions are driven by CEO egos and overconfidence, that M&A bankers are too conflicted to give unbiased advise, that accretive deals can be value-destructive and that the presence or impairment of goodwill provides no useful information to investors.

    Am I being too negative in my portrayal? Possibly. After all, there are companies have grown successfully with acquisitions, at least over some periods. In constructing a value-creating acquisition strategy, it is worth looking at what these successful acquirers share in common.

    Go where the odds favor you
    While acquisitions in the aggregate, and on average, have not been good news for acquirers, there are some subsets of acquisitions where  acquiring company stockholders do much better.

    a. Small versus Large acquisitions: Acquiring smaller companies seems to provide much better odds of success than mergers of equals. In the graph below, for instance, take a look at the returns to acquirers around acquisition announcements of targets, with the targets classified based upon their size in market cap terms, relative to the acquiring company. Markets are much more welcoming of small deals than big ones, justifiably wary of the integration costs and culture clashes that mergers of equal inevitably bring.

    Note that the biggest successes are with target firms that are small, with market caps, less than 6%  of the acquiring firm's market cap and returns get progressively worse as target firm size increases.

    b. Cash versus Stock: There is no consensus finding here, but looking at the figure above, paying with stock seems to deliver higher returns for small acquisitions, but paying with cash seems deliver better returns with larger acquisitions. Perhaps, target company stockholders recognize the propensity of acquiring companies to pay with "overpriced' stock and demand higher premiums...

    c. Private versus Public targets: Acquirers who focus on buying privately owned businesses rather than public companies earn much more positive returns, mostly because they don’t have to pay premiums over a market price that already incorporates much of what they are paying for. In fact, looking at the figure below, the very best targets are divisions of public companies, often divested at bargain basement prices by CEOs who want to get rid of high profile failures. (Quick: Someone make an offer to HP to buy Autonomy for a dollar…. They may take you up on the offer just to get rid of the albatross...)



    d. Cost synergies versus growth synergies: While it is good to be skeptical about promised synergies in acquisitions, companies seems to be much better at delivering cost synergies than growth synergies, as evidenced in the figure below. This phenomenon may reflect the fact that cost synergies are easier to plan for and deliver than amorphous growth synergies.


    Do your valuation, before you make your offer... and value all the "good" stuff
    I believe that the biggest problem with an acquisition based strategy remains the price paid. If you pay too much for a target company, no matter how well matched that company may be to yours, you have a bad deal. The key to a successful acquisition strategy then becomes doing your homework in valuing not only the target company but all of the other goodies that you see coming with the deal, control and synergy being foremost. It is also critical that this valuation not be outsourced to bankers or consultants. They may be well intentioned, but it is not their money that is being spent. Here is the three-step process for valuing an acquisition:


    Step 3: Value Synergy
    Value the combined firm with synergy built in. This may include
    a. A higher growth rate in revenues: growth synergy
    b. Higher operating margins, because of economies of scale
    c. Lower taxes, because of tax benefits: tax synergy
    d. Lower cost of debt: financing synergy
    e. Higher debt ratio because of lower risk: debt capacity
    Subtract the value of the target firm (with control premium) + value of the bidding firm (pre-acquisition). This is the value of the synergy.
    Step 2: Control Premium
    Value the company as if optimally managed. This will usually mean that investment, financing and dividend policy will be altered:
    Investment Policy: Higher returns on projects and divesting unproductive projects.
    Financing Policy: Choose a financing mix/ type that reduces your cost of capital
    Dividend Policy: Return unused cash, especially if you are punished for it.
    Value of control = Target company value with optimal management - Status quo target company value from step 1.
    Step 1: Status Quo Value (Target firm)
    Value the target company as is, with the existing management’s investment, financing and dividend policy (even if it is optimal or efficient)


    Each of these steps will require estimates and forecasts, but that is true for any investment. In fact, I would wager that many companies spend far more time making these assessments with small capital budgeting projects than they do with multi-billion dollar acquisitions. Managers will also claim that synergy is too qualitative and fuzzy to value, which would be fine if they were paying with qualitative dollars, but they are not. If you are interested, I do have more to say in my papers on the value of control and the value of synergy. You can also download the spreadsheets that I have to value control and synergy.

    Get a share of the spoils
    Just because you have valued control and synergy in a merger does not mean that you should offer to pay that amount as a premium. If you do, target company stockholders walk away with the spoils of your “hard” work (in delivering control and synergy value) and your stockholders get nothing. Thus, a key step in acquisition is negotiating for a fair share of both the control and synergy values. That fair share will depend upon how integral the acquiring company is to generating these additional values; the more important the role of the acquirer, the greater the share of the premium it should demand. In fact, if bankers are true deal makers, this is where they should earn their fees.

    Have a plan to deliver the good stuff
    While many acquirers seem to view getting the deal done as the climax of the process, it is really the beginning of a long (and often tricky) process of integration. Good acquirers not only have clear plans for what they will do after the acquisition but they also set aside the resources (people, funds) to put those plans into operation. When mergers work, it is almost never by accident. The KPMG surveys of global mergers over the years have emphasized this planning and post-deal integration as a key component to deal success.

    Hold decision makers accountable
    If you want acquisitions to deliver value, you have to hold everyone in the process accountable. I would start with the managers in the acquiring firm but I would also include the bankers and consultants to the acquiring company. In particular, I think that management compensation and deal fees should have clawback provisions that are conditioned on the performance of the merged firm (in stock prices and profitability).

    Be ready to walk away
    You have to be willing to walk away from a deal, if it does not make sense for you. In too many deals, the objective for the acquiring firm becomes getting the deal done, rather than getting a good deal done. In addition to staying disciplined, i.e., not going back and fudging the valuation numbers to make a deal look good, there is another simple rule that acquirers should consider following. If you get into a bidding war over a target firm, walk away. In fact, while you may nominally be labeled the “loser” in the bidding war, it is far better for your stockholders to be the loser rather than the winner, as evidenced by the figure below:

    If being tagged a loser delivers a 65% differential return over being tagged a winner, as a stockholder, I will take the loser tag.

    Bottom line
    Creating value with an acquisition-based growth strategy is difficult to do, but not impossible. It requires discipline, planning and follow through, and few companies seem to have the capacity to deliver.

    The Acquisition Series
    HP's deal from hell: The mark-it-up and write-it-down two step
    Acquisition Archives: Winners and Losers
    Acquisition Hubris: Over confident CEOs and Compliant Boards
    Acquisition Advice: Big deal or good deal?
    Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
    Acquisition Accounting II: Goodwill, more plug than asset



    Acquisition Accounting II: Goodwill, more plug than asset

    There is no asset on a company’s balance sheet that wreaks more havoc on valuation and good sense than goodwill. The first problem with goodwill is that it sounds good, and when something sounds good, people feel the urge to pay for it. The second problem is that, notwithstanding claims to the contrary, it is not an asset but a plug variable that measures everything and nothing at the same time.

    A short history of acquisition accounting
    To understand the treatment of goodwill in GAAP, it is worth taking a quick look at how acquisitions have been accounted for over time, at least in the United States. Until a decade ago, companies that acquired other companies could pick one of two approaches to “account” for the acquisition.
    • In the first, termed pooling, the acquiring firm was allowed to incorporate just the book value of the target firm’s assets into its balance sheet, and essentially ignore or hide the premium paid over this book value. Thus, there was no goodwill on the balance sheet, but to qualify for pooling, the acquiring firm was required to jump through hoops (some of which were very expensive); for instance, only acquisitions financed entirely with stock qualified for pooling. 
    • In the second, purchase accounting, the acquiring firm had to incorporate the market value of what it paid for the target firm on its balance sheet, and to show the difference between the market value and the book value as “goodwill” on its balance sheet. Under this old system, goodwill was amortized over a fixed period not to exceed 40 years, though this amortization was not tax deductible (at least in the United States).
    In spite of the fact that goodwill was a purely accounting variable and that its “non tax deductibility” made it irrelevant for cash flows, the fear of the earnings hit from amortization led companies to go through contortions (and to pay more) to qualify for pooling. AT&T, for instance, paid an additional $325 million when it bought NCR, to qualify for pooling, making an awful deal even worse. The prevalence of two different acquisition accounting systems also made it difficult to compare the balance sheet numbers for acquisitive companies that used purchase as opposed to pooling. Finally, amortizing goodwill over 40 years for all acquirers essentially resulted in both good and bad acquisitions being treated the same way for accounting purposes.

    To remedy these problems, the accounting rules were changed on June 30, 2001, with four key modifications. First, pooling was disallowed and all firms were required to use purchase accounting. Second, accounting rules were changed to give accountants more discretion, albeit within strict limits, to do a reassessment of the value of a target firm’s existing assets at the time of the acquisition. To the extent that a target firm had assets on its books that were recorded at below (or above) their “fair” value today, this accounting adjustment could lead to an adjusted book value (which is different from the actual book value). In addition, accountants were also allowed some leeway to bring in the values of “intangible assets” such as customer lists and technology patents into the book value of the target firm. Third, the goodwill was then computed to be the difference between the market value paid for the target company and the “adjusted” book value. Finally, rather than amortize this goodwill over 40 years, accountants were required to revalue the acquired company at regular intervals and impair the goodwill, if they felt that the target company had declined in value.

    While these changes made sense at an intuitive level, there are two things worth emphasizing about them. First, for better or worse, it has been a lucrative jobs program for accountants & appraisers, since their services are now required both at the time of the acquisition (to reappraise the value of the existing assets) and each period thereafter (to assess target company values). Second, as is the case with most accounting rules, the rules have obscured the principles of what the changes were meant to accomplish: create more transparency for investors about acquisition costs and more accountability for bad acquisitions.

    So, what does goodwill measure?
    If goodwill is the difference between what an acquiring company pays and the “adjusted” value of its existing assets, what exactly goes into it? To answer that question, let me compare two visions of balance sheets:


    The balance sheet to the top is a conventional accounting balance sheet, with book values recorded based on what was originally paid for the existing assets, net of depreciation and debt & equity, reflecting the company’s history. The balance sheet at the bottom is a intrinsic value balance sheet, with assets broken down into investments already made and growth investments (based upon expectations for the future).

    Within this framework, here is what happens after an acquisition. The accountants are called in to reestimate the value of the existing assets and replace the conventional accounting book value with the estimated value. Goodwill then becomes the difference between the price paid by the acquiring company and the reassessed value for existing assets. So, what else goes into the price that an acquirer may pay, besides the value of the existing assets? Here is my attempt to break it down:

    Thus, accounting goodwill is composed of both goodwill that has a rational basis (a fair value of growth assets, control, synergy) and goodwill that is built on sand. Why should you care? As a stockholder in the acquiring firm, you first want to separate out overpayment from the remaining reasons, since it is an immediate transfer of your wealth to the target company. You could, of course, wait for accountants to impair this portion of the goodwill but it not only happens too late to help investors, but it may also reflect unexpected disappointments on control, synergy and growth assets.

    I have a simple proposal that I know has zero chance of being adopted that may give investors at least a heads up, with acquiring companies. At the time of the acquisition, I noted in an earlier post that the acquiring company’s stock price drops in about 55% of acquisitions. If you accept the argument that this is the market’s collective judgment of how much was overpaid, why not break goodwill down into two components: the “market correction” can be called foolhardy goodwill and the rest can be rational goodwill. Thus, if a company pays $12 billion for a company with an adjusted book value of $ 4 billion, and sees its market cap drop by $ 3 billion on the announcement, you should see $ 3 billion in foolhardy goodwill and $ 5 billion in rational goodwill on its balance sheet. While both types of goodwill may turn out to be wrong, in hindsight, and may need to be impaired, I would argue that firms  (their top managers and bankers) should be held much more accountable for failures on the former, because they chose to do the acquisition in the face of investor opposition.

    The Goodwill Games: The Bottom Line
    • There is no correlation, positive or negative, between the magnitude of goodwill and the quality of a deal: Given the time and resources that accountants bring to the measurement and subsequent impairment of goodwill, you would think that their actions have substantial impacts on markets. In an accounting world, you should expect to see a differentiation across acquiring companies, based upon how much goodwill is created at the time of the deal. Presumably, if you accept the accounting interpretation of goodwill, deals that result in less goodwill should be better than deals that create more, with “better” measured as market reaction to the announcement of the deal or as performance after. As far as I know, I do not know of a single study that finds a correlation between the two. (If you do find any, please let me know….)
    • The presence of goodwill on the balance sheets of acquiring firms make it difficult to compare these firms to those that don't do acquisitions, because it exposes the inconsistency in accounting rules on the treatment of growth assets. A growth firm that grows entirely through internal investments will not show its growth assets on its balance sheet, until it makes those investments. If that growth firm is acquired by another firm, the goodwill that shows up on the company's balance sheets will include growth assets. Investors therefore have to wrestle with what to do about goodwill in both relative and DCF valuation: (a) If you use earnings multiples (PE, for instance) or book value multiples (Price to Book, EV to Invested Capital), comparing acquisitive firms to non-acquisitive firms can be skewed by the presence of goodwill. Since goodwill inflates the book values (of both equity and invested capital), acquisitive companies can look cheap on both price to book and EV to invested capital measures. Analysts and investors often respond by using only "tangible" book value, where goodwill is removed from the equation.  (b) In discounted cash flow valuation, a key ingredient that determines value is return on equity (or return on invested capital) and both can be pushed down for acquisitive firms, if goodwill is treated as part of book capital. Analysts again respond by eliminating goodwill from book value and invested capital for accounting return measures. That may tilt the scales too far in the other direction,  because it gives acquiring companies a free pass on acquisitions and makes them look better than they really are in terms on returns on invested capital. I would argue for an intermediate solution, where the foolhardy goodwill (see above) is left in invested capital and the control/synergy portions are phased in over a 3-5 year period. Firms that consistently over pay for acquisitions or fail to deliver on synergy or control will therefore be assigned lower returns  on invested capital and lower value.
    • The impairment of goodwill does have an effect on stock prices but it may have also damaged earnings quality. Since declining stock prices (for the acquiring firm or the peer group of the target) is a key trigger for an accounting impairment assessment, there is an open question as to whether the impairment is a surprise to investors. Looking at the studies over the last decade, there is evidence that even though goodwill impairment lags economic impairment by many years, stock prices still drop on the impairment of goodwill, with the price impact of goodwill impairment being greatest at small firms that have little analyst following. However, there are also many who contend that goodwill impairments have contributed to making earnings reports more difficult to decipher and thus reduced earnings quality. Finally, there is also evidence that the initial market reaction to the acquisition is a good predictor of the subsequent impairment of goodwill. Perhaps, my proposal to separate goodwill into foolhardy and rational goodwill is not so outlandish, after all...
    In summary, then, the new rules on goodwill have not reduced the propensity of acquirers to overpay for target firms, have not made their financial statements more informative, and might have made it more difficult for investors to value serial acquirers. So, would it not make more sense to move back to a simpler, automated system for reporting on acquisitions, with less accounting judgment and more reporting of facts?

    The Acquisition Series
    HP's deal from hell: The mark-it-up and write-it-down two step
    Acquisition Archives: Winners and Losers
    Acquisition Hubris: Over confident CEOs and Compliant Boards
    Acquisition Advice: Big deal or good deal?
    Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
    Acquisition Accounting II: Goodwill, more plug than asset



    Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals

    Analysts, investors and journalists who follow stocks have an obsessive focus on earnings per share, what it is now and what it will be in the future, as can be seen in the earnings announcement game every that takes up so much of Wall Street’s time and resources. Not surprisingly, acquiring firms, considering new deals, put their accountants to work on what they believe is a central question, “Will the earnings per share for the company (acquirer) go up or down after the acquisition?” A deal that will result in higher earnings per share, post-deal, is classified as accretive, whereas one that will cause a drop in earnings per share is viewed as dilutive. 

    Is it better to have an accretive or a dilutive deal? If you asked that question of most investors, analysts or even CFOs, the answer, you would be told, is obvious. An accretive deal is better than a dilutive deal, with the logical follow through that if your earnings per share increase, your stock price will follow. But is that true? To see why it is not, let us break down the mechanics of what will happen to earnings per share, after an acquisition or merger. The net income of the two firms will be cumulated and divided by the number of shares outstanding in the combined firm, after the merger. Mathematically, here are the two factors that will determine whether a deal is accretive or dilutive:
    1. What are the relative PE ratios of the acquiring/target firms? In a share swap, where the acquiring firm’s shares are swapped for the target firm shares, the combined company’s earnings per share will increase (be accretive) only if the PE ratio of the acquiring firm is greater than the PE ratio for the target firm. It will be dilutive, if the reverse is true. 
    2. How will the deal be financed? If a deal is funded with cash on hand or by issuing new debt, the deal will be accretive, if the company being acquired is profitable and is generating a high enough expected income to cover the lost interest income (if cash is used) or the expected interest expenses (if debt is used). 
    If you are interested, you can download a simple spreadsheet that works out whether a deal will be accretive or dilutive to the acquiring company.

    Reviewing these two conditions make it clear why it is absurd to think that accretive deals are always good and that dilutive deals are bad. The Achilles heel in this reasoning is in the assumption that the PE ratio will stay fixed after the deal; if that were true, higher EPS will always translate into higher price, making accretive deals good for acquiring company stockholders. But it is not, and you can see the rationale by looking at all of the scenarios listed above:
    1. If you are buying a company with a lower PE ratio than yours, there is usually a good reason why that company has the lower PE. It could be that the firm is riskier than average, has lower or no growth or is in a business with sub-standard returns. If any or all of these reasons hold, acquiring this company will bring those problems into the combined company and cause the PE ratio for the combined company to fall. If that drop exceeds the increase in EPS, the stock price of the combined company will also fall, notwithstanding the accretive nature of the deal. 
    2. If you are funding a deal with cash, the deal will almost always be accretive because the income you are generating from cash (especially at today’s low interest rates) will generally be lower than the equity earnings you will get from the company that you are acquiring. But is that value enhancing? Not really. Replacing an investment that generates 1% riskless today with a risky investment that generates a 4% return will make investors in the company worse off, not better. 
    3. If you are financing the deal with debt, the deal will be accretive if the equity earnings that you generate from the acquired company exceeds the interest expense. But here again, that is not a sufficient condition for value creation. You are contractually committed to make the interest expense, while the income you anticipate is “risky”. The basic tenets of the risk/reward trade off will require a much higher risky equity return than the interest rate on the debt you take on for the deal to be value creating. 
    Using the same type of reasoning, you can see that it is possible for a dilutive deal to be value creating: the target firm may have higher growth/higher quality growth/lower risk than you do and acquiring it may push up the combined firm’s PE and/or there may be enough growth in the firm that even though the current earnings don’t cover your interest expenses/foregone interest income, the future earnings will comfortably. It is therefore entirely possible for an accretive deal to be value destroying and a dilutive deal to be value increasing.

    There are CFOs who will hear this argument and say that it is “academic”. The market (and the equity research community) care about earnings per share, they will argue, and it is not sophisticated enough to make the adjustments to PE for risk and fundamentals. The proof, though, is not in what CFOs believe or what equity research analysts say matters, but in how the market reacts to accretive and dilutive deals. A McKinsey study of accretive and dilutive deals uncovered the following market reactions to these deals:

    Note that at least in this short sample period, there is no evidence that markets reward accretive deals and punish dilutive deals. Thus, Leo Apotheker’s defense, offered two days after HP bought Autonomy, that “Autonomy will be, on Day 1, accretive to HP” would have rung hollow, even without the benefit of hindsight. I, for one, think that it is time that we consigned this dilutive/accretive analysis to where it belongs: the dustbin. It is not only truly useless in assessing the quality of deals, but worse, it allows companies to justify (at least to themselves) some really bad deals.


    The Acquisition Series
    HP's deal from hell: The mark-it-up and write-it-down two step
    Acquisition Archives: Winners and Losers
    Acquisition Hubris: Over confident CEOs and Compliant Boards
    Acquisition Advice: Big deal or good deal?
    Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
    Acquisition Accounting II: Goodwill, more plug than asset



    Acquisition Advice: Big deal or good deal?

    HP is one of a multitude of companies that has overpaid on acquisitions, and like those other companies, it cannot claim that it lacked outside advice and guidance. In fact, HP paid $30.1 million in advisory fees to Perella Weinberg and Barclay’s Capital for guidance on how much to pay for Autonomy and whether the deal made sense. So why did they not spot the accounting manipulation or recognize that synergy would be elusive? In general, why, if acquiring firms pay so much for "expert" advice, do so many deals go bad?


    Conflicting roles: The answer can be seen in an imperfect analogy. Asking an investment banker whether a deal makes sense is analogous to asking a plastic surgeon whether there is anything wrong with your face. After all, if either party says “No”, they have no business to transact and no revenues to generate. Allowing the dealmaker (the investment banker) to also be the deal analyst (provide advice on whether the deal is a good deal) is a recipe for bad deals and we have no shortage of those. The solution is simple in the abstract but transitioning to it may be difficult. The deal making has to be separated from the deal analysis. Put differently, investment bankers should do what they do best, which is to manage the mechanics of the deal, and be paid for the service. There should be a third party, with absolutely no stake in the deal's success or failure, whose job it is to assess the deal to see if it makes sense, with compensation provided just for that service. Why has this common sense change not happened yet? First, as I noted in my last post, many acquiring companies want affirmation of decisions that they have already made (to acquire), rather than good advice. Second, the same entity (say, Goldman Sachs or Morgan Stanley) cannot slip back and forth between being a deal maker on one deal and a deal analyst on another, since there will be a shared and collusive interest then in shirking the deal analyst role. You would need credible entities whose primary business is valuation/appraisal and not deal making.


    The deal table: In many businesses, companies measure their success based upon market share and revenues. M&A bankers are no different and their success is often measured by where they fall in the deal table rankings. Here, for instance, is the latest deal table from Bloomberg, listing the top bankers for M&A globally, in 2011 and 2012.
    Note that the rankings are based upon the dollar value of deals done, and that there are no extra columns for good deals and bad deals. Consequently, a banker who does a $11 billion bad deal will be ranked more highly than one who does a $4 billion good deal. There are three implications that follow.
    1. When a big deal surfaces, bankers line up to be part of that deal, willing to bear almost any cost to get involved. 
    2. The bigger the deal, the worse the advice you are likely to get; the conflict of interest that we mentioned earlier gets magnified as the deal gets larger. 
    3. Individual bankers will be judged on their capacity to get deals done and not on the quality of their deal advice or valuation expertise. Thus, it is not surprising that the biggest stars in the M&A firmament are the dealmakers. In fact, it is interesting that Perella Weinberg is listed as one of HP”s advisors on the Autonomy deal. Joe Perella, co-founder of the firm has a long history in the acquisition business that goes back almost four decades to his position as co-head of M&A at First Boston in the 1970s. He left the firm, with the other co-hear of the First Boston M&A team, (Bid 'em up) Bruce Wasserstein, to create Wasserstein Perella, a lead player in the some of the biggest acquisitions of the 1980s. He returned to head M&A at Morgan Stanley for a few years before leaving again to found Perella Weinberg. Through all the years, it seems to me that the singular skill that he possesses is not his capacity to value target companies but that he can get any deal done. 
    So what can we do to change this focus on deal making? We do have to begin by changing the way we compensate bankers in deals but we also have to follow up on deals. I would like to see some entity generate deal tables that track the largest deals from five years ago and report how much those deals have made (or lost) for stockholders in the acquiring firms. It would be interesting to see the list of the top 10 bankers in terms of value creating and value destructive deals.

    Compensation: The third factor that contributes to the deterioration of deal advice is the way in which the deal advisors get compensated for their services. In most deals, the deal advisors get paid for getting the deal done and there is no accountability for deal performance. Neither Perella Weinberg nor Barclay’s Capital will have to return any of the advisory fees that they received for the HP/Autonomy deal, even though the advice that was offered was atrocious. I think that there is a solution, even within the existing system. Rather than tie the entire fee to getting the deal done, a significant portion should be contingent on post-merger performance. Thus, if the acquiring firm’s stock price or profitability fails to beat the peer group’s stock price performance or profitability in the years (two, three or five) that follow, the bankers will either not get a large portion of their fee or be forced to return a proportion of the fees that they have already been paid. Bankers will complain that this puts them at the mercy of  macroeconomic shifts and mismanagement of the post-merger integration, but those are variables that they should be considering when assessing whether a deal should get done.

    In closing, though, acquiring firms are quick to blame bankers for bad advice. As I noted in my last post, I think that the ultimate blame has to lie with the top managers of the acquiring firms. No acquirer  is ever forced to do an acquisition at the wrong price and if they chose to do so, they should be held responsible.


    The Acquisition Series
    HP's deal from hell: The mark-it-up and write-it-down two step
    Acquisition Archives: Winners and Losers
    Acquisition Hubris: Over confident CEOs and Compliant Boards
    Acquisition Advice: Big deal or good deal?
    Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
    Acquisition Accounting II: Goodwill, more plug than asset



    Acquisition Hubris: Over confident CEOs and Compliant Boards

    In my last post, I noted that acquisitions are more likely to destroy value for acquiring firm stockholders than to add value, and that there is little evidence that companies learn from history. That is puzzling, given the manpower, data power and model power that is brought into the acquisition process. How can all these smart people working with sophisticated models and updated data be so wrong so often?

    The answer I think lies in a simple fact: in most acquisitions, the decision to acquire is made first and the analysis follows, and all too often, the decision is not only made at the top of the organization, but at the very, very top by the CEO. That is not the way organizations are supposed to work. Big ideas, no matter who originates them, are supposed to be discussed honestly and openly, analyzed fully and then vetted by an independent, well informed board of directors to make sure that stockholder interests are being served. That may still happen in some organizations, but consider this alternate reality. In a moment of inspiration (insanity) or brilliance (lunacy), the CEO decides to do an acquisition of a target firm for strategic (empire-building) reasons. The managers around him or her, recognizing that the die has been cast, choose not to voice their opinions, get bulldozed when they do, or decide to join the CEO in pronouncing the acquisition a great idea. An investment banker is found to affirm that the deal is, in fact, a great deal and the rest as they say is history. Reminds you of this fairy tale, right? If you find this scenario to be absurd, start by taking a look at James Stewart's article on the HP/Autonomy deal and especially at the back story on how Leo Apotheker, HP's then CEO, pushed for the deal even as there were plenty of doubting voices (both within and without the firm), and how the board essentially went along with his wishes. Then, move on to take a look at these stories about Eisner's role in Disney's acquisition of Capital Cities in 1995 and Zuckerberg's role in Facebook's purchase of Instagram earlier this year to see how much head-strong CEOs can influence the acquisition process.

    If the acquisition process is prone to failure, as the evidence suggests that it is, there are many potential culprits that you can blame. The investment bankers who facilitate the deals for huge advisory fees are an easy target and the accountants/auditors who dress up the books are a close second, but the primary culprit has to be the top management (and particularly the CEO) of the acquiring firm. After all, once a CEO gets set on doing a deal, he can go about picking the facilitators (the investment bankers and accountants) to make the deal look good. As we bring behavioral finance into play, the evidence suggests that over confident CEOs  play a key role in greasing the skids for large (bad) acquisitions. To measure confidence, Malmendier and Tate, who have a series of interesting papers on how over confident CEOs manage, developed two measures:
    1. Insider holdings in the companies that they manage: Rather than diversify and spread their risks by investing in other companies, over confident CEOs seem to double up and invest their wealth/income back into the companies that they manage.
    2. Press reports: Looking across financial news stories for mentions of the CEO in question, they looked for the words "confident" or "optimistic" in descriptions of the CEO   opposed to words such as "cautious", "frugal" or "steady". If the former exceeded the latter, the CEO is classified as an over confident CEO, whereas if the latter dominated, the CEO was classified as a cautious CEO.
    They then looked at a sample of 394 large US firms and found that over confident CEOs were 65% more likely to do acquisitions than cautious CEOs, though they were also less likely to draw on external financing; their over confidence led them to believe that the market was underpricing their stock and thus made them more reluctant to use stock in acquisitions. They were also more like to acquire just to diversify, and the market reaction to their acquisitions is more negative than to acquisitions by cautious CEOs.

    Can no one stop a headstrong CEO? There is a counterweight built into the system, the board of directors, and it can act as a restraint on a CEO embarking on a value-destructive path. Unfortunately, one common feature shared by value-destroying acquirers is a compliant board, that shirks its responsibility to protect shareholder interests. It is not surprising that it HP, which has had issues with corporate governance and board oversight, was the ill-fated acquirer of Autonomy.

    In summary, then, a headstrong, over confident CEO, combined with a compliant board creates a decision making process where there are no checks on hubris and large, value destroying actions often follow. If investors want to prevent their firms from embarking on deals like the HP/Autonomy deal, they need to pay attention to corporate governance, and not just at the surface level. After all, the board at HP met all the Sarbanes/Oxley requirements for a "good" board and may even have scored high on the corporate governance scores in 2010. The problem with corporate governance watchdogs, legislation and scores is that they are far too focused on what the board looks like and far too little on what it does. In my view, it matters little whether a board is small or large, whether it is filled with luminaries or unknowns, experts or novices and whether it meets the criteria for independence. It does matter whether the board acts as a check on the dreams and acts of imperial CEOs.


    The Acquisition Series
    HP's deal from hell: The mark-it-up and write-it-down two step
    Acquisition Archives: Winners and Losers
    Acquisition Hubris: Over confident CEOs and Compliant Boards
    Acquisition Advice: Big deal or good deal?
    Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
    Acquisition Accounting II: Goodwill, more plug than asset



    Market Mayhem: Lessons for Apple

    In my last post, I looked at the options that investors in Apple face today. In this one, I hope to look at what Apple can learn from the market mayhem in its stock, and, in the process, adapt. As an Apple stockholder now, I am at least partly motivated by self interest, but I am also a long time Apple product user and I would like to see the company on steadier footing. So, here are some general suggestions that I would have for Apple management (though I am sure that they are much too busy tending to day-to-day business to be reading blog posts):
    1. Build up credibility with investors: The company has to regain credibility with investors. Apple has acquired a reputation for lowballing its expected results, prior to earnings reports. Instead of making it easier for the company to beat expectations, it has led instead to markets paying little heed to the guidance. In fact, it looks like Apple is taking the first step towards doing this by adopting the Amazon strategy of giving wide bands of forecasts for expected earnings. There will be traders/analysts/investors who will be upset, and may abandon the stock. Good!!!
    2. Be transparent: Become more open about long-term strategy and products. I think that Apple’s secrecy about new products and strategies may be a great marketing strategy but it creates an information vacuum, which is filled with rumors and fantasy. I know that Apple also worries about giving away information to its competitors, but when you are a company the size of Apple, the news will get out to your competitors any way. So, stop acting like you are protecting national security and start acting like a business!!
    3. Take a stand:  The company has to stop trying to be all things to all investors and make its stand on whether it sees itself more as a growth company or a more mature company. Picking one does not mean that the company is giving up on the other, since a mature company can still pursues growth prospects, but it does lay down markers that will determine your investor base. 
    4. Behave consistently with your choice: Once Apple makes its stand as a growth or mature company, it has to behave consistently. Thus, if it decides that it is a mature company, it should return more cash to its stockholders, though I think stock buybacks make more sense to its stockholder base now than dividends do. At the moment, with its huge cash balance, it clearly does not make any sense for Apple to borrow money, but somewhere down the road, it has to consider the debt option, since not using it is depriving itself of the tax benefits embedded in the tax code for using debt instead of equity.
    I know... I know... All of this will make Apple a more boring company, but I do have one avenue that the company should explore that can still provide excitement to investors, while also creating value. Apple’s great successes in the last decade have come from “creative destruction”, where it has gone into established markets with game changers – retailing with iTunes and Apple stores, portable music players with the iPod, the cell phone market with the iPhone and the tablet market with the iPad. Its success in each of these markets has made it a large player in each of them, which is a problem. As Clayton Christensen, Harvard’s strategy guru, notes, it is difficult for established players to be "disruptive innovators" because they have too much to lose, and Apple can no longer afford to be revolutionary in any of its existing markets. It has two choices. It can put its youthful, creative destruction ways behind in and grow up, or it can go for creative destruction in new markets. I think it should try for a combination, playing defense in the smartphone and tablet markets, and using its competitive advantages to crack open new markets. Unlike Samsung or Microsoft, Apple has never been just a technology company. Its strength has always come from a unique mix of design (software & hardware), elegance and efficiency, and it is this combination that has given it pricing power.

    So, where should Apple look next? I would suggest looking for businesses where existing companies churn out poorly designed and consumer-unfriendly products, but are trapped by a lack of imagination and legacy choices into continuing down that path. I can think of at least a dozen that I use or interact with on a day-to-day basis. While televisions have been bandied about as the next big Apple market, I don’t see why the business has to be electronic. I am sure that my airline experience would be better on Apple Air, my hotel stay more comfortable at Apple Hotels and my tax money better spent with Apple Government. 



    Are you a value investor? Take the Apple test

    The bottom has clearly fallen out for Apple's stock price. After last week's earnings report, the stock that had already dropped 30% from its high of $705 set in September to $500/share, dropped another 15% to finish at $440/share. The company that could do no wrong a few months ago now is viewed as incapable of doing anything right. Has the stock fallen too much or is this just the beginning of a longer term drop in value? Is it time to buy, time to sell or time to sit on your hands?

    Looking at the landscape, I would categorize Apple investors and potential investors into three groups right now, based on their views of its value and the current price.
    1. The Pricers: As I see it, the bulk of the investors in Apple have no idea what the value of the stock is and do not care that they don't know its value. They are intent on playing the pricing game, where the key becomes gauging what the rest of the crowd thinks about the stock and trying to get ahead of them. At any stock price, the question they ask is not whether Apple is under or over valued, but whether the price will go up or down in the near term. I have never been good at this game and it must be exhausting, being at the mercy of market sentiment, moods and fancy.
    2. The Value Skeptics: This group has always viewed Apple's rapid rise to the top of the market cap heap with suspicion, convinced that its value could not have risen that fast. Some of this group belong to the hardcore value camp, where no technology company, especially one with intangible assets and an elusive "cool" factor, would be a good value, at any price. Some, though, have reasonable doubts about the capacity of technology companies to maintain earnings in an volatile environment and believe that those of us who assume long term growth prospects for these companies are under estimating the risk of the disruption from new technologies. Just as Apple undercut RIMM and Nokia, they believe that some other company will undercut Apple in the future. Many in this group are feeling self-righteous, arguing the price drop was long overdue but not enough to make the company an attractive investment yet.
    3. The Value Optimists: This group believes that Apple is a bargain at $440 and that its true value is much higher. Some, in this group, base this judgment on simple comparisons. At a market cap of $413 billion, with a cash balance of $120 billion and net income of $42 billion, they note that Apple is trading at roughly seven times earnings, cheap in a market where the median PE ratio is about 16. Some are basing their views on cash flow based valuations and I am one of that group, as you probably already know from my post at the end of 2012. In that post, I valued Apple at $609/share and the latest earnings report barely changes that estimate. I did a follow up simulation, bringing in the uncertainty about my estimates about revenue growth(-2% to +14%), margins (25% to 35%) and cost of capital (11%-14%) into the mix, with the following outcomes:

    Based on my estimates, and they could be skewed by my Apple bias, at its current stock price of $440, there is a 90% chance that the stock is under valued.

    If, like me, you are in this last group, you are being tested mightily now, torn between a belief that the stock is under valued and a market that does not seem to care. It is a good test of whether you are a value investor and what you do will depend upon two assessments:
    • The Gut Check: Are you really a value investor or do you just like talking like one? It is easy being a contrarian value investor, in the abstract, but much more difficult to be one in practice, since you are taking a position at odds with the rest of the market. Not all investors have the stomach  for that, and if you don't, it is a good time to find out. 
    • The Confidence Check: How confident are you in your assessment of value? That confidence will stem from your comfort with the valuation metric/model that you used and the inputs that you used in that model, as well as from your prior experience in investing based on your valuations. Again, you cannot talk yourself into being confident, and if you are not, it is best not to take a stand. 
    If you pass the value investing test and feel confident in your assessment of value, I think you should take the leap.  If you do, as I did (albeit at $500/share),  keep the following cautionary notes in mind:
    1. Don't bet the house: No matter how confident you are in your value assessment, don't go overboard and invest a disproportionate amount of your portfolio in Apple.  This is not just about you being right on the value but also about the market coming around to your point of view, and that is not in your control or mine; betting more than 10% of your portfolio on this stock strikes me as foolhardy.
    2. Don't double down (Dollar averaging): I have never been a fan of dollar averaging, which not only muddies the water about when/how much you invested in a stock but results in increasing your bets as the market goes against you. Take a stand against the market but do not make this an ego trip, where admitting that you are wrong becomes impossible to do. Thus, while I feel more confident now that the stock is under valued than I was a week ago when I bought the stock for $500, I don't plan to buy more shares.
    3. Think of buying the business, not the stock: The old adage that you are buying a piece of a company, not a share of stock, is particularly relevant when you make a bet like this one. My intrinsic valuation is determined by Apple's capacity to generate profits and cash flows and is not dependent upon whether portfolio managers are investing with me or analysts are lowering their price estimates. If I buy Apple at $440 today and I can hold the stock, I will get a share of a cash that is paid out and a share of ownership in the cash that is withheld. I have to keep reminding myself of that truth, even if the market moves against me.
    4. Do not track the day to day stories: In an increasingly connected world, I know that this is really difficult to do, but there is no harm trying. Turn off your financial news channel, don't read opinion stories about Apple and avoid equity research reports like the plague. 
    5. Be willing to wait... even if you are not sure what you are waiting for: The big question that those of us who chose to make this bet face is what the catalyst will be that brings the market back to its senses (at least as we see it...). From my experience, it is almost impossible to tell. For instance, how did Netflix, which was a tailspin, a year ago, turn itself around? There was no single precipitating event but a collection of small news stories and solid earnings reports that seemed to settle the fears that investors had about the company's future direction. With Apple, it could be a new product, a couple of healthy earnings reports or a stock buyback. 
    Let me close by saying that I will go to bed tonight, not thinking about what Apple's stock price will do tomorrow or the day after. I have made my choice and I am at peace with it. If you lie awake at night thinking about the stocks you have bought or sold, you just failed the final test of value investing.



    Data Update 2013: The Dark Side of Numbers

    For the last two decades, I have dedicated the first two weeks of each new year to a ritual. I obtain/collect/download data on all publicly traded companies listed globally, using a variety of data sources, and then analyze and present the data, aggregated at a number of different levels: by country, by region (US, Europe, Emerging Markets, Japan, Australia & Canada) and by industry. I report on measures of operations (profit margins, turnover ratios, working capital), measures of leverage (debt ratios), measures of risk (beta, standard deviation, equity risk premiums, country risk premiums) and pricing measures (earnings multiples, book value multiples, revenue multiples). I just completed my 2013 update and you can find it by clicking here.

    I start with a belief that all data should be accessible and available to all investors at low or no cost, but my motives for providing my reading of the data are far from altruistic. I draw on the numbers that I estimate through the rest of the year for my teaching, analysis (valuation or corporate finance) and writing (blogs, books). In other words, I would have analyzed all of this data anyway and having completed the work, I see little benefit in keeping it behind a pay wall or passwords. Let me hasten to add that nothing that I do is particularly original nor is it path breaking and my task is made easier by the easy access that we have to raw data. I do hope, though, that while I do make mistakes, that I have not let my personal biases or views color the data, and that that nothing that I do is opaque.

    Each year, I also try to add something new to the dataset to keep it fresh and this year, I have added company-specific estimates of  costs of equity and capital (in US dollar terms) in the individual company data sets (look to the top of the linked data page). In making these estimates, though, I had to make very broad assumptions about country risk.  For instance, I used the risk premium of the country of incorporation to the company, though it is preferable to use the risk premium based on operations. So, take these cost of capital estimates with a grain of salt, and if you prefer a more precise estimate for a company, you should do in more detail.

    When I finished my update a year ago, I posted on it here, and talked about one of my favorite movies/books, Moneyball, in the context of arguing that intuition & experience were vastly overrated in business. Much of what we think we have learned or think we know about investing and corporate finance is skewed by psychological flaws that we all share: faulty framing, hindsight bias and selective memory, and good data can play a cleansing role. That post represented the “good” that I see in data/numbers, and I thought that this year’s post, for balance, should offer the other side of the argument. I know that data can be misused and manipulated, and that some of my own data has been used to back up specious arguments in multiple settings. In particular, here are three practices relating to data that I find distasteful and suggestions on how you can counter them.

    1. Data to intimidate: An article in the Wall Street Journal  pointed to fact that people who are unfamiliar with numbers tend to give them too much weight to them and are particularly swayed by "mathematical" arguments, even if they are nonsensical. It is this weakness that is used by some number crunchers to intimidate those that may not have the same degree of facility with numbers. I have seen corporate financial analyses and valuations where analysts use table after table of numbers, to bludgeon others into submission, using acronyms, jargon and greek alphabets to further the rout.
    The counter: The best weapons against number intimidation are common sense and a focus on the big picture. I hope that having access to my data will give you some ammunition in this endeavor but having a solid grounding in first principles of valuation and corporate finance alway helps.

    2. Data to mislead: If you have access to a great deal of data, you can parse the data and choose pieces to back up a preconception or argument that you want to advance. A couple of years ago, the effective tax rates that I publish on my site, for US companies, were used by some to advance the argument that US companies were not paying enough in taxes. Looking at the 2013 update on tax rates, that number is low (14.93%), but it is the average effective tax rate across all US companies, including those that are money losing (and thus paid no taxes). Looking only at money-making companies, the average effective tax rate is 28.37%, and the weighted average tax rate is even higher at 30.05%. So, if you have an agenda, you can take your pick to make the argument that US companies pay too little, just enough or even too much in taxes.
    The counter: While there is little that you can do to stop people from using data selectively, you can counter their arguments by presenting them with the numbers that they are ignoring. In fact, it was in response to the tax rate debate that I started reporting the average tax rates for money-making companies and aggregated tax rates in my datasets.

    3. Data to deflect and evade responsibility: Many analysts use data to avoid making tough judgments about businesses or dealing with uncertainty. Thus, assuming that a company will earn a profit margin typical of the industry is much easier to do than analyzing its competitive advantages and estimating a margin, based on your assessment. Similarly, using a historical or a service supplied equity risk premium in valuation is far simpler than estimating one, based upon the macroeconomic risks that we face in markets today. In fact, using an expert or a service estimate of these numbers (using an equity risk premium from a data service like Ibbotson or even my website) allows analysts to claim immunity from errors and to pass the buck, if the numbers turn out to be wrong in hindsight.
    The counter: I have absolutely no concerns about you borrowing data and spreadsheets from my website but please make them your own by adapting and modifying them to not only fit your needs to but also to reflect your points of view.

    I hope that you find my data useful in your work or research. If you do, that is more than sufficient return on any time that I have invested in putting it together. If you can think of ways in which it can be more useful or complete, please do let me know and I will try my best to incorporate those suggestions into next year's update.



    Hundred dollar bills are hard to come by!

    It looks like I just I cannot stay away from the Apple story, with Tim Cook making a splash (or a belly flop) with his speech in New York yesterday and David Einhorn's proposal coming in for scrutiny from investors and the press. This article in the New York Times DealBook does a pretty good job of summing up the proposal and its underlying thesis, and I was surprised to see my name mentioned, with Mr. Einhorn quoted as having said that my analysis "brings to memory the old joke about the economist who refused to pick up a $100 bill on the street because in an efficient economy, there can’t be $100 bills lying around.” I am flattered that I was even part of this conversation, given that Mr. Einhorn has probably never heard of me nor read my thoughts about market efficiency. I am also grateful that this was all he said about me, because I have been accused of far worse than ignoring hundred dollar bills on the floor. (Just take a look at the comment section of my prior blog posts). My motives for this post are not defensive but I do have a weakness of not being able to let an analogy go, especially when it can be used to good effect. So, at the risk of being labeled an egghead, here is what I think about hundred dollar bills on floors.
    1. Location, location, location: Is it possible that you could find $100 bill on the street? Sure, but you have to get very lucky and the likelihood that you will find one is also going to vary depending on what street you are walking on. Your odds are probably better on Rodeo drive in Los Angeles, where there are wealthy shoppers and relatively few pedestrians (since no one in LA walks more than a block) than on a busy street in New York, where there are literally thousands of people, most of who don't have hundred dollar bills, walking with you. Apple is one of the most highly followed, most talked about stocks in the world and is more like Penn Station in New York City than Rodeo Drive.  I have gone through through Penn Station twice every week day, on my commute, for the last 20 years and have never found a hundred dollar bill on the floor. In fact, I don't think I have even found a twenty. I have found a few dollar bills, several quarters, lots of dimes and thousands of pennies.   It is entirely possible that this is because I am a finance professor and am blinded by my belief in efficient markets, but most of the readers of this blog are not. So here are my questions for you: Have you ever found a hundred dollar bill on the floor? How about a twenty dollar bill? Do you find a lot of these? (If so, could you please let me know the street that you walk on... I am willing to relocate... Incidentally, I put this question to my class of 400 today and there were three people who said that they had found $100 bills on the ground. Two of them were in bars at the time. There is a great analogy in here for investors but I am afraid to even go there.... So, I will leave it to your imagination....)
    2. There is a cost to looking for "free" money: Perhaps, Mr. Einhorn's point is that those of us who have never found hundred dollar bills on the floor have just not been looking, but there are people who do and I am not sure that it is a lucrative enterprise. Using the Penn Station analogy again, there are still a few public phones left in the station, and every day as I walk through, I see people doing the phone scan, where they check the change alcove for money that callers have left behind. Could you make money doing this? I guess so, but it depends upon how much value you attach to your time.
    3. And watch your back pocket: I have spent more of my life now in New York City than any other part of the world, and I guess that some of the native New Yorker has rubbed off on me. If I did see a hundred or twenty dollar bill on the floor in front of me, my scam detection antenna goes into high alert. From experience, I know that when something in this city looks like easy money, there is a catch. In this particular case, I would not be surprised to find out when I bend to pick up the "free" hundred dollar bill that it is (a) a fake bill and (b) that my back pocket will be picked while I am bending over.  
    4. Don't build expectations around luck: If I did find a hundred (or even a twenty) dollar bill on the floor and I felt safe enough to lean over and pick it up, I would feel "lucky" that I found it, but I would not mistake serendipity for skill. I would certainly not build my household budget on the assumption that I will find not one but three hundred dollar bills on the floor every month in Penn Station. That would be not only foolhardy but a recipe for a unbalanced budget.

    I have nothing personal against Mr. Einhorn, other than the standard New York lament that he is a Mets fan and not a Yankee fan. I have agreed with him more often than not and shared his disdain for the over-the-top assumptions that analysts were making for companies like Green Mountain Coffee. In fact, I will offer an argument for Mr. Einhorn's proposal that I think is more substantive than any that I have heard made yet. His suggestion that Apple issue preferred stock to its common stockholders is built on the presumption that, with interest rates at historic lows, there is a void in the market now for  investors (perhaps institutions that need the cash and get a break on taxes on preferred dividends) who would like to make a reasonable return on a safe investment. The assumption is that these investors will  pay a premium (over and above "fair" value, given the risk of the cash flow) for the 4% preferred stock that Apple will issue, and that common stockholders will capture this premium (by selling the preferred shares that they are granted by Apple to these "premium paying" investors). That is not an unreasonable argument, but my skepticism is based on two considerations. The first is that if this is true, we should be able to see the evidence in the preferred stock market, where preferred stock issued by companies that have solid balance sheets and substantive cash flows should be trading at premium prices. Is that happening? I don't know, but if Mr. Einhorn wants to make his case stronger, he should present evidence of the phenomenon, perhaps by comparing preferred dividend yields to earnings yields on common stock and corporate bond spreads. The second is the question of scalability. It is possible that Apple's common stockholders may be able to capture some of this premium with the first $50 billion of preferred stock issue, but will the premium persist as the issue gets scaled up to $100 billion or to $430 billion? I don't think it will, but I remain willing to be persuaded otherwise, and the onus is on Mr. Einhorn to provide the justification. In fact, much of the noise around this proposal comes from the misconception that a company can choose both the face value of its preferred stock and the dividend yield. If Apple issues $500 billion (face value) in preferred stock and sets the dividend yield at 4%, that preferred stock will not have a market value of $500 billion.

    I started this post with the note that Tim Cook was in San Francisco yesterday, delivering a speech to a conference. Listening to what he said, I was reminded of why I continue to be frustrated with Apple's management. First, I don't think any CEO should be labeling a proposal by one his leading stockholders as a "silly sideshow", even if he disagrees with that plan. (Correction: As some of you have noted, Mr. Cook labeled the lawsuit as a silly sideshow, and not the proposal itself. A little more palatable, but Einhorn has the right to sue and Apple has the right to show, in court, that the lawsuit is frivolous and get it thrown out... )  Second, Mr. Cook made a highly publicized speech and told investors nothing of substance. I know that he dropped nuggets of information that may or may not be useful to investors, but talking about how much more money Apple will pay developers next year is the equivalent of a dinner party host with an elephant in the dining room talking to his guests about the the quality of the place settings. At the moment, investors in Apple are centered on the $137 billion in cash that the company has accumulated, and continues to add to, and they want to know what Apple's plans are for that cash. I am sure that Tim Cook has plenty of well paid consultants, giving him advice, but I will offer mine for free, knowing that it will be ignored. Mr. Cook, if you have nothing of substance to tell investors, it is best that you not talk at all, because if you do make more speeches like the one you delivered yesterday, you will more damage than good (as the market response showed)!

    Returning to my central theme, what would I do if found a hundred dollar bill on the floor? First, I will check my surroundings to make sure that I am not the sucker in a con game, and I will then bend down and pick it up. Second, I hope (to be ethical is easy in the abstract, much more difficult in practice..) that I will remember what my mother taught me and look to see if I can find the legitimate owner of that cash. If I do not, I will think of it as my lucky find and treat it accordingly. I will, however, not spend the following days searching for hundred dollar bills on the floor, nor will I build my investment portfolio on the assumption that I will keep finding more free money on the floor.



    Michael Dell's Conflicted Buyout

    Let’s say that you are interested in selling your house and hire a realtor, and that the realtor comes back with what she says is the “best” offer for the house, forgetting to mention that she is the buyer. I would assume that you would be screaming about conflict of interests from the rooftops, right? Now, let’s change the story a little bit. Assume that you are the CEO of a publicly traded company that has been targeted by a group, interested in buying the company. Your fiduciary responsibility to your stockholders, if you decide to sell, is to try to deliver the “highest price” that you can get from the potential buyers. But what if you are also heading the buyout group that is trying to buy the company? The conflict of interest you face would be untenable, since you would, as the lead buyer, want to pay the lowest price. That is, of course, the problem in any management buyout and the issue has risen to the surface with the announcement by Michael Dell, CEO of Dell, that he would like to take the company back private for $13.65/share; that would translate into a $24 billion bid for the company, with about $15 billion coming from debt. Dell will be augmenting his 14% stake in the company by investing more of his wealth but he will joined as an equity investor by Silver Lake, a private equity firm. 

    The standard "management" defenses
    So, how do managers in a management buyout defend what seems to be a flagrant conflict of interest? They offer one of three arguments:
    1. The “fair value” fig leaf: The managers will hire appraisers/investment bankers to value the firm and ensure that investors get a “fair” value. In fact, the board of directors at Dell will (and Silver Lake) have a bunch of investment banks (JP Morgan Chase is the lead bank but it looks like a whole nest of investment banks is involved in this deal and it is unclear who is doing what, though they are all getting paid) that they can draw on  to make this judgment on whether the offering price is a fair one. Without casting any aspersions on the valuation capabilities of these investment banks, there is no chance that any of them can deliver unbiased opinions, when so many fees ride on this deal getting done. Will they deliver a value called a fair value to justify the deal? Of course, but that value will be a “legally defensible” value, not a fair one; the gap between the two is a wide one. 
    2. The “market is right" and "we are paying a premium" kabuki: It is amazing how quickly managers in management buyouts discover the wisdom of markets. As Dell will undoubtedly point out, “if markets thought we were worth only $11/share a few weeks ago, you should consider yourself to be lucky to get a premium on that price”. Interesting argument, but the market price, even in an efficient market, is based on the information that is available about a company, often with the company as the source for the information. The problem in Dell or any other management buyout is that the same management that is buying the company from stockholders has controlled the information spigot for the months leading up to the dal. How do we know that they have not suppressed good news and been liberal about revealing bad news leading into this transaction? I may be overly suspicious of management intentions, but that is the problem when you play both sides of the field.
    3. The “open to other offers” defense:  Managers are also quick to point out that there is time for other bidders to make higher offers for the company and that they remain open to other offers. Talk is cheap, though, and all this openness requires a board of directors that will seriously consider alternate offers and an acquirer who is willing to surmount the obstacles of a shortened calendar and antipathy from managers. To give Dell credit, it has hired another investment bank, Evercore, to find potential buyers for the company, with their fees tied to their ability to find a higher bid. I applaud Dell for at least trying to create a modicum of fairness in the process, even if the intent is to fend off future lawsuits, but Dell's board has already shown their hand in this deal, as this news story indicates.
    What's so special about Dell
    Now, why pick on Dell, if these are problems in every management buyout? The Dell deal magnifies all of the tensions for three reasons:
    1. It is a “big” deal, not the biggest ever but at approximately $24 billion, it does rank among the biggest.
    2. Dell is a high profile stock, widely held and extensively followed. Investors believe that they understand the company and its operations.
    3. Not every buyout has a marquee name atop the buyer board that has been so closely attached to the company. Michael Dell, who started Dell when he was a student at the University of Texas, became incredibly wealthy from Dell’s success in public markets. While he did take a hiatus from the day-to-day management of the company, he has been the CEO of the company since January 2007. During those last 6 years, Michael Dell has pushed been open about his vision for the company, and with a compliant board has spent billions in acquisitions and investments to expand the company's footprint in the enterprise solutions business. In the fiscal year ended February 2012 alone, Dell spent almost $2.7 billion in acquisitions in pursuit of his dream.
    Dell's possible pitches, pitfalls and fixes
    I do not envy Michael Dell or his bankers, though they will be richly compensated for their stress, because there are four potential sales pitches that they can make to investors and none of them casts the company or its management (especially Michael Dell) in a favorable light.

    1. Company has made expensive mistakes over the last few years, it has not been well managed and the market is right in its recognition of those mistakes.
    The pitfall: The same management that made those mistakes now wants to buy the company at a lower price that they, in a sense, caused. That looks to me like rewarding management for a job badly done. Furthermore, for the last few years, Michael Dell has been telling stockholders that these were not mistakes (and were making healthy returns). Paraphrasing a question that you hear in every political scandal, I would ask Mr. Dell: What did you know about these mistakes and when did you know them? Put more bluntly, were you misleading us about the quality of your decisions then or are you misleading us now? (Take a look at Michael Dell's annual reports to stockholders for the last few years)
    A fair fix: As I see it, there are two possible fair solutions. One is that Michael Dell can take the company private, as long as he agrees to cover the cost of his mistakes. Put simply, take the money that Dell has spent over the last five years on acquisitions and investments (an amount in excess of $7 billion), charge a reasonable return (a break even where they delivered just the cost of equity) and add it to the value of the company now. In fact, Southeastern Asset Management, which holds more than 7% of Dell shares and is the second largest stockholder in the company, made exactly this pitch in a letter that they sent to Dell’s board, when they took Michael Dell at his word, capitalized his mistakes and estimated an value of $23.72 per share. The other is that since Michael Dell claims that $13.65 is a fair price for the shares, he should be willing to be bought out at that price. Perhaps, Southeastern should make an offer to buy out Michael Dell's stake at 13.65/share. If he refuses, it would indicate that this is a fair price for him to buy the company, but not to sell it.

    2. Company has made the right decisions over the last few years but the market has been wrong in assessing the effect on value.
    The pitfall: This creates a more defensible scenario for Michael Dell, since he does not have to admit to past mistakes or misleading investors about them, but it creates a whole new set of problems. If this pitch is true, he is arguing that the market price today is too low, relative to intrinsic value. If he is consistent with this argument, I would expect to see JP Morgan (or whoever his hired appraiser is) to come back  tell the board that the offered price is too low and that it has to be raised to a much higher number. I may be cynical, but I feel that this is not going to happen and that the investment bankers are going to come back with a valuation that justifies whatever the Michael-Dell led buyout team decides to do (even if it is sticking with the current offered price).
    A fair fix: One is to have an appraiser who has no ties to the board, the managers or to Silver Lake make an assessment of value per share. To those who feel that no appraisal will ever be fair, here is an alternate one (and this is one that Southeastern Asset Management has suggested as well). Give the existing stockholders a chance to be part of the buyout deal. In other words, offer the shareholders a choice of either cashing out at the buyout price or staying on as part of the buyout team. Michael Dell could reduce the debt he needs for the transaction and will end up with a much larger piece of the company.

    3. Company has made wrong decisions in the past, but it was forced to make these decisions by a “short sighted” market. Once it becomes a private business, it can make the right decisions for the future.
    The pitfall: That is an interesting argument, but the onus for backing it up then has to be on Dell (the man and the company) both in terms of what has been done and future plans. Looking backwards, what is it that the market has forced Dell to do over the last few years? Did it force Michael Dell to spend money on these past acquisitions and investments that are not paying off? Did it force him to make the big bet on enterprise solutions?  If so, how did that happen? Looking forward, what is it that Michael Dell plans to do differently? And what is the basis for his claim that these actions will not be received well by the market. It does not seem fair to blame a market for reacting badly to changes he has not made or even made explicit.
    A fair fix: Let us start with a mea culpa from Michael Dell for mistakes made in the past and an explanation of how the market forced those on him. He should then continue by putting forth the changes that he plans to make to the company, once he takes it private. Let the market react to these changes and he can then pay a price based on that reaction. 

    4. This is not about value, price or changing the way the company is run. Michael Dell is just tired of running a company in the market spotlight, with the stresses of answering to stockholders, analysts and rating agencies. He just wants to go back to running a private business.
    The pitfall: Okay, fair enough, and I feel bad for Mr. Dell, but he got his riches from playing in the same market spotlight. Is he willing to return all that cash back to the market? I know that he is investing more than just his stake in the company but how much of his total wealth will be in invested in a private Dell? Also, has he made clear to Silver Lake, his private equity partner in this transaction, that this deal is not about making money but bringing him inner peace? Finally, does he really think that the lenders who lent $15 billion on this deal will be more forgiving than stockholders of mistakes?
    A fair fix: Michael Dell takes the company private, and either invests back in the company all of the gains he made from the public marketplace or gives it to charity. Also, let’s get an iron card guarantee from everyone involved in the buyout that Dell will not be going back public in 5 or 10 years. 

    The Investor Choices
    As investors in Dell, what are your choices? I see three possible ones, depending upon how much energy and resources you are willing to pour into the battle.
    1. The “karmic” surrender: You accept that bad things happen to good investors, and that this is your fate as a Dell investor. You will take whatever the price that is offered in the deal as your best price and move on without much sound or fury. (I know that this is is the Wikipedia version of karma and that there are deeper and more profound versions of it... So, please, please don't post to tell me that...)
    2. The Primal Scream: You have your “Howard Beale” moment, where you take the best price that Michael Dell will offer, but not before you rant and rave about how unfair the world is to investors like you. 
    3. Storm the castle:  You go for the win. You will need large institutional investors to follow Southeastern Asset Management’s lead and rouse themselves from their slumber and join in the fight. To get you started, here is are some of the largest institutional stockholders as of the last filing: T. Rowe Price (4.41%), Blackrock (4.32%), Vanguard Group (3.63%), State Street (3.58%). After all, Dell owns only 14% of the shares and you could create a coalition that could this deal. I am not a stockholder in Dell, have never been excited about the company, but I will contribute a small part to your struggle. I valued Dell, using my estimates, and arrived at a value per share of $16.38/share. You will, of course, have different views about Dell's future and arrive at a different value. Go ahead and download the model, value the company, and let’s get a shared Google spreadsheet going. Revolutions start with small protests.
    Here is my sense of this deal. At $13.65/share, Michael Dell is probably getting a bargain, but I don't think it is a huge one. As a consequence, it is going to be difficult to find another buyer who will offer a significant premium over the buyout price. I also think that Dell's depleted value today is a consequence of Michael Dell's management over the last few years and it bothers me that he will be benefiting as a result of his own mistakes. If nothing else, as a Dell stockholder, I would like an honest admission from Michael Dell that the wreckage at Dell is not the market's fault but his own, and a couple of dollars more per share on the buyout price will soothe my pain a little.



    Financial Alchemy: David Einhorn’s “value” play for Apple

    If you are an Apple stockholder, yesterday was an eventful day. First, you had David Einhorn becoming more “activist” with his Apple holdings, moving from being just bullish on the stock to pushing for change. Second, Einhorn also unveiled his plan for Apple: the company should give its stockholders preferred shares in the company, with a 4% dividend yield. In pushing for the change, he is quoted as saying that doing so will “unlock billions of dollars in value".

    There will be NO value created.. none.. 
    Before I look at the trade off on and the alternatives to the preferred stock issue, let me dispense with the one part of his claim that cannot hold. Issuing preferred stock will not add value to the company, not one cent. Before I get accused of being a “theorist” or “academic” (which I now know are code words for much worse insults), let me explain my rationale:
    1. The first law of thermodynamics, applied to value: You cannot create value out of nothing and giving preferred stock to your common stockholders is a “nothing” act, as far as the value of the company is concerned. It will not increase the cash flows from operations nor will it alter the risk in Apple’s business. 
    2. The cost of capital will not change: This action will not change the cost of capital. At first sight, it looks like it should since the cost of preferred stock, at 4% (assuming that it trades at par) is much lower than Apple’s current cost of equity (which I estimated at 12% or higher). However, that savings is a mirage, since common stockholders will now have to price in the risk of the additional commitment that has to be met (the preferred dividend) into the cost of equity. If this were not true, every company with a healthy cash flow (Coca Cola, Microsoft, Google) could become a money machine, granting preferred stock to its common stockholders. 
    3. The constant PE ratio is a myth: The most cringe worthy argument that I read yesterday was the one that went as follows: Apple currently trades at a PE of approximately 10.2, $450/share on earnings per share of $44. If you grant each common stockholder a $100 preferred stock, with a dividend of $4, your earnings per share will drop to about $40, and preserving the same multiple will generate a value per share of $400. Add that on to your preferred stock that is worth $100 and you have valuation magic: you have created $50 in value. This is the worst kind of nonsense, since it is nonsense with a believable twist to it, and that is why it has been investment conman’s favorite tool over history. The PE ratio is not a constant, and it will change as you change the nature of your equity risk or cash flows, as you are in this case. 
    Bottom line: If Apple’s share were trading at fair value today (let’s say, at $450/share) and each Apple shareholder were granted a preferred share, with a preferred dividend of 4% and face value of $100, here is what the shareholders will end up holding tomorrow: a common stock with a value of $350 and a preferred share with a value of $100.

    But the price MAY be affected
    While I would contest Mr. Einhorn's claims of "value creation", let me take a more charitable view of what he is trying to do. Perhaps, he is trying to unlock the “price’, rather than the value, a distinction that may make more sense if you read my post on value versus price from yesterday. To make this "unlocking price" argument, you have to not only assume that the stock is under valued (which I would support) but that the under valuation is occurring for a very specific reason. It is not because investors are misjudging the value of Apple’s operations but because they are not giving Apple credit for either its huge cash balance ($130 billion +) or its capacity to generate huge cash flows ($30-$40 billion/year), for one of two causes:
    1. There could a trust discount attached to the cash balance, because investors are worried that Apple might be tempted to do something stupid with the cash, and with this much cash, there is only one action that can do you significant damage and that is overpaying on a really large acquisition. 
    2. Investors may fear that while the cash builds up in Apple, they may never see the cash, because managers are so attached to it that they will not let go or because it is trapped and therefore unavailable for user, due to tax reasons. 
    If investors are discounting cash for one or both of these reasons, the preferred stock may serve to increase the price because it commits Apple to returning the cash (in the form of preferred dividends) in perpetuity. Presumably, “relieved” investors will now breathe a sigh of relief and remove the discount on cash, causing the stock price to go up. The upside is limited to the discount on the cash. Even if cash is being treated as worth nothing today (which would be a 100% discount), that would translate into $140/share.

    Even if we accept this argument, though, it is not clear that granting preferred stock to common stockholders is the optimal way to create this commitment. In fact, there are three alternate routes that the company can go:
    1.  Increase common dividends: The simplest and least involved alternative is to increase the common dividends per share from the existing level of $10.60 per share to a higher value. In fact, if you are looking at granting a $100 preferred stock with a 4% dividend to each common stockholder, you could create an almost equivalent commitment by just raising dividends per share by $4/share. I know that the commitment is a little weaker, since common dividends are not guaranteed, but given how sticky common dividends are (healthy companies very seldom cut common dividends), but not by much. In fact, since investors tend to build in expectations of growth into common dividends that will not get built into a perpetual preferred share, the net commitment effect may actually be neutral. 
    2. Buy back stock or pay a special dividend: If investors distrust you with cash or are discounting it, the best response is to return in right now, rather than commit to return it to the future. The problem for Apple, though, is that a big chunk of the cash cannot be touched unless Apple decides to pay the “differential tax” (between the foreign tax rate and the US tax rate) on the trapped cash (estimated to be $80 billion+ of the cash balance). With Apple’s cash balance, though, you could still put together a substantial buyback ($40 billion) and commit to more buybacks in the future. 
    3. Issue bonds: Instead of giving common stockholders shares of preferred stock, you could give them Apple bonds instead. The advantage of doing so is that you could now potentially have a value impact, not because your operations have magically become more valuable but because the government in its wisdom allows you to subtract interest expenses for tax purposes. Thus, if you were able to give each common stockholder an Apple bond with a face value of $100 and an interest rate of 3% (unlike the preferred stock, you cannot arbitrarily set interest rates at any level you want, since the tax authorities will object), the potential value of the tax benefit per share , using a marginal tax rate of 40% and a cost of capital of 12%, can be computed as follows:
    • Interest tax savings each year = $3 (.40) = $1.20 
    • Present value of these savings in perpetuity = $1.20/.12 = $10/share 
    • The commitment to make interest payments is far stronger than the commitment to pay preferred dividends, since the consequence of failing to make interest payments is default. That is why there is a limit to how many bonds you can issue, before the trade off starts to work against you. 
    Faced with these four choices: the Einhorn preferred stock grant, an increase in common dividends, a stock buyback/special dividend and bond issuance, there is one final consideration to keep in mind. The common stockholders in Apple have to think about the consequences of each of these for their personal taxes. With the common dividends and buybacks, we are on familiar ground and the effect on taxes is straightforward. Dividends will be taxed at the 20% dividend tax rate for most individual investors, as will the capital gains that arise from a buyback and are close to equivalent (though there is a tax timing option embedded that gives the latter a slight advantage). With the granting of preferred stock or bonds to existing stockholders, there is an added tax twist to consider. The preferred dividends will get taxed at 20% whereas interest income from bonds is taxed at the ordinary tax rate (higher than 20% for most investors), giving preferred dividends an advantage over bonds (but not over common dividends/buybacks). In addition, from my limited understanding of tax law, the grant of bonds will be treated as income at the time of the grant whereas the grant of preferred stock will not. (Thus, the Apple stockholder who receives a $100 Apple bond will be treated as having income of $100 in the year of the grant, whereas the receipt of $100 in preferred stock will just reallocate the basis for the Apple stockholding). 

    Bottom line: If the objective behind the preferred stock is to remove the “trust” or the “trapped” discount on cash, why create a complicated mechanism, when a simple one will do? Just raise common dividends, if you do not want to open the door to debt at the moment, but leave that door ajar for the future.


    Preferred Stock: The Big Picture
    Contrary to many reports that I read yesterday, preferred stock is neither widely used nor is it favored by mature, non-financial service companies and for good reason. It brings many of the disadvantages of debt into a company (the fixed commitment, albeit with lesser consequences for failure to pay) without the tax benefit. In fact, there are three big users of preferred stock and Apple does not fit into any of the three categories:
    1. Control freaks: The use of preferred stock is widespread in some parts of the world, such as Latin America, but it takes both a different form (from US preferred) and often has a different motive. In much of Latin America, preferred stock does not entitle you to a fixed absolute dividend but instead gives you a first claim on the dividends and a percentage of the profits. Thus, these preferred shares are really common stock without voting rights. They are used by companies, where insiders hold the voting shares and have no desire to be accountable to the capital markets. 
    2. Young and start-up firms: Young firms often use preferred stock to raise capital because they want to raise capital, without diluting the existing owners’ stakes in the companies. For these companies, the tax benefits of debt are irrelevant in the decision process, since they are often money losers, and the risk of default is too high. To sweeten the pot for investors, they will often add the option to convert into equity to the preferred stock (creating convertible preferred shares). 
    3. Financial service firms: Financial service firms use preferred stock because some measures of regulatory capital allow them to count preferred stock as part of capital. Thus, while they view preferred stock as expensive debt (since it does not have the tax advantages), it does serve the purpose of augmenting regulatory capital. 
    Studies of both US and European companies suggest that when CFOs are asked about their preferences on raising funds, there is a financing hierarchy. Topping the list as most favored is straight” debt and at the very bottom of the list is preferred and convertible preferred. For non-financial service firms, the issuance of preferred is more a sign of desperation than it is of health. No matter what you think about Apple’s prospect, I don’t think you would view them as being desperate for new capital right now.

    Generalizations
    If David Einhorn’s idea is a non-starter when it comes to value creation and not particularly effective even as a price catalyst, he is not alone in his sales pitch. In fact, what he is doing is widespread among companies, consultants and banks and I would propose three changes in the way restructuring plans/ proposals are presented to investors and public.
    1. Stop using price and value as interchangeable terms: Much of what passes for value creation in many companies is not what it is made out to be. I have seen the hue and cry around stock splits, issuing tracking stock and accounting restatements of assets on balance sheets and wondered why we make such a big deal about these actions. All of these tend to be purely cosmetic and have no effect on value. However, they could impact stock prices, if there is a gap between value and price. So, let’s require truth in advertising. 
    2. When you talk about value enhancement or creation, be specific: If an investor, company or consultant claims that an action will enhance value, the onus has to be on the claimant to explain where the value increase is coming from. Simply put, it has to come from increasing cash flows in existing assets, reducing the risk in these cash flows, improving the tax benefit/default risk trade off or from growing more efficiently (improving competitive advantages). That is a broad canvas and every true value enhancing action has to wend its way through one of these paths. 
    3. If you are talking about price enhancement, say so: If you believe that taking an action will increase your price (and has nothing to do with value), don’t claim otherwise. Here again, be specific about what market mistake or friction you are exploiting. If at the limit, your argument is that the price will go up because investors are naive or stupid (which is the basis for the constant PE argument), you might as well say so. 
    In closing, I am glad, as an Apple stockholder, that David Einhorn is rocking the boat, even if I think his proposal is the not the most effective catalyst or game changer. It opens the door to a healthy discussion about how Apple should deal with its large and growing cash balance, and that is a good thing for all concerned.



    Back to Apple: Thoughts on value, price and the confidence gap

    I know that you are probably sick and tired of reading about Apple, and I am getting close to that point too, but this post is really more about investing than it is about Apple. In my post on Apple on January 27, I also posted "my" distribution of value for Apple, concluding that there was a 90% chance that Apple was under valued. One of the responses I got was interesting and it questioned the courage of my convictions by asking why, if I believed that there was a 90% chance that the stock was under valued, I would not "bet the house" (I put a 10% cap on Apple in my portfolio). That, of course, gives me a platform to return to a theme that I have harped on for much of the last year: that valuation and pricing are two very different processes and that many analysts/investors often being confident about one does not imply confidence about the other.

    To set the table for the comparison, let me start with my assessment of the differences between the valuation and pricing processes.

    • The value of a business is determined by the magnitude of its cash flows, the risk/uncertainty of these cash flows and the expected level & efficiency of the growth that the business will deliver. While discounted cash flow valuation may be one way of estimating this value, there are other intrinsic value approaches that also try to do the same thing: estimate the intrinsic or fair value of a business. 
    • The price of a publicly traded asset (stock) is set by demand and supply, and while the value of the business may be one input into the process, it is one of many forces and it may not even be the dominant force. The push and pull of the market (momentums, fads and other pricing forces) and liquidity (or the lack thereof) can cause prices to have a dynamic entirely their own, which can lead to the market price being different from value. 
    Last year, in the aftermath of the Facebook IPO, I posted on the difference between pricing and valuation and my view that much of what passed for valuation in Facebook (in the IPO pricing by the investment banks and by investors in the aftermath) was really pricing. In fact, I think that this picture illustrates my point:

    So, let us assume that you value a company (using whatever your favored valuation tool) is and come to the conclusion that there is a gap between the value and the price. Before you act on this value, you have to answer three questions:

    1. How confident are you about the magnitude of the gap? Since you know the market price, this is entirely a question about the confidence you have in your valuation.
    2. How confident are you that the gap will close? This, unfortunately, is generally not in your control and will be driven by the pricing process.
    3. What are the catalysts that can cause the gap to close? If the gap is to close, the price has to move towards your value and you need "something" to get it started.

    In sum, whether you invest will depend upon the answers to all three questions. You could, therefore, find a big gap between value and price, feel confident about your estimate of value and not invest in the stock, if you don't feel comfortable with the forces that are driving the market price or hopeful about catalysts in the near future. Let me apply this structure to Apple to reconcile my assessment that there is a 90% chance that Apple is under valued at $440/share and my decision to cap my holding of Apple at 10% of my portfolio.

    The Magnitude of the Gap
    I started with a discounted cash flow valuation of Apple at the end of 2012, which yielded $608/share. With the stock trading at $440, that gives me an estimated gap of $168, impressive but meaningless without a measure of confidence about the magnitude of the gap. To arrive at this confidence measure, I used Crystal Ball (an add-on to Excel that allows you to do Monte Carlo simulations) and revalued Apple, with distributions, rather than single values, for three key inputs: revenue growth rate in the near term, target operating margin and a cost of capital. The results of 100,000 simulations (that is the default in Crystal Ball) yielded the distribution for values for Apple:
    APPLE SIMULATION RESULTS: END OF 2012

    All that I did to arrive at the 90% estimate that Apple was under valued was count the number of simulations that delivered values less than $440; in reality, it was closer to 94% but I rounded down to 90%.  Note that to end up at values less than $440, the distributions for the key variables all had to be close to the "bad" ends of their distributions. Thus, for Apple to be worth only $440 (or less), you would need negative or close to zero revenue growth, pre-tax operating margins of 25% (current margin is closer to 35%, down from 40% plus a year ago) and the cost of capital would have to be at 15% (the 97th percentile of US stocks).

    The Closing of the Gap
    Now, comes the trickier question. Will the gap close and if so, when? There are three factors to consider in making this judgment:
    (a) Information: Are you using information in your valuation that the market does not have yet? I know that this would be dangerously close to insider trading in the US, but it is possible that in some markets, you have to access to proprietary information. The gap will close when then information is revealed. With Apple, I used the company's filing with the SEC, and there is no private information in the valuation. I have exactly the same information as everyone else in the market does.
    (b) Liquidity: Are there market trading restriction or liquidity barriers that are preventing the price from adjusting to value? If you have a lightly traded stock, with minimal float, it is possible that the price may stay different from value, until trading picks up. If the stock is over valued (price > value), there may be restrictions on short selling that prevent the price from adjusting to value. With Apple, given its market cap and liquidity, I don't see this as a a problem.
    (c) Behavioral forces: What are the pricing forces in the market and which direction are they pushing the gap? As I noted at the start, prices are subject to the push and pull of momentum, to institutional investors flocking into a stock and then abandoning it and to equity research analysts blowing hot and cold about its next earnings report. With Apple, these forces, for the last year and a half, have been powerful and unpredictable, pushing the price up to $705 a few months ago and down to $440 now. Part of the unpredictability comes from the mix of growth, value and momentum investors who drive the price and part of it comes from the rumor/news ecosystem that the market has developed to fill in the news vacuum created by Apple's secrecy about its future plans. As a consequence, the price/value gap could stay where it is or even get larger in the near term, but the odds of the gap closing do improve as you extend your time horizon. For instance, here are my very rough estimates (based on what I know about momentum and price movements in stocks over short and long periods) of what I see happening to the gap, as a function of time horizon:

    Over the next month, there is a higher chance that the gap will increase rather than decrease, but as the horizon extends, the likelihood of the gap increasing drops. But here is the bad news for intrinsic value investors. Even with a 10 year time horizon, and assuming that you are right about value, there is still a non-trivial chance that the gap will get bigger. Hence, there is good basis for the old Wall Street adage: that the market can stay irrational longer than you can stay solvent.

    The Catalyst
    If there is a gap between price and value and that pricing gap persist, it is no surprise that investors start looking for catalysts that can cause the gap to close. Not surprisingly, there is no easy model to follow, but here are some choices:
    a. Be your own change agent: As investors, it would be nice if we could tilt the game in our favor by having some influence over the gap. While you and I may not be able to do much to alter market dynamics, this is a place where activist investors with enough money and access to megaphones can make their presence felt. And the good news for the rest of us is that we can sometimes piggyback on their success. As Apple investors watch Nelson Peltz tussle with Danone and Bill Ackman take on Herbalife, they may find fresh hope in David Einhorn's frontal run at Apple.
    b. A company act/decision: While publicly traded companies often play the role of helpless victims to the pricing process, they feed the momentum beast when it works in their favor. In my last post, I noted some actions that Apple can take to cause prices to move towards value including being more open about their long term plans, returning more cash to stockholders and finding new markets to disrupt.
    c. A market shift: It remains one the great mysteries of markets. Momentum has a life of its own and it does shift, often in response to small events. While I am not a tape watcher, I believe than trading volume shifts, historically, have been better predictors of momentum changes than watching pricing charts. So, if your technical analysis skills have not rusted, get busy!

    Speaking of Einhorn, the news stories today are about his suggestion that Apple issue preferred shares to its common stockholders with a 4% dividend. I am afraid that this post has already gone on too long for me to comment at length, but here is what I believe. Issuing preferred shares will have no effect on value (so, forget about unlocking value...) but the best case scenario is that it will be a price catalyst, by convincing (some) stockholders of the company's commitment to return cash to investors in the future. Cryptic, I know.. but I will have a separate post on it tomorrow.

    The Bottom Line
    Summing up, my high confidence that there is a big gap between value and price (that Apple is under valued) is tempered by my low confidence, at least in the near term, that the gap will close substantially and that there will be a dramatic game changer (catalyst) in the next few months. While I have a long time horizon, it is not entirely within my control (since I have no idea what financial emergencies may lie in my future), and hence my cap on my Apple investment.  In fact, it was the fear of the havoc that these forces could wreak that led me to sell Apple in April 2012, when the stock was trading at $600+ (at my estimated value of $700, there was a 60% chance that it was under valued).




    It's time: A new semester begins.. and you are welcome to join in...

    As those of you who have been reading my blog for a while know, I have been posting my valuation and corporate finance classes online. A year ago, at the start of my Spring 2012 class, I provided my rationale for doing so, which is that the modern university business model is broken and inefficient and that change is needed. At the start of the Fall 2012 valuation class, I pointed to the lessons that I had learned from the earlier semester and the tweaks I had made as a consequence. The learning continued through the semester and I hope to incorporate what I have learned this semester, since I will be offering my corporate finance and valuation classes online, as in prior semesters and I hope that you will be able to join in (at least for portions). The classes start on Monday (February 4). You can follow my corporate finance class or my valuation class, or if you are a glutton for punishment, both.

    Corporate Finance
    I am undoubtedly biased, but I believe that no matter what you do in business, you should understand corporate finance. By understanding corporate finance, I don’t mean that you have to agree with what I have to say on the topic, but that you have to develop your own narrative that is internally consistent about what it is that business should aspire to accomplish and how they should allocate resources to get to that objective.  This semester-long class should be accessible to anyone who can read a financial statement and can do basic statistics and you can take the class in one of four forums:

    a. My website: I track the class on my website, with links to the webcasts of the lectures posted a few hours after each lecture, all of the lectures notes, quizzes and exams and even emails that I send to the class. You can find the links to the website for the class and to the webcast page below:
    Link for just webcasts: http://www.stern.nyu.edu/~adamodar/New_Home_Page/webcastcfspr13.htm
    The webcasts can be seen in one of three formats: a direct stream from the NYU server, a downloadable video file that you can watch on your computer at your own leisure and a downloadable audio file, if you want a smaller file with just lecture audio. In the interests of not straining the NYU servers (and creating some backlash for me), please try to use the downloadable versions of the sessions, if you decide to use this forum. The classes are scheduled from 10.30-12, Monday and Wednesday and should be accessible a few hours afterwards.

    b. Lore: I have used Lore (which used to be called Coursekit) before and it provides an interesting mix of social media (a Facebook-like discussion page where you can interact with others in the class) and a place for content (where I will post lecture notes, exams and other material to go with the class). To audit the class on Lore, go to the website
    http://www.lore.com
    When prompted, enter this code: NHHXJU. You should be added to the class and you will get emails when anything is posted to the class site. If you find that bothersome and would prefer to check at your own convenience, you can go into your settings on Lore and turn off the email prompting (though you may not be able to turn off my postings… the privileges of being the instructor). 

    c. iTunes U: If you have an Apple device (iPad, iPhone or iPod), you should first download the iTunes U app (which is free). Once you have it downloaded, you can directly join the class using the link below:
    https://itunesu.itunes.apple.com/audit/COHMND8KF3
    Alternatively, you can enter this enrollment code (KA3-L7J-E46) into your iTunes U app and the class should be added to your library. Again, you will be prompted, whenever I post anything to the site but you cannot post directly on the site.

    d. Symmynd: This is a new entrant into the mix and I used it in the Fall. They have the Fall 2012 class archived and you can get to it by going to:
    They will also be carrying my Spring 2013 class and the link should show up on the site shortly.

    Valuation
    The valuation class is a second-year MBA elective course and many of the students in this class have already taken my corporate finance class. However, the class is a stand-alone class that does not require corporate finance. If your interests lie primarily in valuation, you can just take this class, which is about valuing businesses: public or private, small or large, developed or emerging market. It is not a theoretical class. In fact, I firmly believe that there is little theory in valuation and that almost every big question is a pragmatic, estimation question. By the end of the class, my objective is that you will have both the tools and the big picture feel to value just any type of business. As with the corporate finance class, you will have four ways of taking the class.

    a. My website:  You can find the links to the website for the class and to the webcast page below:
    Link for just webcasts: http://www.stern.nyu.edu/~adamodar/New_Home_Page/webcasteqspr13.htm
    All of the caveats and notes that I posted about the corporate finance class apply. The classes are scheduled from 1.30-3, Monday and Wednesday and should be accessible a few hours afterwards.

    b. Lore:  To audit the class on Lore, go to the website
    http://www.lore.com
    When prompted, enter this code: WHKP39

    c. iTunes U: You can directly join the class using the link below:
    https://itunesu.itunes.apple.com/audit/COJL8LZCE3
    Alternatively, you can enter this enrollment code (KKY-C8B-D56) into your iTunes U app and the class should be added to your library. Again, you will be prompted, whenever I post anything to the site but you cannot post directly on the site.

    d. Symmynd: The Spring 2012 corporate finance class is archived and you can get to it by clicking below:
    The Spring 2013 class will be added soon on the site and you can follow online in real time.

    Bottom Line
    I know that you lead busy lives and that it is asking for too much of your time to take an entire class in real time. To alleviate some of the time pressure, I plan to do the following:
    a. Leave the content on for at least a year on the sites: You can take a break, if life gets busy, and come back and finish the class...
    b. Make individual sessions detachable: Many of you already know corporate finance and valuation. If you prefer to dip in and just take a session or two, it should work.
    c. Create shorter versions of the lectures: I know that 80 minutes online is way too long. I am creating 15-20 minute versions of each of the lectures and hope to have those online sometime during the semester. Hopefully, that will relieve the time crunch.

    I also know that it is easy to lose your moorings during an online class, without the feedback that you get in a real class. To counter this issue, here are some of the things I will be trying:
    a. The Lore social media site: I plan to post questions and topics on this site for general discussion. Please feel free to post your questions and responses there.
    b. Class pop quizzes: I will post the pre-class test that I start every valuation class with (with the solution) and a post-class quiz that you can take to see if you get the concepts in the class.
    c. Regular quizzes & exams: While I cannot grade all of the quizzes/exams, I will provide you with a grading template that you can use to grade yourself.
    d. Projects/ Valuations: Both classes revolve around real time, real world projects where you analyze a company or value it. I will try to guide you along, on these projects, but here again, I will not be grading them. I will still provide a template you can use to assess yourself.
    e. Emai

    If you decide to join either class, I hope to see you Monday. 



    A Sweet Spot for US Equities: Opportunity and Dangers

    The US equity markets are on a roll. Today, the S&P 500 hit an all time high, just weeks after the Dow also broke its record. While it has been less than five years since the crisis of 2008 and the epic collapse of equities in the last quarter of that year, the returns earned by those who stayed the course, even relative to pre-crisis price levels, is a testimonial to the dangers of staying out of equity markets for extended periods.  As with every other market surge, this one has brought with it the usual questions: Have stocks gone up too far, too fast? Are we due for a correction? Should we stay in the market or take profits? I could cop out and use the excuse that I am not a market timer, but that would be a lie. All investor are market timers, with the differences being one of degree. So, the honest truth is that I have a view about markets but that it does not dominate my investment decision process.

    Since it is so easy to be swayed by story telling, when talking about equity markets, I try to bring the same tools to assessing markets that I do for individual stocks. The intrinsic value of equities, in the aggregate, is determined by four variables:
    1. Cash returned to equity investors: Ultimately, we buy stocks to get cash flows in return, with those cash flows evolving over the last three decades from almost entirely dividends to a mix of dividends and stock buybacks. Holding all else constant, the more cash that is returned to investors in the near term, the more you will be willing to pay for stocks
    2. Expected growth: The bonus of investing in equity, as opposed to fixed income, is that you get to share in the growth that occurs in earnings and cash flows in future periods. Other things held equal, the higher the expected growth in earnings and expected cash flows, the higher stock prices should be
    3. Risk free rate: The risk free rate operates as more than base from which you build expected returns as investors. It also represents what you would earn from investing in a guaranteed (or at least as close as you can get to guaranteed) investment instead of stocks. Consequently, stock prices should increase as the risk free rate decreases, if you hold all else fixed
    4. Risk premium: Equities are risky and investors will demand a “premium” for investing in stocks. This premium will be shaped by investor perceptions of the macro economic risk that they face from investing in stocks. If the equity risk premium is the receptacle for all of the fears and hopes that equity investors have about the future, the lower that premium, the more they will be willing to pay for stocks
    Note that while it is easy to focus on each of these variables and draw conclusions about the impact on stock prices, they tend to move at the same time and often pull in different directions. For instance, stronger economic growth will push up earnings growth but interest rates will usually go up as well. In a similar vein, paying out more in cash flows to investors in the current period will often mean less being invested into businesses and lower growth in the future. It is the trade off that determines whether stock prices will go up or down as a consequence. On each of these variables, the US equity market is looking at "good" numbers right now: the cash returned to investors by US companies has rebounded strongly from post-crisis lows, earnings growth is reasonable, the risk free rate is at a historic low and the equity risk premium, while not quite at pre-crisis levels, has declined significantly over the last year. To explore both where we are and the potential dangers that we face as investors, let’s take a look at each variable.

    1. Cash flows
    a. Background: Until the early 1980s, the primary source of cash flows to equity investors in the United States was dividends. As I noted in this post from a while back, US companies have increasingly turned to returning cash in the form of buybacks. While there are some strict value investors who believe that dividends are qualitatively better than buybacks, because they are less volatile, the aggregate amount returned by US companies in buybacks is too large to be ignored. 
    Over the last decade, buybacks have been more volatile than dividends but the bulk of the cash flows returned to stockholders has come in buybacks.
    b. Level: In the most recent twelve months for which data is available (through December 2012), the companies in the S&P 500 bought back almost $400 billion worth of stock, much more than the $270 billion that they paid out in dividends. In terms of index units and as a percent of the level of the index, the aggregate cash flows have recovered fully from their post-2008 swoon.
    c. Sustainability: While it is good that cash flows are bouncing back, we should worry about whether companies were over reaching and paying out too much in 2012, perhaps in advance of the fiscal cliff at the end of 2012, in which case you should expect to see a drop off in cash flows in the near term. There are three reasons to believe that this is not the case. First, as Birinyi Associates notes in this blog post, the pace of buybacks is increasing in 2013, not dropping off, with the buybacks authorized in February 2013 at an all-time high. Second, the cash returned in 2012 may have been a historic high in dollar value terms, but as a percent of the index, it is close to the average yield over the last decade. Third, the aggregate cash balances at the S&P 500 company amounted to 10.66% of firm value at the end of 2012, suggesting that companies have cash on hand to sustain and perhaps even increase cash returned to stockholders. While a portion of this cash is trapped, it is possible that corporate tax reform, if it happens, will release this cash for distribution to stockholders.

    2. Expected growth
    a. Background: For dividends and buybacks to continue to grow in the future, there has to be growth in earnings. While that growth can be estimated by looking at history or by tracking analyst forecasts of earnings for the individual companies, it has to be earned by companies, reinvesting their earnings back into operations and generating a healthy return on equity on those investments.
    Intrinsic growth rate = Equity Reinvestment Rate * Return on equity
    Thus, while history can sometimes yield skewed values (up or down) on growth and analysts can become overly optimistic or pessimistic, the intrinsic growth rate will be grounded in reality.
    b. Level: To look at earnings growth in the S&P 500, lets begin by looking at history. In the table below, we report on earnings growth rates over 5 years, 10 years, 20 years and 50 years in index earnings.

    Arithmetic average
    Geometric Average
    Last 5 years
    6.46%
    4.42%
    Last 10 years
    9.66%
    8.33%
    Last 20 years
    9.60%
    8.28%
    Last 50 years
    8.30%
    6.90%
    Over the last 5 years, the compounded average annual growth rate in aggregate earnings for the S&P 500 has been 4.42%. As the most widely followed index in the world, analyst estimates of growth in earnings are widely available both for individual companies in the S&P 500 index and for aggregate earnings in the index. Using the former to construct a bottom-up estimate of growth yields 10.57% as the expected growth rate in March 2013. Since there is evidence that analyst estimates of growth are biased upwards at the company level, we also looked at the “top down” estimates of growth that analysts are forecasting for aggregate earnings in March 2013, obtaining a lower growth rate of 5.33% a year for the next 5 years.
    c. Sustainability: Are analysts over estimating earnings growth? One way to check is to compute the intrinsic growth rate by computing the equity reinvestment rate and return on equity for the index. To compute the equity reinvestment rate, we use the aggregate cash returned to investors (75.31) in 2012 and the earnings on the S&P 500 (102.47) in 2012:
    Equity Reinvestment Rate = 1 - 75.31/102.47 = 26.51%
    To compute the return on equity on the index, we divide the aggregate earnings on the index in 2012 by the aggregate book value of equity on the index (613.14) at the start of 2012:
    Return on equity = 102.47/613.14 = 16.71%
    The product of the two yields a sustainable growth rate:
    Sustainable growth rate = .2651 * .1671 = .0443 or 4.43%
    While this number is lower than the top-down analyst estimate of growth, it is within shouting distance of the estimate. There is, of course, a concern that some investors and analysts have voiced about the operating earnings number reported for the S&P 500, arguing that it is over stated. If it is, then the equity reinvestment rate and ROE are both over stated, and the expected growth rate will be lower.
    3. Equity Risk Premium (ERP)
    a. Background: Put simply, the equity risk premium is the market price of equity risk. It is determined on the one hand by perceptions of the macro risk that surround investors, with greater risks going with a higher ERP, and on the other hand by the collective risk aversion of investors, with more risk aversion translating into a larger ERP. A larger ERP implies that investors will pay lower prices for the same set of equity cash flows. The conventional wisdom that this number is stable in mature markets was shaken by the banking crisis of 2008, as premiums in the US and European equity markets experienced unprecedented volatility.
    b. Level: There are two ways in which ERP can be estimated. One is to look at a long period of history and to estimate the premium that stocks would have generated, over an above the treasury bond rate, over that period. This “historical” premium approach yields 4.20% as the ERP for US stocks in 2013, using data from 1928-2012. The other is to estimate an “implied” premium, by backing out an internal rate of return from current stock prices and expected cash flows. This approach yields much more volatile equity risk premiums over time, as can be seen in the graph below: 
    The implied ERP at the start of 2013 was 5.78%, lower than the ERP at the start of 2012, but still at the high end of the historical range.
    c. Sustainability: I have been estimating the monthly ERP for the S&P 500 since September 2008, and as can be seen in the figure below, the premium of 5.43% at the start of March 2013 represents a significant decline from a year ago. Note, though, that it is still much higher than the premium that prevailed in September 2008, just prior to the crisis. In fact, the average implied ERP over the last decade has been 4.71%, lower than the current implied ERP.
    [I have an  long, not-very-fun update that I do on equity risk premiums that you can download and peruse, if you are so inclined. It includes everything that I know about ERP]

    4. Risk free rate
    a. Background: As sovereigns increasingly face default risk, it is an open question whether any investment is risk free in today’s environment. However, for an investor in US dollars, the return you can expect to make on a long term treasury bond not only represents a base from which all other expected returns are computed but is an opportunity cost of investing in something risk free instead of stocks.
    b. Level: By any measure, risk free rates are at historic lows in much of the developed world. On March 26, 2013, the ten-year US Treasury bond rate was at 1.91%, well below where it stood prior to the last quarter of 2008 and well below rates that prevailed a decade earlier. 
    The average for the ten year bond rate for the last decade was 3.59% and lengthening the time period pushes the average up to 4.62% (last 20 years) and 6.58% (last 50 years)
    c. Sustainability: Is the treasury bond rate destined to rise and if it does, will it bring down stocks? To answer this question, we have to look at what has kept rates low for such an extended period. While the answer to some is that it is the Fed’s doing, I, for one, don’t attribute that much power to Ben Bernanke. The Fed has played a role, but it has succeeded (if you can call it success) only because inflation has been benign and real economic growth has been abysmal for this period. There are at least four scenarios that I see for the future direction of interest rates, with differing implications for stocks. 
    Scenario
    Treasury bond rate
    Outlook for stocks
    More of the same (anemic economic growth, low inflation)
    Stays low
    Neutral
    Stronger economic growth, low inflation
    Rises to reflect higher real growth
    If economic growth translates into earnings growth, neutral. If not, mildly negative.
    Low economic growth, high inflation
    Rises to reflect higher inflation
    Negative. Higher required returns on stocks, no offsetting positive.
    Higher economic growth, low inflation, Fed Magic
    Stays low
    Positive

    If you believe that the Fed can keep a lid on interest rates, as economic growth returns, the outlook is positive for stocks. I think that the most likely scenario is that the interest rates will rise as the economy improved, and the outlook for stocks will depend in large part on whether earnings growth picks up enough to offset the interest rate effect.

    Valuation of the S&P 500 Index
    To see the interplay of these numbers and the resulting consequences for stocks, I valued the S&P 500, as of March 26, 2013, using the following inputs: 
    Based upon my assumptions, the market’s current winning ways can be justified. Replacing the current implied equity risk premium with the average premium over the last decade (4.71%) yields a level of almost 1800 for the index, and using the analyst-estimated growth rate will make it even higher. Higher risk free rates have a negative, albeit muted, effect on value, if accompanied by higher growth rates, but do have a much more negative impact, if growth rates remain unchanged. You may have very different views on the market drivers and if you are interested, you can input your numbers into the attached spreadsheet to get an assessment of value for the S&P 500 index.

    Bottom line
    When stocks hit new highs, the natural impulse is to look for signs of over valuation, but there are good reasons why US stock prices are elevated: cash flows are high, growth looks good, the macro risks seem to have faded (at least some what) and the alternatives are delivering lousy returns. In the near term, stocks remain vulnerable to two possibilities. One is that another macro crisis will pop up (Italy, Spain, Portugal or a non-EU black sheet) that will cause equity risk premiums to jump back to the 6%+ levels that we have seen so often in the last 5 years. The other is a sudden surge in interest rates, unaccompanied by better earnings or higher earnings growth. Since all risky asset classes (corporate bonds, real estate etc.) will be also adversely affected by either of these developments, I don't see much point to shifting from equities to other risky assets to protect myself against these risks. I could, of course, choose to stay in cash, but as the last 5 years have indicated, waiting for the "right time" to invest can leave you on the sidelines for too long. So, I am going to stop worrying about the overall market and go back to finding under valued companies.




    Marty Lipton: Shareholder Champion, Stakeholder Protector or Management Tool?

    I do not personally know Marty Lipton, nor have I met him. Based on what I have read about him and by him (he is a prolific writer), he strikes me as an extremely competent lawyer and he is certainly a good friend and champion of New York University (the institution that I teach at), chairing the board of the trustees for the university. I have never, though, thought of him as a champion of long term shareholders in publicly traded companies, which is the role he plays in a recent article by Andrew Sorkin in the New York Times.

    The article itself was precipitated by a post, titled "Bite the Apple, Poison the Apple", by Mr. Lipton in the Harvard Law School Forum on Corporate Governance and Financial Regulation, where he argued that the threat to the company from activist shareholders (and David Einhorn, in particular) should serve as a clarion call for action to deal with the misuse of shareholder power. I am not sure what powers Mr. Einhorn misused in making his case that Apple should do something with its cash, but knowing Mr. Lipton's views on corporate governance (which is to side with incumbent managers, no matter what), I was not surprised by the article, but I was that it was picked up in the New York Times by Sorkin. In his article, Sorkin implicitly accepts Lipton's view that activist investors are short term, that they do damage to companies by being vocal and that long term shareholders are not served by activism.  I think he is wrong on all three counts.

    1. Activist Investors are no more short term than any other investor group
    To address the question of whether activist investors are interested in the long term, Sorkin quotes Leo Strine, the Chief Judge of the Delaware Court of Chancery, who seems to have seen evidence to conclude that "the answer is usually no".  I consider myself to be a long term shareholder: I do my homework before buying the shares and I have a median holding period of eight years. I don't operate under any illusions about what drives activist investors to do what they do, which is the desire to make money on their investments (and who does not?). However, I have not seen any evidence that would lead me to believe that activist investors are any more short term than any other group of investors, and there is, in fact, evidence to the contrary. 
    • Holding period: The studies that I have seen of both institutional activists (holding period of about 20 months, on average) and individual activists provide evidence that they hold their investments for longer than their passive counterparts. In fact, Sorkin undercuts his argument that stockholders are short term by noting that Nelson Peltz has been a stockholder in Heinz for more than six years, Bill Ackman is a long term investor and director at JC Penney and David Einhorn has held Apple stock for many years. 
    • Cash focus: It is true that activist investors often push for companies to return more cash to stockholders, either as dividends or in stock buybacks, but why is this evidence that they are short term? Assuming that companies that reinvest money back into their own businesses are more long term than companies that return cash makes no sense, if these companies operate in bad businesses. The companies that are typically targeted by activists are mature companies that have cash surpluses and relatively few investments and returning cash back to their stockholders strikes me as exactly what investors would want them to do.
    It is possible that Judge Strine was misquoted on his claim that activist investors are usually short term, and if so, he should set the record straight. It is also possible that he has evidence to back his claim, and if he does, I would love to see it. There is a third possibility that he was engaging in some casual empiricism, which we are all inclined to do now and then, but is a dangerous practice, if you are the chief judge in one of the most powerful courts (at least when it comes to business law) in the country.

    2. Activist investors have every right to be vocal, even if they are wrong
    Sorkin is disturbed by the use of the media by activists to make their case for change, and that the change that they are pushing for may not be the "right" change for other shareholders in the long term. I don't share his trepidation about either one. As a long term investor who is looking for price catalysts, I envy the megaphones that activist investors have to broadcast their views and be their own catalysts. Not also that activist investors are not alone in using the media to make their cases. In fact, the media's favorite long term investor, Warren Buffet, has never been shy about using the media to good effect to generate returns on his investments.

    Do private equity investors push for changes that may not be in sync with long term stockholders? Sure! I have argued that activist investors are often too focused on "financial' value creation and too little on "operating" value creation. However, it is a leap from there to claim, as Mr. Lipton has, that David Einhorn does not have the right to make his argument or that doing it in public is somehow damaging to Apple. As a shareholder, he has every right to make his case and the rest of the shareholders have the right to decide whether they agree with his proposal or with incumbent managers (who may oppose it).  You don't have to believe that managers are always wrong and activist investors are always right to also believe that it is healthy for everyone concerned for managers to have to explain what they are doing to stockholders. If managers are credible (and their track record will play a role in this) and can make a good case that they are right (and activist investors are wrong), they stand a good chance of winning over stockholders to their side. If managers are not credible and/or refuse to make a case for their actions, I think that stockholders will and should be more receptive to activist investors' suggestions. 

    3. Long term shareholders are well served by activism
    As a shareholder in any company, I welcome the appearance of an activist investor (or two) into the shareholder ranks. The game, as it is structured, is tilted in favor on incumbent managers. Activist investors, motivated as they are by self interest, help to shift the balance back (even if it is only a little bit). In fact, in the absence of activism, you can rest assured that boards of directors will continue to be rubber stamps for  CEOs pushing through their own agendas, aided and abetted by an ecosystem of lawyers, bankers and consultants who make money of the status quo. And the status quo stinks at many companies, with about third of all publicly traded companies actively destroying value for their owners. (I will back this up in a future post) It is these companies that are disproportionately targeted by activist investors and deservedly so, and long term stockholders welcome them, for the most part. In fact, the evidence suggests that stock prices at companies targeted by activist investors go up on the announcement of the targeting, and stay up for the long term

    As for Mr. Lipton, he has either created or had a hand in creating some of the worst abominations in corporate governance. From fathering the "poison pill" to arguing that  stockholders should have no say on CEO pay, he has been on the management's side of every corporate governance issue over the last three decades. In fact, reviewing his briefs over the years, it is clear that his problem is not with activist investors but with any investors who deign to question management motives or actions. To Mr. Lipton, the only good stockholders are masochists, who takes the punishment that is meted out silently, raise no protests and vote with their feet.  As a stockholder, I would rather have David Einhorn, at his worst, on my side than Mr. Lipton at his most magnanimous. To argue, as Mr. Lipton does in his brief on Apple, that his entreaties on part of management are in the best interests of long term stockholders is analogous to making a case that Marie Antoinette was really championing the cause of French bakers when she supposedly asked her starving populace to eat cake. 

    What about the other stakeholders in the firm? When apologists for management use the interests of other stakeholders as their shield against accountability, I, for one, take it for it is, a smokescreen. I don't believe that managers who  insulate themselves against stockholder pressures care about protecting the interests of employees, customers or society. In fact, I will wager that these managers will use the same "other stakeholder interests have to be served" excuse with each of these groups, while the only interest group that is finally served is their own.

    In fact, I think that the company that Mr. Lipton focused on, in his post, Apple, illustrates my point. I love the company and its products but as a stockholder, I have become increasingly frustrated with its managers, in general, and Tim Cook, in particular. In fact, I am not alone, since a third of the stockholders at the annual meeting a short while ago voted against his pay package. As I see Mr. Cook go from forum to forum, saying nothing of substance and wreaking havoc on the stock price almost every time he talks, I want more activism, not less. 

    Bottom line
    Managers at public companies are human, make mistakes, and are often unwilling to change their minds (or ways) without pressure from stockholders. The boards of directors at these companies, in spite of all of the corporate governance legislation passed in the last few decades (or perhaps because of the legislation) tend to go along with incumbent management, unless pushed to act. That push will not come from traditional institutional investors, who are too timid or lazy to challenge the status quo, and the small shareholders (long term or short term) have little chance of being heard. Without activist investors rocking the boat, who is left to challenge managers to explain their actions?  



    Apple: News, Noise and Value

    As has been the case for much of the last two years, the Apple earnings report on April 24, 2013 was a media event, previewed endlessly on investment sites, covered heavily by the media and tweeted about by both Apple fans and foes. While I try to stay away from the hype around earnings reports, this is a good occasion to revisit my earlier posts on Apple, and especially the one I made at the start of this year on its valuation.

    The Signal amidst the Noise

    One of the most difficult parts of being an investor in Apple has become dealing with the cacophony of rumors, stories and news releases that seem to permeate the day-to-day coverage of the stock. Not only do we, as investors, have to determine whether there is truth to a story but we also have to evaluate its impact on value (and indirectly on whether to continue holding the stock). To keep my perspective, as I read these stories, I go back to basics and draw on my “financial balance sheet” view of a company. While it resembles an accounting balance sheet in broad terms, it is different on two dimensions. First, it is a forward looking and value based assessment of a company, rather than being backward looking and historical cost based. Second, it is flexible enough to allow me to record the potential for future growth as an asset, thus giving businesses credit for value that they may create in the future from growth. In very broad terms, here is what Apple’s financial balance sheet  looked like just before the most recent earnings report:

    There is nothing surprising about this balance sheet but it brings together much of what has happened to the company between April 2012 and April 2013. During the year, the company has become increasingly dependent upon its smartphone business, accounting for 60% of revenues and even more of operating income, generating immense amounts of cash for the company (with the cash balance climbing $50 billion over the course of the year to hit $145 billion). During the course of the year, we have seen a slowing of revenue growth and pressure on margins, both of which have contributed to declining stock prices. The other big change over the course of the year is that the value of growth potential (from unspecified future products) has faded, at least in the market’s eyes, and this is reflected in the decline of $200 billion in market value over the last nine months.

    The Last Earnings Report (April 23, 2013)
    The most recent earnings report contained a mix of good news on the financial front (cash and financing mix) and bad or neutral news on the operating asset front. Using the same framework that I used in the last section, here is how I parsed the news in the report:

    First, in the no news category, revenue growth is no longer in the double digits and smartphones continue to increase their share of overall revenues & operating income. Well, we knew that already and the revenue growth was well within the expected bounds. Second, the bad news is that margins are shrinking faster than we expected them to, though I get the sense that Apple is understating its margins (by moving some expenses forward) and its guidance for the future with the intent of getting ahead of the expectations game. Third, in near term bad news, the fact there is no mention of any new products or breakthroughs suggests that there will be no revolutionary product announcement (iWatch, iTV, iWhatever) in the next quarter. However, if you are a long term investor, it is mildly disappointing that it looks like that there will be no blockbuster announcements in the next three months but it is clearly not the end of the world.

    On the financial side, there was substantial news, much of which I think is positive. 
    1. Cash return to stockholders: The decision to decision to return about $100 billion more in  cash to stockholders in buybacks and dividends by 2015  has to be viewed as vindication for those (like David Einhorn) who have arguing that Apple should be explicit about its future plans for cash and that it should distribute a large chunk cash with stockholders. 
    2. Buybacks versus Dividends: In a bit of a surprise, the cash return will be more in the form of buybacks than dividends. I, for one, am on board with that decision because hiking the dividends further will essentially make this stock a "dividend" play, with an investor base that will put dividend growth in the future ahead of all other considerations.  If Apple wants to retain the option of entering a new and perhaps more capital intensive business in the future, it is better positioned as a consequence of this decision. 
    3. Debt coming? In an even bigger surprise, Apple has opened the door to taking on conventional debt. While the details are still fuzzy and the initial bond issue may be for only about $10 billion, it seems likely that the debt issued will grow beyond that amount. To those who would take issue with this decision, arguing that Apple does not need to borrow with all of its cash reserves, you may be missing the reason why this debt will add to value. If the trade off on debt is that you weigh the tax benefits of debt against the bankruptcy cost, there can be no arguing against the fact that borrowing money will add value for stockholders. To those who feel that it is in some way immoral or unethical, based upon the argument that Apple is sheltering its foreign income from additional US taxes while claiming a tax deduction for interest expenses, I would be more inclined to listen to you if you showed me convincing proof that you make mortgage interest payments every year but did not claim the mortgage tax deduction in your tax returns, because you think that it deprives the treasury of much needed revenue. The US tax code is an abomination, with its treatment of foreign income as exhibit 1, but to ask Apple (and its stockholders) to pay the price for the tax code's failures makes little sense to me. 

    In summary, the net effect of the earnings report is negative on operating cash flows (with the declining margins) but positive on the financial side (with any discount on cash dissipating, as a result of the cash return announcement, and the tax benefits from debt augmenting value). 


    Intrinsic value impact
    In my post from the end of last year, I had reported on an intrinsic valuation of Apple of $609/share, using data as of December 2012, with a distribution of values in a later post. Given that there have been two earnings reports since, I decided to revisit that valuation. In addition to updating the company's numbers (all of the numbers except leases) to reflect the trailing 12 months (through March 31, 2013), I also incorporated the information from the most recent earnings reports to update my forecasts on three variables in particular:

    1. Revenue growth: As the competition in the smartphone business continues to increase, I am inclined to lower my expected revenue growth rate for the next 5 years to 5% from my original estimate of 6%. While this is well below the revenue growth of 11.28% over the last year (even using the last 'bad" quarter comparison to the same quarter the previous year), it is the prudent call to make, especially in the absence of news about new products in the near term.
    2. Operating margin: I had projected a target  pre-tax operating margin of 30% in my December 31, 2012, valuation, about 5% below the prevailing margin of 35.30% from the last annual report (the 10K in September). The pre-tax operating margin has dropped to 30.92% in the trailing 12 months ending March 31, 2012, and was about 29%, just in the last quarter. Since margins are coming down faster than expected, I lowered my target margin to 25%. 
    3. Cost of capital: The cost of capital that I had used in my December 2012 valuation was 12.49% reflecting my expectation that Apple would stay an all equity funded firm in the foreseeable future. The decision to use debt upends that process and adding $50 billion in debt to the capital structure, while buying back $50 billion in stock raises the debt ratio in the cost of capital calculation to about 13%, while lowering the cost of capital to about 11.29%. 

    The net effect of these changes is that the value per share that I obtain for Apple is about $588, about 3.5% lower than the value of $609 that I estimated in early January. You can download the spreadsheet with my valuation of Apple. Again, make your own judgments and come to your own conclusions. If you are so inclined, go to the Google shared spreadsheet  and enter your estimates of value.

    If you are concerned about whether borrowing $50 billion will put Apple in danger of being over levered, I did make an assessment of how much debt Apple could borrow, by looking at the effects of the added debt on the costs of equity, debt and capital, with the objective being a lower cost of capital. I try to be realistic in my estimates of cost of equity (adjusting it upwards as a company borrows more) and the cost of debt (by coming up with a prospective rating at each dollar debt level and cost of debt at each debt ratio). If Apple can maintain its existing operating income, its debt capacity is huge ($200 billion plus) but even allowing for a halving of their operating income, it has debt capacity in excess of $100 billion. As with the valuation spreadsheet, you are welcome to download my capital structure spreadsheet for Apple and play with they numbers.

    Clear and present dangers
    Given the price collapse over the last few months, it would be foolhardy not to stress test the numbers in this valuation. In the first set of tests, I went back to the discounted cash flow valuation and computed my break even numbers for growth, operating margins and cost of capital, changing each of these variables, holding all else constant. The table below lists the current numbers for Apple for these variables, my estimates and the break even that yields today's stock price ($420 on April 28, 2013).






    Holding all else constant, Apple's revenues would have to decline 5% a year for the next 5 years to justify a value per share of $420. Similarly, the pre-tax operating margin would have to drop to 12% from 30% today, holding the other variables at base case levels, to get to the same price. As an investor in Apple, there seems to be plenty of buffer built in, at least at current stock prices.

    Will Apple go the way of Dell and Microsoft?
    As a technology firm, though, your concerns may be about the company hitting a cliff and essentially either losing value or becoming a value trap. In particular, you may be worried that Apple may follow in the footsteps of two technology giants that have had trouble delivering value to stockholders in the last decade. One is Dell Computers, where Michael Dell's attempts to rediscover growth have failed and the company is now facing a more levered, low growth future. The other is Microsoft, a less dire case, but a stock that hit its peak about a decade ago and has plateaued since. Can Apple be "Delled" or "Microsofted"?

    To be Delled: What awaits a company when it's product/service becomes a commodity and it operates at a cost disadvantage. 
    Dell was an success story in the growing PC business through much of the late 1990s and the early part of the last decade. As the market for PCs grew, Dell used its cost advantages over Compaq, IBM and HP to make itself the most profitable player in the market. What's changed? First, the market for PCs hit a growth wall, as consumers turned to tablets and other connected devices. Second, PCs became a commodity, just as Dell lost its cost advantage to Lenovo and other lower cost manufacturers. With Apple, the peril is that their biggest and most profitable business, smartphones, may be heading in that direction. Unlike Dell, though, Apple is more than a hardware manufacturer and it's success at premium pricing in the PC business is indicative of the pricing power that comes from creating the operating system that runs the hardware. I believe that the risk of Apple being Delled is small.

    To be Microsofted: The destiny of a business that has a profitable, cash-cow product(s) but runs low on imagination/creativity.
     Riding the success of Windows and Office, Microsoft became the largest market cap company about a decade ago. Like Apple, it seemed unstoppable. So, what happened? From the market's perspective, the company seemed to run out of imagination and creativity and investors got tired of waiting for the next big hit and moved on. Note, though, that while the stock price and market capitalization have not moved much over the last ten years, the company has returned billions in cash to its stockholders. Could this value stagnation happen to Apple? Yes, but to me (and I have never been shy about my Apple bias), there are is a big difference between the companies. One is that I don't think that Microsoft lost its imagination and creative impulses a decade ago. I don't think it ever had any. While Windows nor Office were workmanlike and professional products, neither can ever be called elegant or creative (and I speak as a heavy user of Office products). Apple, on the other hand, has created iconic products through the decades, some less successful than others (remember the Newton), and I find it hard to believe that those creative juices just dried up last September.

    Buy or Sell? Hold or Fold?

    If Apple was being priced as a high growth stock, with sustained margins and on the expectations of "big" new hits in the future, I would be worried about the last earnings report. It is not. As you can see from the break even table in the last section, it is being priced as a low growth, declining margin company, with no great hits to come. I find it striking that the same investors who have priced the stock on this basis react to incremental news on these items (growth, margins, new products), as if they had not already priced it in.

    As I see it, if I have Apple in my portfolio at $420 and the company continues to disappoint on every dimension (growth, margins, new products), I will have a boring stock that delivers billions in earnings and pays a solid dividend. However, if the company surprises by stopping margin leakage and increasing revenue growth in the smartphone market or by introducing the iWatch or the iTV, it will be icing on my investment cake. In a market, where my alternative investments are richly priced, Apple looks like a winner, to me. It stays in my portfolio, the price disappointments of the last few months notwithstanding.

    My earlier posts on Apple

    1. Apple: Thoughts on Bias, Value, Excess Cash & Dividends (March 1, 2012)
    2. Apple: Know when to hold 'em, know when to fold 'em (April 3, 2012)
    3. Emotions, Intrinsic value and Dividend Clienteles: The Apple postscript (April 6, 2012)
    4. Apple's Crown Jewel: Valuing the iPhone Franchise (August 29, 2012)
    5. Winning by Losing: The power of expectations (October 9, 2012)
    6. The Year in Review: Apple's Universe (December 27, 2012)
    7. Are you a value investor? Take the Apple test (January 27, 2013)
    8. Market Mayhem: Lessons for Apple (January 31, 2013)
    9. Back to Apple: Thoughts on value, price and the confidence gap (February 7, 2013)
    10. Financial Alchemy: David Einhorn's value play for Apple (February 8, 2013)




    The Golden Rule? Thoughts on gold as an investment

    Paraphrasing Winston Churchill, gold is a "riddle, wrapped up in a mystery inside an enigma", at least as far as I am concerned. I don't understand what moves the gold price and I have never held gold in my portfolio. That does not mean, however, that I am not fascinated by the price of gold and immune from its movements. That was brought home last week, when the price of gold dropped by 9% on April 15, 2013, the biggest one day drop in thirty years. Not only did the prices of other precious metals (silver dropped 12%) and industrial metals drop, but stock prices took a tumble as well. While the attention has focused on the price drop in recent days, gold has had a good run over the last decade.

    The nominal and inflation-adjusted prices of gold have soared in the last decade, and at the end of 2012, the nominal price was at an all time high of 1664 and the inflation-adjusted price was close to its previous high set at the end of the 1970s. The big question that has been debated in recent days is whether gold will continue to drop in the coming days. More generally, is gold is under or over priced? With my limited understanding of gold, I decided to give it a shot.

    Does gold have an intrinsic or fundamental value?
    The intrinsic value of an asset is a function of its expected cash flows, growth and risk. Since gold is a non cash-flow generating asset, I argued in this earlier blog post  that you cannot estimate an intrinsic value for gold. It is the same argument I would make about all collectibles: Picassos, baseball cards or Tiffany lamps included.  If one of the central tenets of value investing is that you should never invest in an asset without estimating its value, that would seem to rule out gold as an investment for a classic value investor. In fact, Warren Buffett has repeatedly argued against investing in gold because it's value cannot be estimated.
    There is an alternate route that can be used to estimate the "fundamental" value of a commodity by gauging the demand for the commodity (based on its uses) and the supply. While that may work, at least in principle, for industrial commodities, it is tough to put into practice with precious metals in general, and gold, in particular, because the demand is not driven primarily by practical uses. 

    What drives gold prices?
    If gold does not have an intrinsic value, what is it that drives its value? There are at least three factors historically that have influenced the price of gold.

    1. Inflation: If as is commonly argued, gold is an alternative to paper currency, you can argue that the price of gold will be determined by how much trust individuals have in paper currency. Thus, it is widely believed that if the value of paper currency is debased by inflation, gold will gain in value. To see if the widely held view of gold as a hedge against inflation has a basis, I looked at changes in gold prices and the inflation rate each year from 1963-2012. 

    The co-movement of gold and inflation is particularly strong in the 1970s, a decade where the US economy was plagued by high inflation and the correlation between gold prices and the inflation rate is brought home, when you regress returns on gold against the inflation rate for the entire period:
    Annual % Change in Gold price = -0.08 + 4.37 (Inflation rate)
    R squared = 19.9%
    While this regression does back the conventional view of gold as an inflation hedge, there are two potential weak spots. The first is that the R-squared is only 20%, suggesting that factors other than inflation have a significant effect on gold prices. The second is that removing the 1970s essentially removes much of the significance from this regression. In fact, while the large move in gold prices in the 1970s can be explained by unexpectedly high inflation during the decade, the rise of oil prices between 2001 and 2012 cannot be attributed to inflation. In fact, taking a closer look at the data, it is clear that gold is more a hedge against extreme (and unexpected) movements in inflation and does not really provide much protection against smaller inflation changes.

    2. Fear of crisis: Through the centuries, gold has been the “asset” of last resort for investors fleeing a crisis. Thus, as investor fears ebb and flow, gold prices should go up and down. To test this effect, we used two forward-looking measures of investor fears – the default spread on a Baa rated bond and the implied equity risk premium (which is a forward looking premium, computed based upon stock prices and expected cash flows). As investor fears increase, you should expect to see these premiums in both the equity and the bond market increase. 

    While the relationship is harder to decipher than the one with inflation, higher equity risk premiums correlate with higher gold prices. Again, regressing annual returns on gold against these two measures separately, we get:
    Annual % Change in Gold Price = -0.25 + 8.91 (ERP)
    R squared = 10.3%
    Annual % Change in Gold Price = 0.10 + 0.25 (Baa Rate - T.Bond Rate)
    R squared = 0%
    These regressions suggest little or no relationship between bond default spreads and gold prices, but a positive relationship, albeit one with substantial noise, between gold prices and equity risk premiums. Thus, gold prices seem to move more with fear in the equity markets than with concerns in the bond market. Every 1% increase in the equity risk premium translates into an increase of 8.91% in gold prices.

    3. Real interest rates: One of the costs of holding gold is that while you hold it, you lose the return you could have made investing it in a financial asset. The magnitude of this opportunity cost is captured by the real interest rate, with higher real interest rates translating into much higher opportunity costs and thus lower prices for gold. The real interest rate can be measured directly used the inflation indexed treasury bond (TIPs) rate or indirectly by netting out the expected inflation from a nominal risk free (or close to risk free) rate.
    Note that the TIPs rate is available only for the last decade and that the real interest rate is computed as the difference between the ten-year US treasury bond rate in that year and the realized inflation rate (rather than the expected inflation rate). Regressing changes in gold prices against the real interest rate yields the following:
    Annual % Change in Gold price = 0.27 - 6.94 (T.Bond Rate - Inflation Rate)
    R Squared = 36.6%

    High real interest rates are negative for gold prices and low real interest rates, or negative real interest rates as is the case today, push gold prices higher.

    A Relative Valuation of Gold
    Knowing that gold prices move with inflation, equity risk premiums and real interest rates is useful but it still does not help us answer the fundamental question of whether gold prices today are too high or low. Can you do a relative valuation of gold? I don’t know but I am going to try.

    A. Against the inflation index
    The most comprehensive paper that I have seen on the relationship between gold prices and inflation  is available here, with a follow up here. In these papers, the price of gold is related to the CPI index and a ratio of gold prices to the CPI index is computed. I try to replicate their findings and I use the US Department of Labor CPI index for all items (and all urban consumers) set to a base of 100 in 1982-84, but with data going back to 1947. The level of the index at the end of 2012 was 231.137. Dividing the gold price of $1664/oz on December 31, 2012, by the CPI index level yields a value of 7.20. To get a measure of whether that number is high or low, we computed it every year going back to 1963: 

    At the year-end price in December 2012, gold prices were at an all time high, relative to the CPI. Updating the gold price to 1382.2/oz, the price on April 17, yields a Gold/CPI ratio of 5.98.

    The median value is 2.55 for the 1963-2012 time period and 2.91 for the 1971-2012 period. Thus, based purely on the comparison of the current measure of the Gold/CPI ratio to the historical medians does miss the fact that  equity risk premiums are high and real interest rate are negative today, both of which should make gold more attractive as an investment. Consequently, I regressed the Gold/CPI index against equity risk premiums and real interest rates and while real interest rates seem to have little effect on the Gold/CPI ratio, there is strong evidence that it moves with the ERP, increasing (decreasing) as the ERP increases (decreases):
    1963-2012 Time Period:
    Gold Price/ CPI = -1.75 + 115.4 (ERP)
    R Squared = 52.9%
    1971-2012 Time Period
    Gold Price/ CPI = -0.88 + 100.2 (ERP)
    R Squared = 49.1%
    The implied equity risk premium for the S&P 500 at the start of April 2013 was 5.79%, and plugging that value into the gold/CPI regression yields the following:
    Gold/CPI (given ERP = 5.79% on 4/1/13) = -0.88 + 100.2 (.0579) = 4.92
    While gold remains over priced, relative to historic norms, it looks far less over priced once we account for today's risk premiums.

    B. Against other precious metals
    There is another way that you can frame the relative value of gold and that is against other precious metals. For instance, you can price gold, relative to silver, and make a judgment on whether it is cheap or expensive (on a relative basis). At the end of December 2012, the gold price was $1664/oz and the silver price was $30.35/oz,, yielding a ratio of 54.84 for gold to silver prices (1664/30.35). To get a measure of where this number stands in a historical context, we looked at the ratio of gold prices to silver prices from 1963 to 2012: 

    The median value of 51.22 over the 1963-2012 period would suggest that gold is not over priced, relative to silver. In fact, silver has dropped in price more than gold has this year and using the April 17, 2012 prices for gold (1382.2) and silver (23.31), we get a ratio of 59.30. Given that gold and silver move together more often than they move in opposite directions, I am not sure that this relationship can be mined to address the question of whether gold is fairly priced today, but it can still be the basis for trading across precious metals.

    Gold as insurance
    It can be argued that pricing gold relative to silver or against the inflation index misses the primary rationale for investors holding gold, i.e., as insurance against uncommon but potentially catastrophic risks to their assets, from hyper inflation to war and terrorism. Viewed from that perspective, gold operates as insurance for an investor whose assets are primarily financial and thus exposed to these catastrophic risks. Put in less abstract terms, if you add gold to your portfolio, it is not to make money, per se, but to buy protection against “black swan” events that could swamp your other investments. If you view gold as a hedge/insurance against event risk, there are two implications:
    1. You should not expect to gold to generate high annual returns over long periods. In fact, notwithstanding boom periods  (the 1970s and the last decade) gold has, for the most part, generated low returns over long periods, relative to other risky investments. 
    2. It also follows that the price of gold should reflect the cost of buying the insurance, which in turn will be driven by the uncertainty you feel about the future and the likelihood of catastrophic events. Thus, the multiple crises over the last decade (banking, war, terrorism) explain both the surge in gold prices over the last decade and the correlation with equity risk premiums.
    It is worth noting that gold is not the only insurance against black swan events. There eare other ways, using other real assets (collectibles, real estate, other commodities) or financial derivatives (including puts on indices) that can deliver the same hedging results, perhaps at a lower cost.

    The bottom line
    I have always been uncomfortable talking about the value of gold as an asset and its place in my portfolio. Writing this post has been cathartic, since it has allowed me to recognize the two sources of my discomfort. First, I am most comfortable with cash flow generating investments, where I can estimate an intrinsic value, and my valuation tool kit is limited when it comes to valuing gold. Second, I don't share the fervor that some investors  have for gold, who seem to view it as much in emotional terms as in financial ones.

    As a complete novice in assessing the value of gold, here is how I see its value. As a stand-alone investment, I would not buy gold, given its history (of delivering low returns in the long term) and given how it is priced today. As insurance, though,  I think it makes sense to add to your portfolio, even at today's prices. You don't have to be a conspiracy theorist or paranoid about central banks to have legitimate fears that prices in financial markets, built upon uncommonly low interest rates, may collapse. I know that the price of gold as insurance is higher than it has been in the past, but the risks that you are insuring against are also much higher than they have been historically.

    Update: If you are interested in exploring the data on your own, you can download the raw data on gold prices, silver prices, CPI, interest rates, ERP and other variables. 



    Equity Risk Premiums (ERP) and Stocks: Bullish or Bearish Indicator

    If you have been following my blog postings, you are probably aware that I have an obsession with equity risk premiums (ERP), and have done an annual survey paper on the topic  every year since 2008 (with the 2013 update here). I also post a monthly update for the ERP for the S&P 500 at the start of the month on my website. As a consequence, my attention was drawn to a post by Fernando Duarte and Carlo Rosa, economists at the Fed in New York, on the topic. They argue that equity risk premiums are at historic highs, primarily because the US treasury rates are low, and note that these high equity risk premiums are a precursor to good stock returns in the future. I don’t disagree with their authors that equity risk premiums are high, relative to history and that the low risk free rate is in large part responsible these large premiums, but I am less sanguine about using the ERP as a market timing device, especially at this time in history.

    Measurement approaches
    There are three ways of estimating an equity risk premium. One is to look at the difference between the average historical return you would have earned investing in stocks and the return on a risk free investment. This historical premium for the 1928-2013 time period would have stood at about 4.20%, if computed as the difference in compounded returns on US stocks and on the 10-year US treasury bond. (I know. I know. We can have a debate about whether the US treasury is truly risk free, but that is a discussion for a different forum.) The second is to survey portfolio managers, CFOs or investors about what they think stocks will generate as returns in future periods and back out the equity risk premium from these survey numbers. In early 2013, that survey premium would have yielded between 3.8% (from the CFO survey) to 4.8% (portfolio managers) to 5% (analysts). Finally, you can back out a forward looking premium, based upon current stock prices and expected cash flows, akin to estimating the yield to maturity on a bond. That is the process that I use at the start of every month to compute the ERP for US stocks, and that number stood at 5.45% On May 18, 2013

    What is the ERP? 
    The equity risk premium is the extra return that investors demand over and above a risk free rate to invest in equities as a class. Thus, it is a receptacle for investor hopes and fears, with the number rising when the fear quotient dominates the hope quotient. In buoyant times, when investors are not fazed by risk and hope is the dominant force, equity risk premiums can fall. In the graph below, you can see my estimates of the implied equity risk premium for US stocks from 1961 to 2012 (year ends) with annotations providing my rationale for the shifts over time periods. 
    The average implied equity risk premium over the entire period is 4.02% and that number is the basis for the bullishness that some investors/analysts bring to the market. If the equity risk premium, currently at 5.45%, does drop to 4.02% , the S&P 500 would trade at 2270, an increase of 26.5% on current levels. And history, as Duarte and Rosa note, is on your side, albeit with significant noise, in making this assumption that equity risk premiums revert back to norms over time. As I will argue in the next section, the high ERP in 2013 is very different from high ERPs in previous time periods and extrapolating from past history can be dangerous. 

    A Fed-engineered ERP?
    This equity risk premium, though, is over and above the risk free rate. To provide a sense of the interplay between the risk free rate and the equity risk premium, I plot the expected return on stocks (based upon future cash flows and current stock prices), decomposed into the equity risk premium and  the and the risk free rate each year from 1962 to 2012. 


    Over the last decade, the expected return on stocks has stayed surprisingly stable at between 8-9% and almost all of the variation in the ERP over the decade has come from the risk free rate. In particular, the higher ERP over the last five years can be entirely attributed to the risk free rates dropping to historic lows. In fact, the expected return on stocks on May 18, 2013 of 7.40% is close to the historic low for this number of 6.91% at the end of 1998. 

    So what? While the relationship between the level of the ERP and the risk free rate has weakened over the last decade, the two numbers have historically moved in the same direction: as risk free rates go up (down), equity risk premiums have risen (fallen). In fact, a regression of the ERP on the ten-year US treasury bond rate from 1960-2012 is presented below: 
    ERP = .0348                            + .0842 (US T. Bond Rate) R squared = 4.68% 
    (1.57) 
    Thus, an increase of 1% in the ten-year bond rate (from 2% to 3%, for instance) increases the ERP by 0.0842%. In fact, running the regression through from 1960-2003 (excluding the last decade) yields an ever stronger result: 
    ERP = .0202                           + .2592 (US T. Bond Rate) R squared = 43.52% 
    (5.62) 
    During this period, a 1% increase in interest rates would have led to an increase of 0.26% in the ERP. The last decade has weakened the relationship between the ERP and the T.Bond rate dramatically.

    In light of this evidence, consider again two periods with high ERPs. In 1981, the ERP was 5.73%, but it was on top of a ten-year US treasury bond rate of 13.98%, yielding an expected return for stocks of 19.71%. On May 1, 2013, the ERP is at 5.70% but it rests on a US treasury bond rate of 1.65%, resulting in an expected return on 7.35%. An investor betting on ERP declining in 1979 had two forces working in his favor: that the ERP would revert back to historic averages and that the US treasury bond rate would also decline towards past norms An investor in 2013 is faced with the reality that the US treasury bond rate does not have much room to get lower and, if mean reversion holds, has plenty of room to move up, and if history holds, it will take the ERP up with it.

    In the table below, I list potential consequences for the S&P 500, in terms of percentage changes in the level of the index, of different combinations of the risk free rate and the ERP: 


    Thus, if risk free rates move to 3% and the equity risk premium drops to 5%, the index is undervalued by about 5%, but if rates rise to 4% and the equity risk premium stays at 5.5%, the index is overvalued by 8.28%. There is another interesting aspect to the table that bears emphasizing. While the sum of the risk free rate and equity risk premium is the expected return on stocks, stocks are worth much more for any given expected return, if more of that expected return comes from the risk free rate. In the figure below, note the S&P index levels for an expected return of 9%, using different combinations of the risk free rate and ERP: 


    Thus, the same mean reversion that market bulls point to with the ERP can be used to make a bearish case for stocks. The historical average expected return for stocks between 1960 and 2012 of 10.43%, this would translate into the S&P 500 being over valued between 12-40%, depending upon the composition of the expected return. In fact, that is the reason that you have the large divergence in the market between those who use normalized PE ratios and argue that stocks are massively overpriced and those who use the equity risk premium or the Fed model today to make the opposite case.  I am sure that you have your own views on both where the risk free rate and the equity risk premium are headed. If you want to explore the effect on stock prices of changing the variables, please use the linked spreadsheet

    Bottom line
    In a previous post, I noted that stocks do not look over priced. While you may feel that this post is in direct contradiction, let me hasten to provide the bridge between the two.  In the prior post, I noted that stock prices are being sustained by four legs: (1) robust cash flows, taking the form of dividends and buybacks at historic highs for US companies, (2) a recovering economy (and earnings growth that comes with it), (3) ERP at above-normal levels and (4) low risk free rates. Thus, my argument is a relative one: given how other financial assets are being priced and the level of interest rates right now, stocks look reasonably priced. 

    The danger, though, is that the US T.Bond rate is not only at a historic low but that it may be too low, relative to its intrinsic level, based upon expected inflation and expected real growth (a topic for another blog post coming soon). If you believe that the T.Bond rate is too low, then you have the possibility that you are in the midst of a Fed-induced market bubble(s) and that script never has a good ending. The scary part is that there are no obvious safe havens: gold and silver have had a good run but don’t seem like a bargain and central banks around the world seem to be following the Fed’s script of low interest rates. You could use derivatives to buy short term insurance against a market collapse but, given that you are not alone in your fears about the market, you will pay a hefty price. 

    There is a middle ground. In my last ERP update, I argued that stock market investors were dancing to the Fed’s tune and wondering whether the music would stop. Let me rephrase that. If the market is dancing to the Fed’s tune, it is not a question of whether the music will stop, but when. When long term interest rates move back up, as they inevitably will, the question of how much the equity markets will be affected will depend in large part on whether the ERP declines enough to offset the interest rate effect. Thus, while I would not be arguing that stocks are cheap, simply because the ERP today is higher than historic norms, I am not ready to scale down the equity portion of my portfolio (especially since I have no place to put that money). Looking at the table of market sensitivity to risk free rate/ERP combinations, there are enough soft landing scenarios for the market that I will continue to buy individual stocks, while keeping an eye on the ERP & T.Bond rate.



    A tangled web of values: Enterprise value, Firm Value and Market Cap

    Investors, analysts and financial journalists use different measures of value to make their investment cases and it is not a surprise that these different value measures sometimes lead to confusion. For instance, at the peak of Apple's glory early last year, there were several articles making the point that Apple had become the most valuable company in history, using the market capitalization of the company to back the assertion. A few days ago, in a reflection of Apple's fall from grace,  an article in WSJ noted that Google had exceeded Apple's value, using enterprise value as the measure of value. What are these different measures of value for the same firm? Why do they differ and what do they measure? Which one is the best measure of value?

    What are the different measures of value?
    To see the distinction between different measures of value, I find it useful to go back to a balance sheet format, with market values replacing accounting book values. Thus, the market value balance sheet of a company looks as follows:

    Note that operating assets include not only fixed assets, but also any intangible assets (brand name, customer loyalty, patents etc.) as well as the net working capital needed to operate those assets and that debt is inclusive of all non-equity claims (including preferred equity).

    Let's start with the market value of equity. Rearranging the financial balance sheet, the market value of equity measures the difference between the market value of all assets and the market value of debt.


    The second measure of market value is firm value, the sum of the market value of equity and the market value of debt. Using the balance sheet format again, the market value of the firm measures the market's assessment of the values of all assets.



    The third measure of market value nets out the market value of cash & other non-operating assets from firm value to arrive at enterprise value. With the balance sheet format, you can see that enterprise value should be equal to the market value of the operating assets of the company.


    One of the features of enterprise value is that it is relatively immune (though not completely so) from purely financial transactions. A stock buyback funded with debt, a dividend paid for from an existing cash balance or a debt repayment from cash should leave enterprise value unchanged, unless the resulting shift in capital structure changes the cost of capital for operating assets, which, in turn, can change the estimated value of these assets.

    The measurement questions
    To arrive at the market values of equity, firm and enterprise, you need updated "market" values for equity, debt and cash/non-operating assets. In practice, the only number that you can get on an updated (and current) basis for most companies is the market price of the traded shares. To get from that price to composite market values often requires assumptions and approximations, which sometimes are merited but can sometimes lead to systematic errors in value estimates.

    I. Market value of equity
    While the conventional practice is to multiply the shares outstanding in the company by the share price to get to a market capitalization and to use this market capitalization as the market value of equity, there are three potential measurement issues that have to be confronted:
    1. Non-traded shares: There are some publicly traded companies with multiple classes of shares, with one or more of these classes being non-traded. Though these non-traded shares are often aggregated with the traded shares to arrive at share count and market cap, the differences in voting rights and dividend payout across share classes can make this a dangerous assumption. If you assume that the non-traded share have higher voting rights, it is likely to you will understate the market value of equity by assigning the share price of the traded shares to them. 
    2. Management options: The market value of equity should include all equity claims on the company, not just its common shares. When there are management options outstanding, they have value, even if they are not traded, and that value should be added to the market capitalization of the traded shares to arrive at the market value of equity in the company. For a company like Cisco, this can make a significant difference in the estimated market value of equity (and in the ratios like PE that are computed based on that market value). Again, using short cuts (such as multiply the fully diluted number of shares by the share price to get to market capitalization) will give you shoddy estimates of market value of equity.
    3. Convertible securities: To the extent that a company raised funds from the use of bonds or preferred stock that are convertible into common equity, the conversion option should technically be treated as part of the value of equity (and not as debt or preferred stock). Failing to do so will understate the market value of equity in companies with lots of convertible securities outstanding.
    II. Debt
    In theory, the firm and enterprise values of a company should reflect the market value of all debt claims on the company. In practice, this is almost never the case for two reasons:
    1. Non-traded debt: The problem of non-trading is far greater with debt than equity, because bank debt is a large proportion of overall debt, even for many companies that issue bonds, and is the only source of debt for companies that don't issue bonds. Lacking a market value, many analysts have resorted to using book value of debt in their firm value and enterprise value computations. Though the effect of doing so is relatively small for healthy companies (book values of debt are close to market values of debt), it can be large for distressed companies, where the book value of debt will be far higher than the market value of that debt, leading to much higher estimates of enterprise and firm value for these firms than is merited.
    2. Off balance sheet debt: To the extent that firms use off-balance sheet debt, we will understate the firm and enterprise values for these firms. While this may sound like a problem only with esoteric firms that play financing games, it is actually far more prevalent, if you recognize lease commitments as debt. Most retailers and restaurant companies have substantial lease commitments that should be converted into debt for purposes of computing firm or enterprise value. 
    III. Cash 
    Cash should be simple to value, right? That is generally true but even with cash there are questions that analysts have to answer:
    1. Operating versus non-operating cash: To the extent that some or a large portion of the cash balance that you see at a company may be needed for its ongoing operations, you should be separating this portion of the cash from the overall cash balance and bringing into the operating asset column (under working capital). There are two problems we face in making this distinction between operating and excess cash. The first is that operating cash needs will be different across different businesses, with some businesses requiring little or no operating cash and others requiring more. The second is that cash needs have changed over time, with a shift away from cash based transactions in many markets and companies collectively require less cash than they used to a few decades ago. Analysts and investors, for the most part, have no stomach for making the distinction between operating and non-operating cash on a company-by-company basis and use one of two approximations. The first is to assume no operating cash and treat the entire cash balance as excess cash in computing enterprise value. The second is to use a rule of thumb to compute operating cash, such as setting cash at 2% of revenues for all firms. Again, while either approach may do little damage to value estimates at the typical firm, they will both fail at exceptional firms, where the cash balances are very large (as a proportion of value) but are untouchable because they are is needed for operations.
    2. Trapped cash: In the last decade, US companies with global operations have accumulated cash balances from their foreign operations that are trapped, because using the cash for investments in the US or for dividends/buybacks will trigger tax liabilities.  If a company has a very large cash balance and a significant portion of that cash is trapped, it is possible that the market attaches a discount to the stated value to reflect future tax payments. Netting out the entire cash balance to get to enterprise value will therefore give you too low an estimate of enterprise value, a point to ponder when netting out the $145 billion (with >$100 billion trapped) in cash to get to Apple's enterprise value.
    IV. Other non-operating assets
    When companies have non-cash assets that are non-operating, your problems start to multiply. With many family group companies, where cross holdings are the rule rather than the exception, the effect of miscalculating the value of non-operating assets can be dramatic.
    1. Cross holdings in other companies: When a company has non-controlling stakes in other companies, the market value of these holdings should be netted out to get to the enterprise value of the parent company. Doing so may be straightforward if the cross holdings are in other publicly traded companies, where market prices are available, but it will be difficult if it is in a private business. In the latter case, the value of the cross holding on the balance sheet will, in most cases, reflect the book value of the investment, with little information provided to estimate market value. The problems become worse if there are dozens of cross holdings, rather than just a handful. Not surprisingly, most analysts completely ignore cross holdings in computing enterprise value and the remaining net out the book value of the holdings. For companies that derive a large proportion of their value from cross holdings, this will lead to an upwardly biased estimate of enterprise value. When a company has a controlling or a majority stake in another company, a different kind of problem is created when computing enterprise value. The market value of equity in the parent company reflects only the majority stake in the subsidiary but the debt and cash in the computation are usually obtained from consolidated balance sheets, which reflect 100% of the subsidiary. To counter this inconsistency, analysts add the minority interest (which is the accountant's estimate of the equity in the non-owned portion of the subsidiary) to arrive at enterprise value, but the minority interest is a book value measure.
    2. Double counting of operating assets: One of the real dangers of fair value accounting and its push to bring more invisible or intangible assets to the balance sheet is that it increases the risk that analysts will double count. Thus, even if brand name and customer lists are valued and put on the balance sheet, they are very much part of the operations of the firm and should not be netted out as non-operating assets. Only assets that don't contribute (and are never expected to contribute) to operating income can be treated as non-operating assets.
    Mismatches and Measurement Errors
    Looking at the standard practices in value estimation, there are two clear inconsistency problems that you see crop up. One is in the mixing of market values, estimated values and book values for different items in the computation. The other and related question is that the market values can be updated constantly but the book value based numbers are as of the last financial statement.

    I. Market versus Book value
    In a typical enterprise value computation, the only number that comes from the market is the market capitalization, reflecting the market value of equity in common shares. The remaining numbers all come from accounting statements and reflect accounting estimates of value, with varying implications. With debt, as we noted, the difference between book and market value is likely to be small for healthy firms but much larger for distressed companies. With cash, the accounting estimates of value should be close, with the caveat that trapped cash may be discounted by the market to reflect expected tax liabilities. With cross holdings, the gap between book and market value can vary depending on how old the holding is (with older holdings have larger gaps) and the accounting for that holding.
    While getting true market values for bank debt and cross holdings may be a pipe dream, there is no reason why we cannot estimate the market values for both. For debt, this will require using the interest expenses and average maturity on the debt to compute an estimated market value of the debt (akin to pricing a coupon bond). With cross holdings (minority holdings and interests), it may require us to use sector average price to book ratios to estimate the values of the cross holdings.

    II. Timing Differences
    While you would like values to be current (since your investment decisions have to reflect current numbers), only market-based numbers can be updated on a continuous basis. The only market-based number in most enterprise value calculations is the market capitalization number (reflecting current stock prices), with the other numbers either directly coming out of accounting statements (debt, cash) or indirectly dependent on information in them (options outstanding, lease commitments). There are two questions, therefore, that you have to confront: (a) Should you try for timing consistency or current value? (b) If you go current value, what types of biases/problems will you face because of the timing mismatch?
    1. Consistency versus Current Values: If you are using the value estimates to look at how values change over time or why values have varied across companies in the past, consistency may win over updating. Thus, rather than using the current market value of equity, you may use the market value of equity as of date of the last financial statement. If you using the value estimates to make investment or transaction judgments today, the current value rule should win out. After all, if you find a company to be cheap, you get to buy it at today's price (and not the price as of the last financial statement). 
    2. Biases/Errors from Time mismatches: Assuming that the need to be updated wins out, your biggest concern with using dated estimates of debt, cash and other non-operating assets is that their values may have shifted significantly since the last reporting date. Not only can companies borrow new debt or repay old debt, which can affect the cash balance, but the operating needs of the company can lead to a decline or augmentation in the cash. For young growth companies, with large investment needs and/or operating losses, the cash balance today can be much lower than it was in the last financial statement. For mature companies in cashflow-rich businesses, cash balances can be much higher than in the last financial statement.
    In fact, the mismatch can sometimes lead to strange results, especially for young, growth companies that have had operating/financial/legal problems in the very recent past. A drop in market capitalization combined with a cash balance from a recent financial statement that is much higher than the true cash balance can combine to create negative enterprise values for some firms.

    Financial service companies
    This discussion has been premised on two assumptions, that debt is a source of capital and that cash is a non-operating asset to businesses. There is a subset of the market where both assumptions break down and it is especially so with financial service companies, where debt is more raw material than source of capital and cash & marketable securities cannot be claimed by investors. With banks, investment banks and insurance companies, the only estimate of value that should carry weight is the market value of equity. You can compute the enterprise values for JP Morgan Chase and Citigroup but it will be an academic exercise that will yield absurdly high numbers but will provide little information to investors.

    The Numbers
    To illustrate the difference between the different measures of value, I first screened for global non-financial service companies with market capitalizations exceeding $25 billion and computed the firm and enterprise values for each of them. You can download the entire spreadsheet of 292 companies by clicking here. I then created a list of the top 20 companies by market capitalization and ranked them based upon the other measures of value as well.

    Apple is more valuable than Google, if you use market capitalization as your measure of value, whereas Google is more valuable than Apple, if you use enterprise value, and GE dwarfs both companies, based upon enterprise value, because it has $415 billion in debt outstanding. Note that much of this debt is held by GE Capital and given my earlier point about debt, cash and enterprise value being meaningless in a financial service company, I would view GE's enterprise value with skepticism. Nothing in this table tells me which companies are good investments and which ones are over priced and all the caveats about mixing market and book value, timing differences and missing numbers apply.

    Why have different measures of value?
    Having multiple measures of value can create confusion, but there are two good reasons why you may see different measures of value and one bad one.

    1. Transactional considerations
    The measure of value that you use can vary, depending on what you are planning to acquire as an investment. For instance, in acquisitions, where the acquiring firm is planning on acquiring the operating assets of the target firm, it is enterprise value that matters, since the acquiring firm will use its own mix of debt and equity to fund the acquisition and will not lay claim on the target company's cash. In contrast, if you are an individual investor in a publicly traded company, the market capitalization may be your best measure of value since you have little control over how much debt the company has or how much cash it holds. In fact, enterprise value based calculations can be misleading for individual investors, since they can mask default risk: a firm on the verge of default can look cheap on an EV basis.

    2. Consistency in multiples
    In investing, we use estimates of market value to arrive at measures of relative value (multiples), so that we can compare how the market is pricing comparable companies. Relative value requires that the market value be scaled to a common variable (earnings, revenues, book value) and is governed by a simple consistency rule. The measure of value that we use in the numerator of a multiple should be consistent with the measure of earnings or book value that we use in the denominator. Equity values should be matched up to equity earnings or book equity and enterprise values to operating income or book capital. Consider, for instance, PE ratios and EV/EBITDA multiples. The PE ratio is obtained by dividing the market value of equity by the net income (or price per share by earnings per share); both the numerator and denominator are equity values. The EV/EBITDA is obtained by dividing the enterprise value (market value of operating assets) by the EBITDA (the cash flow generated by these operating assets). In the table below, I list the potential choices when it comes to consistent multiples:
    3. Agenda-based value estimation
    In some cases, the choice of value measure may depend upon the agenda or biases of the analyst in question. Thus, an analyst that is bullish on Apple will latch on to its enterprise value to make his or her case, since it makes Apple look much cheaper.

    Closing thoughts
    When it comes to which value estimate is the best, I am an agnostic and I think each one carries information to investors. The PE ratio may be old fashioned but it still is a useful measure of value for individual investors in companies, and enterprise value has its appeal in other contexts. Understanding what each value measure is capturing and being consistent in how it is computed, compared and scaled is far more important than finding the one best measure of value.



    The Fed and Interest Rates: Lessons from Oz

    In my last post on equity risk premiums and the market, I argued that the equity markets have been priced on the presumption that the Fed has the power to control where interest rates will go in the next few years. Wednesday’s press conference by Ben Bernanke was a perfect example of how the Fed has become the center of the equity market universe and how every signal (intentional, implied or imagined) of what the Fed plans to do in the future causes large market gyrations.

    The Fed speaks and markets react
    Ben Bernanke’s press conference was at the end of the meetings of the Federal Open Markets Committee (FOMC) and it provided an opportunity for the market to observe the Fed’s views of the state of theeconomy and its plans for the foreseeable future. The Fed’s optimistic take on the economy (that it was on the mend) and Bernanke’s statement that the Fed could start winding down its bond buying program (and by extension, its policy of keeping interest rates low) was not viewed as good news by the market. The reaction was swift, with stocks collapsingin the two hours of trading after the Bernanke news conference and rippleeffects spreading to other global markets over night.

    Implicit in this reaction is the belief that the Fed is an all-powerful entity that can choose to keep interest rates (short term and long term) low, if it so desires, for as long as it wants. While this belief in the Fed’s power to set interest rates is touching, I think it is at war with both history and fundamentals. In fact, if there is blame to be assigned for the market collapse, it has to to rest just as much on investors who have priced contradictory assumptions into stock prices as it does on the Fed for encouraging them to do so.

    Fundamentals and History
    As with any asset, the treasury bond market sets prices (and yields) based upon demand and supply, with perception, expectations and behavioral factors all playing a role in the ultimate price (and rate). Holding all else constant, then, it seems obvious that the Fed with its bond buying program can change the dynamics of the market, increasing bond prices and lowering long term rates.

    Without contesting the basic economics of the demand/supply argument, it is worth noting that even with treasury bonds, there is an intrinsic value relationship that should govern the level of interest rates. In particular, the risk free interest rate can be decomposed into two components: the expected inflation rate in the currency in question and an expected real interest rates:
    Risk free rate = Expected Inflation + Expected real Interest rate
    The real interest rate itself is a function of demand and supply for capital in the economy, which should be determined by expected real growth. As the economy becomes stronger, and real growth increases, real interest rates should also increase. If we make the assumptions that actual inflation in the most recent time period is equal to expected inflation and that the actual real growth in the most recent period is the expected real interest rate, you have an equation for what I will call a fundamental risk free interest rate:
    Fundamental interest rate = Actual inflation rate + Real growth rate
    While the assumptions that underlie this equation can be contested (past inflation is not always the best predictor of expected inflation and actual real growth may not be a proxy for expected real growth), we can use the historical data to check how the actual interest rate on a long term treasury bond (the 10-year T.Bond) compare to the fundamental interest rate derived above:


    Note that the actual inflation rate in each year and the real GDP growth in that year are aggregated to yield the fundamental interest rate. Thus, in 2006, the actual inflation rate was 2.52% and the real GDP was 2.38%, yielding a fundamental interest rate of 4.90%. Comparing it to the ten-year treasury bond rate that year of 4.56% yields a gap of -0.34% (T.Bond rate - Fundamental interest rate). There are two conclusions I would draw from this graph.
    1. Over the 1954-2012 time period, the actual T.Bond rate has moved, for the most part, with the fundamental interest rate, rising in the 1970s as inflation surged and dropping in the 1980s as inflation retreated. There have been gaps that open up between the treasury bond rate and the fundamental interest rate but they seem to close over time. In fact, when the T.Bond rate increases (decreases) relative to fundamental interest rate, the treasury bond rate is more likely to fall (increase) in the next period.
    2. Across the entire time period (1954-2012), the 10-year treasury bond rate averaged 6.11% and the fundamental interest rate average 6.83%, but breaking down into sub-periods suggest that there has been a shift in the relationship over time. In the 1954-1980 time period, T.Bond rates were 2.20% lower, on average, than the fundamental interest rates but in the 1981-2012 time period, the average treasury bond rate has been 0.52% higher than fundamental interest rates.
    In January 2013, the treasury bond rate at 1.72% was about half the fundamental growth rate of 3.43% (Inflation in 2013 of 1.76% + Real GDP growth of 1.67% = 3.43%). Not only is the gap of 1.71% high by historical standards, but the ratio of the T.Bond rate to the Fundamental interest rate was close to historic lows (the lowest was 2011, when the T.Bond rate was 40% of the fundamental interest rate). If you are interested, you can download the raw data on interest rates, inflation and real GDP growth and come to your own conclusions.

    The Fed Effect
    Does the Fed matter? Looking at the data on interest rates and fundamentals over time, the answer is undoubtedly yes. Over the last three decades, you can see the imprint left by consecutive Fed Chairs from Paul Volcker to Alan Greenspan to Ben Bernanke on inflation, real growth and T.Bond rates. To examine the relationship between Fed policy and T.Bond rate/fundamental interest rate difference, I focused on the one number that the Fed truly controls, the Fed Funds rate, as an indicator of whether the Fed is adopting a looser or tighter monetary policy, and look at the relationship between the Fed funds rate and the gap between the T.Bond rate and the fundamental interest rate:


    Looking at the graph, it seems clear that increases (decreases) in the Fed funds rate have caused the gap between treasury bond rates and fundamental interest rates to move in the same direction. In fact, running a regression of the change in the Fed funds rate each year against the change in the gap (T.Bond rate - Fundamental interest rate) in the next year yields the following:
    Change in the gap in year t = - 0.0001% + 0.5333 (Change in the Fed Funds rate in year t -1)
                                                     (0.03)         (3.25)            
    R squared = 14.33%

    Put in more intuitive terms, based on the historical data, a cut in the Fed funds rate of 1% decreases the gap between the T.Bond rate and the fundamental growth rate by 0.53%. There are two sobering notes worth emphasizing. The first is that the Fed funds rate currently is close to zero and that effectively implies that its use as tool to make T.Bond rates decrease relative to fundamental growth rates is limited.  (I know that the Fed has been much active with the other tool in its war chest, bond buying, but that tool too has its limits). The second is that the Fed is not as powerful at setting interest rates as most investors think. Only 14.33% of the variation in the gap can be explained by the Fed funds rate and changes in real growth & inflation have far bigger impacts. 

    So can the Fed really “control” interest rates and keep long term rates from rising? I may not have much company on this one, but I think that the Fed's power comes primarily from the perception that it has power and not from its direct control over the interest rate mechanism. This may seem like heresy in a market that views the Fed both as the arbiter of interest rates and the protector of the bull market, but if long term interest rates start rising, I don’t think that the Fed can do much to stop them. In fact, as I watch investors look to Ben Bernanke to save them, here is the scene that plays out in my mind, from the Wizard of Oz. For those of you who may still be unfamiliar with the classic, here is a quick recap. A tornado plucks Dorothy from her home in Kansas and dumps her in Oz (and right on top of the Wicked Witch of the East). When Dorothy seeks help to get home, she is advised to seek out the powerful Wizard of Oz, and on her way to meet him, she gathers together a motley crew of needy characters (the Scarecrow, who needs a brain, the Tinman, who desires a heart and the Cowardly Lion, who is searching for courage). When they get to the Wizard's lair, here is what they find:


    Is that Ben Bernanke I see behind the curtain and is that contraption the Fed's vaunted interest rate setting machine?

    If the T.Bond rate does rise next year towards the fundamental interest rate, it will ironically make investors attribute even more power to the Fed, since it will coincide with the winding down of the bond buyback by the Fed. The Fed, we will be told, allowed long term interest rates to rise by using it extensive powers. Here is what I believe. Thus, if the economy improves, interest rates will rise, with or without the Fed buying bonds and if the economy falters, interest rates will stay low, with our without the Fed buying bonds.

    The way forward
    As my last two posts on the market indicate, my biggest concern with markets right now is that investors may be pricing inconsistent assumptions about the macro environment. In other words, investors are pricing stocks on the assumption that the US economy will return to growth, while interest rates stay low. While each assumption can be defended separately, I don’t see how they can co-exist, no matter what the Fed or any other entity may tell us.

    As investors, therefore, we have to think through the possible scenarios and adjust our portfolios accordingly. Here is my very crude attempt to delineate the possible scenarios, with permutations of real growth/inflation:

    Real Economic Growth
    High
    Moderate
    Low/Negative
    High
    Negative for bonds
    Mildly positive for stocks
    Negative for bonds
    Negative for stocks
    Negative  for bonds
    Negative for stocks
    Moderate/Low
    Negative for bonds
    Positive for stocks
    Negative for bonds
    Mild positive for stocks
    Neutral/ Positive for bonds
    Negative for stocks
    Deflation
    Neutral for bonds
    Positive for stocks
    Neutral for bonds
    Negative for stocks
    Positive for bonds
    Negative for stocks


    There are two things to note about these scenarios. The first that some of these scenarios are more likely than others, though I am sure that opinions will vary about which one. For instance, the soft landing scenario, favored by many economists/investors today, sees moderate growth with low inflation, one that is negative for bonds (because interest rates will start creeping back towards the fundamental growth rate) and mildly positive for stocks. I think that the high real growth/deflation scenario is unlikely, since it is difficult to see the economy growing at a robust rate and prices falling at the same time (especially given monetary policy over the last few years). I also have to believe (and perhaps hope is winning out here) that the negative real growth/deflation scenario has a low chance of occurring, and it would be very negative for stocks, though it will help bond holders. The second is that there are far more scenarios which are negative for bonds than positive, a direct result of interest rates being at historic lows and the Fed running low on ammunition. 

    My personal investing foibles should be of little interest to you, but I have tried to build in some degree of protection into my overall portfolio, especially against interest rate changes. A few weeks ago, I invested in ProShares UltraShort 20+ year (TBT), an ETF that sells short (with leverage) on long term treasuries; it is one of many ETFs that offers this choice. (As some of my readers have pointed out, the ultrashort funds come with baggage. For those who prefer a more predictable play, go with TBF, which also shorts the treasury bond, but without leverage).  I did not buy full protection against interest rate changes, since that would have required me to invest a huge amount of my portfolio in this ETF and because I don't attach a high probability to the most disastrous scenarios for bonds. The partial protection that I did buy has worked as advertised.

    That may not be your preference, either because your assessment of the likelihood of the scenarios will be different from mine or because you feel that there is a different asset class (gold, emerging market equities etc.) that will provide you better protection. In my view, the one scenario that is unlikely to unfold, no matter how much you wish it to be true, is the one where real economic growth (2-2.5%) returns, inflation stays at moderate levels (2-2.5%) and the 10-year treasury bond rate stays at 2%. I understand that the Fed is doing a difficult job (that the executive and legislate branches have shirked), that it is well intentioned and has some very smart policy makers, but when you fight markets and fundamentals, you have to capitulate at the end. No one is bigger than the Market, not even Ben Bernanke.



    Market Mood Swings: Facebook Euphoria

    Facebook's stock price briefly hit $38, its IPO price, just before today's opening bell. In the 15 months since it went public, the stock had certainly had its ups and downs as evidenced in this graph:

    As some of you who have tracked my blog posts over the last couple of years know, I have tried to make sense of Facebook's value and how the market has been pricing it. Given today's news, I thought it would be useful to go back first to these earlier posts and then do a fresh valuation of the company, with updated information.

    The lead up to the IPO
    Facebook had perhaps the most elaborate run-up to an IPO in stock market history, with billions of dollars in transactions in the private share market, stories aplenty in the news media and even a hit movie about its founders. My first attempt at valuing Facebook was in February 2012, when I attached a value of $68 billion to its equity, with extremely generous assumptions on revenue growth and margins. In estimating this value, I assumed that Facebook would have a revenue growth path very similar to Google's, while sustaining operating margins like Apple. 

    As the initial public offering drew nearer, I grew increasingly wary about the offering for two reasons. The first was the sense that many investors, especially institutional, seemed to think that the Facebook IPO was an absolute no-lose proposition, no matter what the offering price was, since momentum would carry the stock higher. In this post, from February 2012, I cautioned investors from buying into this proposition. The second was that the company and its bankers seemed to assume that they could set the terms for the offering and that the market could go along. In my experience, those who believe that they have power over markets realize otherwise, sooner rather than later.

    The IPO
    On May 17, 2012, just after the lead investment banks set the offering price at $38/share and the day before the offering date, I did my final pre-IPO valuation and estimated a value per share of about $25/share. While you can get the excel spreadsheet containing the valuation in this post, I think this picture better illustrates the assumptions and linkages that went into my estimate of value:

    The actual offering date is now part of market lore, from the technical problems that NASDAQ had in getting the trading started to the substantial support that the investment banks had to offer to keep the price from collapsing. After an initial spurt in the price to $42, the stock ended the day at $38.23 a share.

    Once the price support faded, the stock price retreated in the weeks after the IPO to drop below $30 in June 2012. In a post after the IPO, I argued that the market reaction to the IPO was just desserts for the arrogance and hubris of both investment bankers and the company in the lead up to the IPO. 

    The Early Returns
    In the months after the IPO, Facebook faced a mountain of troubles, some of its own doing and some reflecting the costs of going public. The IPO failure colored investors' views of the company and its management, leading them to put the worst possible spin on every action and occurrence at the company. At the same time, the IPO also exposed the company to significant costs, especially as the costs of stock-based compensation were recognized, leading to a drop in operating income.  The nadir for the stock was the quarterly earnings report about a year ago, when the company reported sagging revenue growth and much lower margins. The momentum game turned fully against the company, with many of the analysts and institutional investors who had been cheerleaders in the pre-IPO days arguing that the stock was a "sell".

    On August 20, 2012, Facebook had dropped below $20/share and I made an argument that the market had over reacted to news and that the earnings reports were not as catastrophic as they were perceived to be. I also argued that investors were being distracted by side stories about expiring lock ups and mobile mashups. In fact, my estimate of value in August 2012 was $23.94, just a couple of dollars below my estimate on the day before the IPO. At the end of the post, I noted that I had a limit buy order at $18/share on the stock and that notwithstanding my concerns about corporate governance in the company and the near term effects of momentum, it looked like a decent buy. 

    Now, a confession. I had never, ever bought a stock on the date that it hit its absolute low, until my limit order for Facebook got fulfilled at the start of trading on September 4, 2012. The stock hit its low of $17.58 that day and, even with setbacks along the way, it has not looked back since. I would love to claim timing precision but it was absolute luck, and I would rather be lucky than good.

    Learning from Earnings: Updating the Facebook valuation
    If the first two earnings reports were viewed as negative surprises, they did bring expectations down for the company and the company has delivered positive earnings reports in its last three earnings reports. While it is easy to get lost in the minutia of these reports, here are the news stories that I see embedded across the earnings reports:
    1. Revenue growth continues to be strong: Revenues at the company over the first two quarters of the current financial year have been about 46% higher than revenues in the first two quarters of the last financial year, just above the expected growth rate of 40% used in the IPO valuation.
    2. Operating margins remain high: Operating margins declined last year, primarily because of the expensing of stock-based compensation from pre-IPO days. That load has been lifted in this fiscal year and the operating margin over the last four quarters is about 30%, if R&D is expensed, and closer to 40%, if it is capitalized.
    3. Facebook remains for the most part an "advertising" company: While Facebook has made attempts to broaden its revenue base and product mix, it remains dependent upon advertising for 84% of its revenues in the last four quarters, not significantly different from pre-IPO days.
    4. Facebook seems to have broken the "mobile media" code: It is true that the last few earnings reports have included good news on the mobile media front, with Facebook showing the capacity to deliver, but am afraid that I don't share the euphoria with which some investors have greeted this news. Don't get me wrong! Being successful in mobile media is critical to Facebook's success but the revenues that I (and others) have projected for Facebook last year assume that success. So, the good news in the mobile media market keeps them on the forecasted revenue path, but failure would have been devastating. 
    5. Management has matured: If there is good news that came out of the botched IPO, it is that the managers at Facebook (from the top down) seem to have learned two critical lessons. First, they no longer seem to be taking markets for granted and are taking the effort to explain not only what they are doing but why. Second, they seem to have realized that analysts and bankers don't lead the market, but follow it. Nevertheless, the company remains a corporate governance nightmare, with voting rights concentrated in Mark Zuckerberg's hands, but at least for the moment, he seems to be behaving more like a benevolent monarch than a malevolent dictator. 
    Incorporating the information in the last earnings report, I tweaked my valuation of Facebook and the word "tweaked" is used intentionally. None of the big news in the earnings reports represents significant departures from assumptions made in earlier valuation. The good news in revenue growth and operating margins was already being assumed and the fact that Facebook remains an advertising driven company puts limits on how big revenues can get. My estimate of value per share for Facebook has risen from $24/share at the depths of despair last August to about $27.65/share today (July 31, 2013). As always, you are welcome to download the spreadsheet and replace my assumptions with yours.

    So, what now?
    The old "buy and hold" advice, where we are told to buy good companies and leave them in our portfolios for posterity, makes little sense with growth companies, where markets often over shoot and under shoot. Last August, it was my belief that markets were over reacting to limited information in an earnings report from a young company and pushing its price down too much. Today, I believe that the markets are over reacting again to limited news from an earnings report and pushing the price up too much. As an investor who was lucky enough to buy last August, because the stock was trading below my estimate of its intrinsic value, I have to be consistent and sell, if the opposite holds now. The only pragmatic consideration that I have relates to taxes, since I will save substantially, if I can wait until September 4 to sell (when my gains will become long term capital gains).

    So, what if you don't own the stock? Should you sell short? I personally would not, since it is entirely possible that the momentum game that was so firmly against Facebook last year might work in the other direction now. There may be investors who will be drawn in to the stock if it crests the $38 IPO price, though there is really no economic or value significance around the number. 

    One final note. Even though I am selling Facebook, I will continue to follow the company. After all, the company may very well fall out of favor with investors in a few months and be back on my buy list. Bipolar markets are sometimes an intrinsic value investors best friend.

    My previous posts on Facebook
    The IPO of the decade: My valuation of Facebook (February 16, 2012)
    Facebook: Playing the IPO pop game (February 26, 2012)
    Facebook and Field of Dreams: Hoodies, Hubris and Hoopla (May 17, 2012)
    Facebook: Sowing the wind, reaping the whirlwind (May 23, 2012)
    Facebook face plant: Time to friend the company (August 20, 2012)
    Much ado about liquidity: Lockup Expirations and Stock Prices (November 19, 2012)





    Market Multiples: Global Comparison and Analysis

    In my last two posts, I looked first at measures of country risk, both from a default risk and an equity market perspective, and then at stock pricing, using earnings and book value multiples, across developed and emerging markets. In summary, the conclusion that I drew was that the shift away from emerging markets in the last six months may be obscuring a much larger shift towards convergence between emerging and developed markets over the last decade. Thus, we can debate whether this convergence is rational or overdone, but it is quite clear that stock markets around the world have more in common now than they are different. Having said this, it is worth noting that the developed and emerging market categories that I used in the last post, which were based on geographic location, may no longer reflect the reality that there is vastly more diversity within each region than there used to be. In this post, I intend to look at the pricing of stocks, by country, not only to illustrate this diversity but also to look for mis pricing, at a country level, around the globe.

    PE Ratios around the globe
    The price earnings ratio, notwithstanding its volatility and measurement weaknesses, remains among the most widely used tools in investing. In fact, some global investors still compare PE ratios across countries and often direct their money towards countries with low PE ratios, on the presumption that this must indicate "cheapness".

    To put this approach into practice, I first computed PE ratios in June 2013, by country. During the computation, I noted a couple of phenomena, which while unsurprising, are still worth emphasizing. The first is that almost 60% of all companies globally have negative earnings and PE ratios are thus not meaningful for these companies. The second is that there are significant outliers, with a few companies with exceptionally high PE ratios (usually because earnings have dropped to close to zero) pulling the  averages to high numbers, especially in countries with relatively few companies. To get a more representative value, I computed the PE ratio based on aggregate values for market capitalization and net income. Put simply, I summed up the market capitalization of all the companies in a market and divided by the total net income of all companies in a market. This aggregate value is not as sensitive to outliers and reflects more closely a weighted average of the companies in the market, with values representing the weights. 

    The heat map below allows you to compare PE ratios across countries, and within regions.

    Note that the countries with the lowest PE ratios (in yellow and orange) are also among the world's riskiest (a large swath of Africa, Venezuela (Latin America) and Eastern Europe). Put differently, these countries look cheap, but they have good reasons to be cheap. The bulk of developed markets have PE ratios between 10 and 15, with the weighted PE ratio at 10.49 for Germany, 12.81 for Japan and 14.27 for the US. Surprisingly, Mexico and Chile have the highest weighted PE ratios, with Mexico at 18.04 and Chile at 18.64. There are also large sections of the world where PE ratios cannot be computed, either because earnings information is not available or because earnings are negative.

    If most of the low PE countries are high risk and the bulk of the high PE countries are low risk, we have to use more finesse in looking for cheap and expensive markets. In fact, a cheap market would offer a combination of a low PE and low risk and an expensive market would be one with high PE and high risk. To look for those mismatches, I combined the PE ratio dataset with the equity risk premiums estimated in the prior blog post and generated a list of the ten countries with the highest and lowest PE ratios, with accompanying equity risk premiums. 

    Of the ten countries with the lowest PE ratios, only two (Kazakhstan and Azerbaijan) had equity risk premiums less than 10% and I cam not tempted to invest in either country (given their dependence on commodity prices and political risk profiles). There are more interesting countries on the highest PE list, though a couple reflect commodity price volatility; the drop in copper prices, for instance, has hit Chilean company earnings harder than it has market capitalizations. 

    Price to Book Ratios
    The price to book ratio is often a less volatile and more reliable measure of pricing in a market. While accounting choices can affect book value, the effects of these choices are more muted than on earnings. As with PE ratios, I computed both the average price to book ratios and price to book ratios based upon aggregate market capitalization and book equity and decided to use the latter as the indicator of overall pricing. The map below provides comparisons of the aggregate price to book ratio across the globe:

    Unlike PE ratios, there seems to be little relationship between the dispersion of price to book ratios across the globe and country risk. Some of the highest price to book ratios are in the riskiest countries: Namibia, Indonesia and Venezuela all have price to book ratios that exceed 2.50 and are all high risk countries.

    As with PE ratios, a naive strategy of directing your money to the countries with the lowest price to book ratios may be dangerous, since these low multiples of book value can be explained by low returns on equity. The following is a list of the ten countries with the highest and lowest price to book ratios:

    Note that the countries with the highest price to book ratios also tend to have very high returns on equity, whereas some of the countries on the lowest price to book ratios have negative or low returns on equity. There are some mismatches, especially on the low PBV list, with Zimbabwe, Lebanon and Russia joining Kazakhstan and Azerbaijan as markets with low price to book ratios and high returns on equity. In addition to all the caveats about hidden (and not so hidden) risks, it is also worth noting that some of these markets have only a handful of listings and no or low liquidity.

    Enterprise Value to EBITDA multiples
    Some investors and analysts take issue with equity multiples, arguing that they do not account for overall value and leverage. Consequently, I estimated enterprise value to EBITDA multiples for individual countries, using both simple averages and aggregated values. The resulting global map of EV to EBITDA multiples is below:

    This map more closely corresponds to the PE map, with riskier countries having lower EV to EBITDA multiples (with Mongolia being an exception). The median value across the globe is 8.03, with the United States (8.45), Australia (8.59), India (9.48) and China (9.99) trading above the value and much of Western Europe trading below.

    Just as I balanced PE ratios against risk and PBV against ROE, I brought in return on invested capital (ROIC) into the comparison of EV/EBITDA multiples, on the assumption that higher ROIC is more likely to accompany higher EV/EBITDA multiples. Again, the list of countries with the highest and lowest EV/EBITDA multiples, with ROIC for each, is in the list below:
    Unlike with equity multiples, the relationship between ROIC and EV/EBITDA is in the inverse of expectations, with countries with the higher (lower) returns on invested capital having the lowest (highest) EV/EBITDA multiples.

    Wrapping up
    At the end of the comparisons of equity and enterprise value multiples, I must confess that I feel little inclination to make abrupt asset allocation judgments based upon any of these multiples. It is true that some markets seem to offer better risk and return trade offs than others, but these markets seem to come with warning labels (about political or commodity price risk). It is also possible that I am missing some hidden patterns here and you are welcome to download the dataset containing my estimates of both average and aggregate values, by country. 

    Notwithstanding the noise in the numbers, I am glad that I was able to look at the numbers across countries. I feel a little more informed about how stocks are being priced across the globe and how investors are pricing in the most extraordinary and unusual risks in some markets. I also realize how much I have left to learn about how stocks are priced in countries with non-traditional risks and will keep working at filling in the gaps in my knowledge.

    1. Rediscovering risk in emerging markets: A country risk premium update
    2. Developed versus Emerging Markets: Convergence or Divergence? 
    3. Market Multiples: Global Comparison and Analysis
    4. Global Businesses and Country Risk: Investment Challenges and Opportunities (Still to come)



    Developed versus Emerging Markets: Convergence or Divergence?

    In my last post, I looked at country risk first from both a bondholder perspective (with ratings, default spreads and CDS spreads) as well as an equity investor perspective (with my estimates of equity risk premiums by country). While default spreads in sovereign bonds and differences in CDS spreads are explicit and visible to investors, the question of whether equity markets price in differences in equity risk premiums is debatable. In fact, there are quite a few analysts (and academics) who argue that country risk is diversifiable to global investors and hence should not be priced into stocks, though that argument has been undercut by the increasing correlation across equity markets. In this post, I look at the pricing of stocks across different markets to see if there is evidence of differences in country risk, and if so, whether market views of risk have changed over time.

    Stock Prices and Risk Premiums
    Holding all else constant, stocks that are perceived as riskier should sell for lower prices. That can be illustrated fairly simply using a basic discounted cash flow model. Consider a firm that pays out what it can afford to in dividends and is in stable growth (growing at a rate less than or equal to the economy forever). The value of equity in the firm can be written as:

    Rewriting the expected dividends next period as the product of the payout ratio and expected earnings, we get:
        

    Now, assume that you are valuing two companies with equivalent growth rates and payout ratios, in US dollars, and that the only difference is that one company is in a developed market and the other is in an emerging market. If investors in the emerging market are demanding a higher equity risk premium, the emerging market company should trade at a lower PE ratio than the developed market company.

    So what? A simple test (perhaps even simplistic, since holding growth and payout constant is tough to do) of whether equity risk premiums vary between developed and emerging markets is to compare the multiples at which companies in these markets trade. If emerging markets command higher equity risk premiums, you should expect to see stocks trade at much lower multiples (PE, PBV, EV/EBITDA) in those markets, relative to developed markets, for any given level of growth and profitability.

    Market Convergence: The Pricing Story
    To examine how developed market and emerging market PE ratios have evolved over time, I computed PE ratios for each company in every market each year from 2004 to 2012, with an update to June 2013. I eliminated any company that had negative earnings and divided the market capitalization at the end of each year by the net income in that year.

    I then categorized the companies into developed and emerging markets, using conventional geographical (but perhaps controversial) criteria. I included US, Canada, Western Europe, Scandinavia, Australia, New Zealand and Japan in the developed market group and the rest of the world (Latin America, Asia, Africa, Middle East and Eastern Europe/Russia) in the emerging market group. In sum, there were 36,067 companies in the developed market group and 24,429 companies in the emerging market group. 

    I considered various summary statistics (the simple average, a weighted average, an aggregate market cap to earnings) but decided to use the median PE as the best indicator of the typically priced stock in each market. In the figure below, you can see the median PE ratios for developed and emerging market companies by year, from 2004 through June 2013.

    Prior to 2006, emerging market PE ratios were about 30% lower than developed market PE ratios, but after almost catching up in 2007, the banking crisis of 2008 caused a drop in emerging market PE ratios, relative to developed markets. In the years since, emerging market companies have clawed their way back and the PE ratio for emerging market companies exceeded that of developed market companies in 2012. The shift away from emerging markets in the first six months of 2013 has put developed companies into the lead again, though the developed market PE premium (over emerging markets) in June 2013 is significantly lower than the premiums commanded in the early part of last decade.

    Deconstructing the Convergence
    The convergence of PE ratios across the globe is striking, but it is worth noting that it is more attributable to a decline in PE ratios in developed market PE ratios than to a surge in emerging market PE ratios. In fact, this phenomenon is made more explicit if we look at the median price to book ratios across developed and emerging market companies from 2004 to 2013:
    The convergence that we see in PE ratios is even more striking when it comes to price to book ratios, but note that the convergence is largely coming from the drop in price to book ratios in developed markets, not from a increase in those ratios of emerging markets.

    Reasons for Convergence
    The convergence in PE ratios and PBV ratios between developed and emerging markets is confirmed when we look at other multiples (EV/EBITDA, for instance). The question therefore becomes not whether there is convergence, but why the convergence is occurring.  There are at least three possible stories (and perhaps more).

    1. Decline in profitability at developed market companies, relative to emerging market companies: It is possible that shifts in global economic power have made developed market companies less profitable than they used to be, thus lowering pricing multiples for these companies. One measure of profitability is the return on equity earned by companies, estimated by dividing net income  by book equity. The median returns on equity for developed market and emerging market companies, each year from 2004 to 2013, are contrasted below:
    Note that emerging market companies have had higher returns on equity than developed market companies in every year. While the 2008 crisis has resulted in declines in return on equity across both groups of firms, developed market companies have almost caught up in terms of return on equity with emerging market companies, suggesting that it is not profitability that explains the PE/PBV convergence.

    2. Declining differential equity risk premium (between developed and emerging market companies): A second potential explanation is that the differential equity risk premium between developed and emerging markets has decreased over the last few years. There is a fairly simple mechanism for backing out the implied costs of equity and equity risk premiums from the price to book ratios and returns on equity. If we assume firms are collectively in stable growth, the price to book ratio can be written as:

    Moving the terms around allows us to restate the equation in terms of cost of equity:

    To compute the costs of equity in US dollar terms, we will set the expected growth rate for each year to be equal to the US treasury bond rate in that year and derive the cost of equity for developed and emerging markets in that year. I know that assuming the same growth rate in developed and emerging markets is simplistic, but I will revisit this assumption later.

    For instance, take 2004, when the price to book ratio for developed markets was 2.00, the return on equity for developed markets was 10.81% and the US T.Bond rate was 4.22%. The implied cost of equity for developed markets in 2004 is 7.52%:
    Implied cost of equity in 2004 (developed) =((.1081-.0422)/2.00) + .0422 = .0752 or 7.52%
    In the same year, emerging market companies had a price to book ratio of 1.19, a return on equity of 11.65% and a resulting implied cost of equity of 10.46%:
    Implied cost of equity in 2004 (emerging) =((.1165-.0422)/1.19) + .0422 = .1046 or 10.46%
    If you accept these estimates, emerging markets had an equity risk premium about 2.94% higher than developed markets:
    Differential ERP = 10.46% - 7.52% = 2.94%
    I repeated this estimation process for 2005 through 2013 to yield the following:

    The last column is striking, as the differential ERP dropped close to zero at the end of 2012 before rebounding a little bit in the middle of 2013. In fact, at the 0.50% level in 2013, it is still well below historical norms.

    3. Decline in differential real growth: Now, let's revisit the assumption that I made in the last section that both developed and emerging markets will grow at the same rate (set equal to the US treasury bond rate each year). You can take issue with that assumption, since emerging markets have not only more growth potential but have delivered more real growth that developed markets over the last two decades. If you assume higher growth in emerging markets than developed markets, the table above overstates the equity risk premium for developed markets, while understating the premium for emerging markets. I redid the table setting the growth rate in developed markets at 0.5% below the risk free rate, while allowing the growth rate in emerging markets to be 1% higher than the risk free rate; this results in 1.5% difference in annual real growth rates between the two groups. 


    While the differential ERP is higher in every year, with the assumption of higher growth in emerging markets, the trend line remains unchanged with the differential value hitting a low at the end of 2012. Unless you assume a widening of the difference in expected real growth between developed and emerging markets between 2004 and 2012, which would be difficult to justify given the growth in size of emerging markets over that period,  a decrease in differential equity risk premiums seems to be the most likely explanation for the convergence in multiples across markets.

    In summary, the shrinking differences in pricing between developed and emerging markets cannot be explained by profitability trends or changes in real growth but can be at least partially explained by narrowing risk differentials between the markets and the globalization of companies.

    Implications
    The trend lines in profitability, risk and pricing over the last decade are interesting from a macro standpoint but there are three general lessons/implications for investors:
    1. Reality check for expectations in emerging markets: For the last two decades, developed market investors have been lured into investing in emerging markets by the promise of higher returns in those markets, though accompanied with the caveat of higher risk. If the last few years are any indication, it is time for investors to adjust expectations for emerging market returns, going forward. Emerging market companies are no longer being priced to generate premium returns, but they are also no longer as risky as they once were (at least relative to developed market companies).
    2. Markets can still over shoot: While it is clear that emerging markets have evolved in terms of economic growth, political maturity and risk, it also remains true that there is more risk in these markets than in developed ones. Markets, however, often move in ebbs and flows, under estimating this differential risk in some periods and over estimating it in others. Thus, a reasonable case can be made that markets were being over optimistic about emerging market risks, when they priced stocks to generate roughly the same expected returns in developed and emerging markets at the end of 2012 (see the table in the last section) and that the correction this year is a reversal back to a more reasonable differential premium. For those who believe that the reasonable premium is that observed between 2004 and 2006 (when the average differential in ERP was 2.5% and higher), this would lead to the conclusion that there is far more pain to come in emerging markets. If you believe, as I do, that the norm is closer to that reflected in the average since 2008 (about 1 to 1.5%), the correction is about half way over.
    3. Think global, not localAs companies, notwithstanding where they are incorporated, increasingly become global competitors, it can be argued that equity risk premiums will converge across markets, since each market will be composed primarily of global companies exposed to risks around the world. For investors and analysts in developed markets, there is the unsettling reality that emerging market risk is now seeping into their portfolios, even if it is composed purely of domestic companies. For investors and analysts in emerging markets, there has to be the recognition that the automatic discounts that they apply to emerging market company multiples, relative to developed markets, may no longer be appropriate. I will return to this issue in a future post.
    1. Rediscovering risk in emerging markets: A country risk premium update
    2. Developed versus Emerging Markets: Convergence or Divergence? 
    3. Market Multiples: Global Comparison and Analysis
    4. Global Businesses and Country Risk: Investment Challenges and Opportunities (Still to come)



    Rediscovering risk in emerging markets: A Country Risk Premium update

    Investors have a mixed relationship with risk, forgetting that it exists in the good times and obsessing about in bad times, and nowhere is this dysfunction more visible than in emerging markets. After a few years where investors seemed convinced that emerging markets were no riskier than developed markets, they seem to have woken up to the existence of risk in emerging markets, with a vengeance, in the last few months. As emerging markets around the world have been pummeled, analysts have sought to assign blame. Some have pointed the finger at the Federal Reserve, claiming that mixed signals on quantitative easing and the steep rise in US interest rates have caused currency and market fluctuations globally. Others attribute dropping stock prices to slowing economic growth in the largest emerging markets, with China at the top of the list. There are a few who point to the rise of country-specific political factors, with governments in Brazil and Egypt facing pressure from their populace.

    While there is some truth to all of these explanations, there is a more general lesson about risk in recent market movements. While the last five years have seen a narrowing of the risk differences between developed and emerging markets, partly due to the maturation of emerging markets and partly because developed markets seem to have acquired some of the worst traits of emerging markets, emerging markets still remain more vulnerable to global economic shocks than developed markets. That does not make them bad investments but it does mean that investors should demand premiums for investing in emerging markets, with higher premiums for riskier markets.

    If you accept this proposition, it follows that you cannot value or invest in companies with emerging market risk exposures without having estimates of risk premiums by country. At the start of each year, for the last two decades, I have put up my estimates of risk premiums, by country, on my website. For the last three years, in response to the rapid intra-year shifts in country risk, I have also done mid-year updates. After the turmoil of the last few weeks, I decided that this would be a good time for a mid-year country risk update.

    I. Default Risk Measures
    The most easily accessible data on country risk takes the form of sovereign default risk measures. While ratings agencies have been assigning ratings to sovereign bonds issued by countries for decades, the growth of the credit default swap (CDS) markets have given us access to CDS spreads for a subset of these countries. 

    a. Sovereign Ratings & Default Spreads
    Ratings agencies have been critiqued since the banking crisis of 2008 for being being biased (in favor of issuers) and overlooking major risks, but I think the bigger problem with them is that they are slow in reacting to change. That effectively makes sovereign ratings into lagging indicators of country risk.

    The slow process of ratings change can be seen by looking at the changes in sovereign ratings between January and June 2013. In the attached spreadsheet, I have the local currency sovereign ratings from Moody’s for 118 countries (You can also get the sovereign ratings directly from Moody’s and Standard & Poor’s). During this turbulent six-month period for emerging markets, there were only 15 countries that saw ratings changes, with 10 downgrades and 5 upgrades, and they are listed below: 

    Note that 9 of the 15 ratings changes were only a single notch, four were two notches and two countries saw their ratings improve three notches (with the Cayman Islands moving up three notches to Aaa and Cyprus moving down three notches to Caa3).

    Even if sovereign ratings don’t change, the default spreads associated with them as markets reassess the price of risk. Between January and June 2013, there was an uptick in default spreads across the ratings classes. The figure below summarizes average default spreads by sovereign ratings class in January and June 2013: 
    Sovereign default spreads are about 10-15% higher than they were six months for most of the ratings classes. 

    b. CDS Spreads 
    The credit default swap market is a quasi-insurance market, where investors can insure against country default risk; thus the CDS spread of 2.50% for Brazil at the end of June 2013 can be viewed loosely as the annual cost of insuring against default on a Brazilian US$ denominated government. While I have posted on the limitations of the CDS market, it does have one significant advantage over the sovereign rating process. It can and does react (sometimes too much in the view of its critics) instantaneously to events unfolding in real time in individual countries. As a consequence, it is much more volatile than ratings-based measures of default risk.

    Sovereign CDS spreads are available for 63 countries and the attached file has the CDS spreads in January and June 2013 for all of the countries. In contrast to the ratings, the CDS spreads changed for every country on the list between January and June and the changes are dramatic in some cases. Across the entire list, the median (average) change in CDS spread was 14.54% (17.45%) between January and June, consistent with the uptick in default spreads over the same period.

    Looking at the changes over the six months, the ten countries that saw the biggest percentage increases and decreases in spreads are listed below: 

    Thus, Brazil, which did not see any change in its sovereign local currency rating between January and June 2013, did see a 74% increase in its CDS spread, reflecting the political unrest of the last few weeks. Interestingly, every one of the ten countries that saw the biggest percentage increases was an emerging market, with six of the top ten countries on the list coming from Latin America. On the list of companies that saw the biggest decreases in CDS spreads, eight were developed markets with only two emerging markets (Costa Rica and Romania) making this list. If nothing else, this table indicates that in the market's view, the divergence in risk between developed and emerging markets widened over the period.

    II. Country Risk Scores
    There are some who view both sovereign ratings and CDS as too narrow in their focus of debt. A country that has little exposure to default risk can still be exposed to other types of risk. There are services that try to provide more comprehensive measures of country risk, encompassing economic, political and legal risks. Political Risk Services (PRS), for instance, provides measures of country risk on different dimensions as well as a composite measure of country risk. These scores are numerical, with higher scores indicating safer countries and lower scores signaling more risk.

    Since the PRS scores are proprietary, I cannot provide the entire list, though you can buy the list, as I did, on the PRS website for about $120. However, I did compute the percentage changes in PRS scores from January to June 2013 and discovered as with ratings agencies, that country risk scores tended to be sticky and changed relatively little. There was no change in the median PRS score between January and June 2013 and the average PRS score  median (average)  changed by only -0.19%, indicating a very mild increase in overall risk across the countries. In the table below, I highlight the ten countries that saw the biggest increases and decreases in risk based upon the PRS scores between January and June (Again, remember that a lower number indicates more risk and a higher number is less risk): 

    Almost all of the countries on both lists are emerging markets, which is to be expected since you would expect the biggest volatility in risk scores in these countries. Thus, Latin American and African countries dominate both the “increased risk” and “decreased risk” lists, with this measure.

    III. Equity Risk Measures
    While default risk measures can be used to price sovereign government bonds, it is an open question as to whether they should affect or be used in equity pricing. While there are some who argue that country risk should be diversifiable to a global equity investor, the increasing correlation across countries has made that argument difficult to defend. I believe that equity risk premiums vary across countries and that the variation is correlated with the default spreads for these countries. In fact, I posted on country risk premiums and the different approaches for estimating country equity risk premiums a year ago, when I made my mid-year update for the 2012 data.

    I use a two-step approach to estimating country risk premiums (CRP) for markets where I start with the default spread for country in question (obtained either from the sovereign rating or the sovereign CDS) and scale up that spread for the higher risk in equity markets.
    Adding this country risk premium to a mature market equity risk premium (I use the implied ERP for the US as my estimate) yields a total equity risk premium for the country:
    Equity risk premium for a country = Mature Market ERP + Country Risk Premium
    I am using my July 1, 2013 estimate of the implied equity risk premium for the S&P 500 of 5.75% as my mature market premium.

    Updating the sovereign default spreads to June 2013 and applying the relative equity risk multiple to these spreads, I get the updated equity and country risk premiums for much of the world. To get a sense of how the risks vary across the world, I created a global heat map of equity risk premiums (To be honest, even if you learn nothing from them, heat maps look cool.):


    You can download the spreadsheet that contains the equity risk premiums by country by clicking here. I have added a lookup sheet to the spreadsheet, where you can pick any of the 135 countries for which I have data and pull up sovereign ratings, CDS spreads and my estimates of risk premiums. I hope you find it useful.

    There are about 30 countries that don’t make this list because they do not have sovereign ratings or CDS spreads. If you happen to be investing in these countries, I do have a suggestion. I have a table of countries classified by PRS score into groups at this link, with an average equity risk premium by group. You can find the group that your country falls into and find another country in the same group that I have estimates of equity risk premiums and country risk premiums. To illustrate, neither North Korea nor the Democratic Republic of Congo is on my equity risk premium list, but based on their PRS scores, they are in the same group as Venezuela, which has an estimated equity risk premium of 12.50%, based on its rating. I know that this is simplistic but desperate times call for desperate measures.

    What now?
    What can we learn from the sifting of these various measures of country risk over the last six month? Overall, while investors don't seem to think that the world as a whole is riskier than it was six months ago, their perception of where the risk is coming from has changed. They believe, rightly or wrongly, that more of the risk in the future will come from emerging markets rather than developed ones. While this is a break in the trend over the last five years, when risk premiums in developed and emerging markets converged, it is a shift back towards a pre-2008 world, when the risk differences between developed and emerging markets was stark.

    As investors, there are three big questions that we face that are related to the risk shift that we are seeing globally. The first is whether the adjustment is complete or ongoing; if it is ongoing, that would imply more pain to come in emerging markets and argue for shifting money from emerging to developed markets for the near future. The second is whether the stock price adjustments that have already occurred in emerging markets are commensurate with the risk shift. If stock prices have dropped too much (little), given the risk reassessment, it would be a good (bad) time to be in emerging market stocks. That will require more than an off-the-cuff judgment and I will look at it more closely in my next post. The third is whether individual companies with global operations are being priced correctly, as country risk assessments change. In past crises where emerging markets have become more risky, global companies that are based in these markets have often seen their stock prices drop too much. I will look at this question as well in a future post.

    Country risk premium posts
    1. Rediscovering risk in emerging markets: A country risk premium update
    2. Developed versus Emerging Markets: Convergence or Divergence? 
    3. Market Multiples: Global Comparison and Analysis
    4. Global Businesses and Country Risk: Investment Challenges and Opportunities (Still to come)



    MOOCs and Books: Spanning the Digital Divide

    As those of you who have followed my blog for awhile know, I post just before the start of a new semester about my upcoming classes and ways in which you can, if you so desire, be part of the experience.  In just under a week, on September 4, I will start the fifty first iteration of my valuation class to the second year MBAs at the Stern School of Business at New York University.  I am just as excited today, as I was when I taught my first version of this class in the 1980s, and I have learned and continue to learn about valuation, each time I teach this class.

    Looking back, though, I am struck by both how little and how much technology has changed my classes over the last three decades. The place where there has been the least change is in the classroom, where, as an old fashioned lecturer, my requirements have remained constant: a podium (though I hardly ever stand behind one), a working microphone and a willing/curious audience. I still prepare for classes, exactly the way I did for my very first class, running through the lecture in my head and getting my narrative in place. The slides I use may look slightly more polished than the hand written slides I used twenty five years ago and the projectors may be brighter & sleeker, but they remain props that I can live without. It is true that I have to compete for the attention of my stiudents against more powerful distractions (as tablets, smartphones and computers stay propped open), but that is a challenge I relish (and sometimes lose).  

    So, what has technology changed? First, it has given me richer ways of explaining the nuts and bolts of number crunching to those who are interested. Last semester, I put a series of webcasts on valuation/corporate finance practice (from creating trailing 12-month financials, converting leases to debt, computing implied equity risk premiums). Second, it has allowed me to roam the world without leaving the confines of my office. Today, I used Skype Premium to give a two-hour live talk on teaching to a group of freshly minted doctoral students in Hyderbad, India, where they were able to see me (and my presentation) and interact. Third, it has allowed me to package the classroom experience and offer it to a much wider audience. This semester, as in the last few, I will be putting my valuation class online, with nothing held back. In the 26 sessions, starting September 4 and ending December 13, I will try to package and present through everything I know or have learned about valuation, while also revealing to you the great deal that I have left to learn. The class is meant for second year MBAs but if you have the basics of accounting, like working in the numbers and are willing to put in the time, you should not find it too steep a climb. If you so desire, you can watch every lecture, review every slide, do every exam/project and even read every email I send the class. There are three forums you can use:

    My site: http://people.stern.nyu.edu/adamodar/New_Home_Page/webcasteqfall13.htm 
    Entry requirements: None. There should be no password required to watch the webcasts or download material. 
    Description: If you have a computer and a decent broadband connection, you can use the link above to access all of the resources that my regular class has access to. The slides are posted at the top of the page (and are downloadable) and the sessions will be posted sequentially as I teach them. You can watch them in one of three ways:
    1. If you don't want large video files (125-200 MB) inhabiting your computer, you can stream them from the NYU server. (Warning: The files are big and can hang up, if your connection is slow).
    2. If you don't mind downloading the files on to your computer, you can download the video file (usually in mp3 format) and watch it either in your browser or later on your media player of choice. 
    3. If you prefer just an audio file, you can download the lecture in just audio format and then use the slides that you have downloaded to supplement the lectures.
    With each session, I will list (and you can download) the slides that I used for the session, the pre-class test that I usually start each session with and a post-class test that you can take, if you want to see if you "get" the material from the session.

    Lore: http://lore.com
    Entry requirements: Once on the site, click on Join your course, and enter the code DMR44Z. It will let you audit the class.
    Description: Lore is an online education company that I have used for more than two years now which marshals what is on my website into more bite-sized and organized pieces. As with the website, you will be able to watch the lectures through Lore and download the slides. One advantage that Lore has is that is has a discussion board where you can can post questions (or answer them) and articles/news for discussion.


    iTunes U: https://itunesu.itunes.apple.com/audit/COJN7B8T55 (Link works only from Apple device, not computer).
    Entry requirements: An Apple iPad or iPhone with the iTunes U app (free) installed, An Android tablet/phone with the Tunesviewer app (free). First, download the iTunes U app on to your device. Then, click on the link above from your device. Alternative, click on Catalog, and then click on the ENROLL button at the bottom of the Catalog page and enter J7R-DK5-BM3 when prompted.
    Description: This is the latest addition to my online choices and it has the smoothest interface. The lectures open up on your iPad and the lecture notes and tests can be viewed on the device as well. The best (and worst) feature of the iTunes U version is that it sends you a notification when something is added to the class; this can of course be irritating and you can turn it off.

    I know that some of you are wondering why I am not using Udacity, Coursera or EdX to put my lectures online, but there are two impediments. The first is that will require agreement at the university level, which I cannot (and have no desire to) force. The second is that these entities have their own long term interests to think about (which I respect) but those interests may not be congruent with yours and mine.

    I know that some of you have started on my class, in earlier semesters, with the intent of finishing but life has got in the way. If you feel up to it, give it another shot and see if you can get a little further this time. Remember also that while the classes will be posted as they occur, the webcasts and material will stay online for a year and you can catch up over time. In fact, for those of you who prefer to see the complete packaged version of the entire class, my classes on corporate finance and valuation from the spring are on iTunes U as well in archived form:
    Archived Corporate Finance class (Spring 2013)
    Archived Valuation class (Spring 2013)

    In my other avatar, I like writing about what I teach, and just as technology is delivering change (often disruptive) to the education business, it is starting to make itself felt in the publishing business. A few months ago, I finished my second edition of one of my books on investments (Investment Philosophies) and as I readied the e-Book version, I realized how little I was using the power of technology, since the eBook was nothing more than the onscreen version of my physical book. Consequently, my publisher (John Wiley & Sons), Symynd (a company that carried my valuation class online last semester) and I got together a few months ago on new project, where we tried to expand the digital reach for the book by combining it with the key aspects of an online class. Since I have always wanted to teach the investment philosophies class (and have never had a chance to do so), I was on board, and created 38 webcasts (about 15 minutes apiece), tied to chapters in the book. The bundled product, containing the book, webcasts, slides and post-class exercises, is now available on Symynd's website. The book/course costs $75, but you can get it for $45 until September 16, 2013, if you enter the promo code PROMO75.  Since the book alone costs about the same, you can think of the course as being icing on the cake for free. In the next few months, Symynd/Wiley/I are planning to do the same with my applied corporate finance and valuation books. If you are budget constrained and are unable to spend the $45, I have created both an online version and an iTunes U course around the webcasts, slides and exercises. It is not as polished as the Wiley/Symynd version and it does not come with the book, but it does provide the essence of the class.

    I consider myself lucky to be in two businesses, education and publishing, that are in the midst of disruptive change. For those in both businesses who are defenders of the status quo, the change that is coming will threaten many long standing (and indefensible) privileges including tenure, bundling and lack of accountability. For the rest of the world, though, who have have had to shell out outlandish amounts of money as college tuition and to pay absurd sums for "new" editions of college text books, I hope that the change delivers much needed good news (and power).



    Rebirth and Reincarnation: Escaping the corporate death spiral


    The Chinese saying (  = you are born, get old, get sick and die) that I quoted in my last post may be realistic, but it is not exactly an uplifting calling for life and it is no wonder that you look for an escape from its strictures. One option that almost every religion offers is the possibility of an afterlife, cleverly tied to how closely you follow that religon's edicts. For corporations approaching the end stages of their life cycle, this option is a non-starter, since there is no corporate heaven (unless you count starring in a Harvard case study or in a TV show as heavenly) or hell (though bankruptcy court comes awfully close). The other option is the possibility of a rebirth or reincarnation, in a different life, if you are Shirley Maclaine, or in the same life, if you manage to redefine yourself. After all, we are uplifted by stories of people who having experienced that rebirth; athletes who transition to successful business people (Magic Johnson) or actors who become presidents (Ronald Reagan). On this count, corporations have an advantage over individuals since they are legal entities that can reinvent themselves, while holding on to their corporate identities. 

    Looking back at history, there are companies that have beaten the odds of the business life cycle, fought off decline, and been reborn as successful ventures. Two examples that were noted in the comments section of the last post come to mind: IBM’s fall from glory in the 1980s and its subsequent rebirth as a vibrant corporation and Apple’s climb back from the dark days of 1997 to the top of the market capitalization table in 2012. As we think of these and other examples (and they are the favorites for obvious reasons for case study writers), it is worth noting that the very fact that we can name these companies suggests that they are the exceptions rather than the rule. Notwithstanding that sobering reality, it is still useful to put these success stories under the microscope, not only to get an understanding of what allowed these companies to succeed, but also to develop forward-looking criteria that we may be able to use in investing. 

    At the outset, I have to admit my trepidation about this exercise. First, I am not a corporate historian or strategist and I am sure that there is much that I am glossing over as I make my list of “rebirth” criteria. Second, I am always wary of drawing big lessons from anecdotal evidence, recognizing how easy it is to reach the wrong conclusions. Nevertheless, here are the common factors that I see in these success stories: 
    1. Acceptance that the old ways don’t work any more: To have a corporate rebirth, a company still has to get through the three step reaction to corporate aging that I noted in my last post and come to an acceptance that the old ways, successful though they might have been in the past, don’t work any more. That acceptance, as I noted, does not come easily or quickly and the longer and more hoary the history of the company, the longer it takes. Thus, while there are many younger investors whose experience with IBM has generally been positive, I remember the late 1980s when a series of CEOs at the company raised denial to an art form and almost pushed the company into irrelevance. Acceptance also requires more than lip service to change and has to be backed up by actions that indicate that the company is indeed willing to jettison big portions of its past.
    2. A Change Agent: This may be a cliché but change has to start at the top. In fact, change at IBM really began when Lou Gerstner became CEO of the company in 1993. At Apple, the change agent was obviously Steve Jobs, a man who had been banished from Apple for his lack of focus a decade prior, but returned as CEO in 1997. It would be simplistic to say that the change agent always has to come from outside the company, because there have been companies where insiders who have spent a lifetime in the company have been willing to shake it up. (Bob Goiuzeta at Coca Cola and Jack Welch at GE were company men who still revolutionized their companies.) I think it is safe to say, though, that change agents are usually not shrinking violets and that they are ready to shake up the status quo. 
    3. A Plan for Change: Pointing out that the existing ways don’t work any more is important but it is futile unless accompanied by a new mission and focus. At IBM, Gerstner changed the mindset of the company (and its employees) early in his tenure, an incredible accomplishment given how deeply entrenched it was in the existing ways. Coming from RJR Nabisco, he brought both a customer-focus and a willingness to let go of IBM’s past mistakes (Anyone remember OS/2?) and this allowed him to create the modern IBM. Steve Jobs shocked Apple employees by entering into a détente with Microsoft, where in return for $150 million in cash and a promise by Microsoft that it would continue producing Office for the Mac, he essentially gave Microsoft a free legal pass to borrow from the Mac OS in updating Windows. He used the breathing room that this agreement gave him to redefine Apple as an entertainment rather than a computer company and the rest as they say is history.
    4. Luck: Much as we would like to attribute success to great skill and failure to poor management, it remains true that the X factor in business success is luck. Gerstner was lucky that he made his changes at IBM in the 1990s, a decade of not only robust overall economic growth but especially so for technology companies. Steve Jobs was helped by the ineptitude of his competition, so blinded by their investment in the status quo (music companies to selling us music on CDs and cell phone companies thinking of cell phones as extensions of landline phones) that they either did not react or reacted too slowly to Apple's innovations.
    I am sure that this is not a comprehensive list and that I have missed a few items but I want the list to be tractable because I intend to use it in my investment analysis. Companies that have been value traps can become great investments, if they can find a path to rebirth; an investor who bought IBM shares in 1993 or Apple shares in 1997 would have profited immensely from their reincarnations. So, as an investment exercise, you could prepare a list of the companies where stock prices have stagnated for long periods and check to see which of them have the ingredients in place for rebirth: an acceptance that the old ways don’t work (with tangible evidence in investment, financing and dividend decisions to back it up) and a change agent (new management), a new focus (with actions to back it up). The last factor, luck, is immune from assessment but you can consult your astrological signs or read the tea leaves, if it helps to make the right choices.

    Putting this approach to use on Microsoft, Cisco and Merck, let's look at whether these companies have the ingredients for rebirth (and thus not be the value traps that I made them out to be). In the table below, I have listed the three ingredients (leaving out luck) and how each of the companies measures up on each ingredient.



    Microsoft
    Cisco
    Merck
    Acceptance
    Not sure. The company still believes that it can produce hardware (smart phones, tablets), using the same strategy that worked for it on software (overload the product with features and overwhelm the opposition).
    This is a company that had incredible success in the 1990s with its strategy of buying small technology companies and converting them into commercial successes. That strategy failed over most of the last decade. The company seems to be suggesting that it will scale back in the future, but while it has announced layoffs, its acquisition pace has not slackened.
    Merck has been a mature pharmaceutical company for two decades but its R&D policies suggest that it sees itself differently. While there are noises coming from the company that are good (increased buyback, accountability in R&D), the company has been slow to adapt.
    Change Agent
    Steve Ballmer is leaving and a new CEO is coming in. That is the good news.  The bad news is that this new CEO is being picked by the same board of directors at Microsoft that seems convinced that nothing is wrong with the company.
    The CEO who built this company up in the late 1990s was John Chambers. The CEO who made bad acquisitions during the last decade was also John Chambers. The CEO of the company that claims to have seen the error of its ways is once again John Chambers. Unless he has multiple personalities, I don't see how he can pull this off.
    Who is Merck’s CEO? This may just be ignorance on my part but I had to look it up: it is Ken Frazier, who has worked at Merck since 1992.  I compliment the gentleman for keeping a low profile but change agents are not sell-effacing characters.
    Focus/Plan
    None that I can see (yet). The acquisition of Nokia suggests that Microsoft is going to keep trying to go after the smartphone business. Even if it succeeds, that strikes me as more opportunistic and 'me too" than visionary.
    The company has told us it will not go for growth for the sake of growth, but it continues to do large acquisitions
    The evidence suggests that Merck is slowly coming to an acceptance that its historic model is running out of steam (stock buyback, talk about cutting R&D) but there is little sense of what is going to replace the existing model.
    Rebirth Assessment
    Change in CEO provides hope, at least for the moment.
    Actions speak louder than words. If Cisco can go a year without major acquisition & a new focus emerges, chances improve.
    Looks like the best case scenario is that it is heading to the equivalent of corporate “senior” living.
    Of the three companies, I would argue that Microsoft offers the most in terms of possibilities simply because it is getting a new CEO, Cisco is talking the talk (of changing) but is not walking the walk and Merck seems to be stuck in a rut. You are welcome to disagree with me on my conclusions but even if you do, there is no reason why you cannot use the framework to make your own judgments. 

    Speaking of Apple, I am sure that there are many frustrated stockholders who are wondering whether the company is ready for another rebirth. Much as I like the company as an investment (and I value it at $600), I don't see the ingredients in place yet. While the company has capitulated on the financial front (agreeing to borrow money & buy back more stock) it still seems to be caught in the smartphone rat race with no end in sight. Tim Cook has shown his operating acumen but he does not strike me as a change agent and I am still unsure about his vision for the company. Maybe that will all change in the next few months, but I am not holding my breath!



    Decline and Denial: Thoughts on Blackberry Endgame and Microsoft as Value Trap

    The last few days have been filled with reminders for me of both the destructive and the redemptive powers of life. The weekend started with a family outing to a Yankee game. As a fan, it was wrenching to see Mariano Rivera and Andy Petite, two players who I have watched for almost two decades, pitch for the final time in Yankee stadium, but it was redeemed at least partially by a young Yankee pitcher, Ivan Nova, pitching a complete game on Saturday. Yesterday was my birthday, a joyous day marred only by the realization that putting as many candles on the cake as my age merited would likely set off fire alarms. Before I could feel sorry for myself, though, my eighteen-year old daughter, a freshman in college, called, exhilarated about getting a hundred on her first college exam. Towards the end of the day, the story that Blackberry had an offer to be taken private by Fairfax Financial for $4.7 billion crossed the newswires, an occasion for mourning not just by longtime Blackberry users but for anyone who appreciates life changing technologies, but that story was accompanied by one from Apple, announcing that the company had sold nine million iPhones over the weekend. 


    A Life Cycle view of Business
    A Chinese saying, that we are all born, grow old, get sick and the die (, , , ), which provides an unvarnished assessment of the cycle of human life, can be extended to businesses as well. Businesses too are born, grow with vigor, mature, decline and die; some, of course, die early and never see growth and some live longer, more productive lives. If the fundamentals of corporate finance can be boiled down to a investment choices of a business (the investment decision), how those choices are financed (the financing decision) and how and when cash is returned to the owners of businesses (the dividend decision), those decisions can be framed in terms of the business life cycle:


    The business life cycle also shapes how we approach valuation, with the principles not changing, but the focus shifting at each stage of the cycle. When valuing young, growth companies, the drivers of value are almost invariably in the investment choices that the company makes and the effects of those choices on both growth and profitability. Thus, with Tesla and Facebook, it is the revenue growth and target operating margins that determine value and not how much debt they have in their capital structure or how much they pay in dividends. When valuing mature companies, the focus in valuation changes to valuing existing assets (and their earning power) and to the effects on value of better financing and dividend choices. Thus, for Apple, as much of the discussion of value is focused on whether the company will gain from its use of debt and buying back stock as it is on the future growth of the company. When valuing declining companies, the focus is on winding down portions of existing businesses, while repaying debt due and returning as much cash as possible, in a timely fashion, to stockholders. In my December 2011 post on Blackberry, I estimated a value of about $ 9 billion for the company, on the assumption that the best course for the firm was to narrow its focus to a niche product (I called it the Blackberry Boring, a phone for security-conscious corporates that would prevent games, apps or other distractions from getting in the way of employees checking their email) and liquidate itself over time (five years) in an orderly fashion. I followed up by looking at Blackberry (RIM) and Nokia as potential contrarian plays in June 2012, but luckily, I went with Nokia as my pick. That option play paid off partially because Nokia recovered from its lows but the big payoff came, ironically, when Microsoft bought them early this month.

    Reactions to Decline: Anger, Denial and Acceptance
    If aging is part of being human, it is just as human to fight aging and businesses seem to follow the same script. Rather than accept maturation and decline as inevitable parts of the business life cycle, businesses seem to go through their version of the stages of grief, starting with anger (at markets), denial (about being mature or in decline) and final acceptance. 

    Stage 1: Anger
    When growth companies transition to becoming mature companies, the market responds by lowering the multiples that they are willing to pay for earnings and some investors demand that the company behave like a mature company, borrowing more and returning more cash to its stockholders (in dividends and buybacks). In many of these companies, managers respond first by accusing markets (and by extension, their own investors) of being short term and ignorant of the facts. While that characterization may fit some (or even many) investors, it still remains true that markets are often more perceptive than managers are. 

    Stage 2: Denial
    Managers, angry at investors for treating their companies as mature or declining, make it their mission to prove the world wrong by going for more growth, and in the process, often do further damage to themselves and their investors. The impetus to fight maturation and decline is fed by four factors:
    1. The emotional connection: In the midst of the Second World War, when it was clear that Britain could no longer hold on to its far flung colonies, Winston Churchill was quoted as saying that "I have not become the King's First Minister in order to preside over the liquidation of the British Empire." Many managers at iconic companies that have fallen into decline tend to go along with this sentiment, especially if (like Churchill) they were involved in building up the companies in the first place. That explains why a Michael Dell would leave a comfortable retirement in 2007 to return to his namesake company as CEO, in a futile attempt to turn the company around. 
    2. Fountain of youth ecosystem: Just as there is a lucrative ecosystem that makes money of the desire to stay young (cosmetic surgery, magic supplements, hair transplants etc.), there is an even more lucrative ecosystem of bankers, consultants and turnaround experts who promise mature and declining companies that they will lead them back to everlasting growth. They play to management egos and offer them hope, while eating through billions of dollars of stockholder money, with little to show for it.
    3. Analyst Growth Obsession: Many equity research analysts are obsessed with earnings growth, judging companies on how much they grow rather than on how much value that growth adds. Thus, a declining company that invests badly to grow at a low rate is viewed as better than a declining company that shrinks, while paying out large dividends. Not surprisingly, managers feel the need to feed this obsession for growth.
    4. The PR problem: If your business is declining and your growth prospects don't look good, the right thing for you to do as a top management is to accept that reality, convey it to your employees and start shrinking the business. However, that is not painless and people will lose jobs, employees will see their paychecks shrink and customers will lose their favorite products. If you are in the public eye, you (as the CEO) will be labeled a Scrooge or worse. It is no wonder, therefore, that companies that are serious about facing up to decline prefer to do so as private businesses rather than as public companies.
    While denial is understandable, it is also costly to investors. As I have noted in a prior post, growth can be value destructive, if it is expensive. In fact, to illustrate the effects of “value destroying” growth, I have taken a base case of a mature company, with no growth prospects and $100 million in after-tax earnings that pays out its entire earnings as cash flows. If you attach a cost of capital of 10% for this company, its value is $ 1 billion (=$100 million/.10). Now assume that the managers of this company decide to push for growth, though that growth requires them to invest immense amounts of capital (in acquisitions, R&D and new projects) with a return on capital of 5%. In the figure below, I have the value of the company at different growth rates. 

    You can consider the difference between $1 billion and the estimated value of a company at any given growth rate to be the cost of denial to investors in the company. Thus, at a 5% expected growth rate, the value of the company is $792.47 million and the cost of denial by managers (and for stockholders) is $207.53 million. (You can play with the spreadsheet by clicking here).

    This analysis should open investors eyes to a clear and an ever-present danger when investing in mature and declining companies that look cheap (on a value basis or even based on a PE or PBV ratio). Those companies are cheap, only if their managers don’t try too hard. In fact, the more activity there is on the part of management to "fix" the growth problem, the less cheap the companies become. To me, this is the key to understanding “value traps”, companies that look cheap on every metric but stay cheap forever. To offer you three examples, consider Cisco, Microsoft and Merck’s stock prices over the last decade:

    These are companies that I have seen tagged as cheap companies repeatedly over the last ten years, but none of them would have delivered much in terms of returns. These three companies had management teams that have tried  hard to return them to growth status, spending billions of dollars in that venture: Merck in R&D, Cisco on acquisitions and Microsoft on “new” products. I know that I have the benefit of hindsight here, but I would wager that investors in these companies would have been better served, if they had lowered their sights on growth and focused on delivering the most earnings from existing investments and returning the cash back to stockholders. 

    I decided to take a shot at valuing Microsoft by breaking it down into the value of assets in place (Microsoft Office and Windows, for the most part) and expected value of growth. In the fiscal year ended June 30, 2013, Microsoft reported $26,764 million in pre-tax operating income on revenues of $77,849 million; revenues increased by 5.60% over the previous year but operating income was down 4.26%. Using the company's effective tax rate of 19.2% for the year and attaching a cost of capital of 8% to the company (in the 60th percentile of US companies), you can value Microsoft assuming no growth in the future:
    Value of assets in place (with no growth, no reinvestment) = $26,764 (1-.192)/ .08 = $270,316 million
    Adding their cash balance of $ $77,022 million on June 30 to this value and subtracting out the debt outstanding of $15,600 million yields an estimated value of equity of $331,738 million, about $61,198 million higher than the market cap of $270,540 million. Put briefly, assuming no growth in earnings, Microsoft is worth about 22% more than its market capitalization. You can take give the spreadsheet a try, if you are so inclined. (I know that I may be overstating the value of assets in place by assuming that Office and Windows will generate earnings in perpetuity, but using a fifteen-year annuity yields a value close to the market price.)

    It is no wonder then that Microsoft keeps looking cheap using all the standard metrics (PE, EV/EBITDA etc,) but there may be a core problem that we are ignoring. For most of the last twenty years, Microsoft has spent billions on new technologies and products and has little to show for it. While it is difficult to isolate the return on capital on just these new investments, it is quite clear that it has been less than the cost of capital. I think I am being generous to Microsoft in assuming that its'  new ventures have earned an average return on capital of 6%, but with that assumption, it is quite clear that if Microsoft continues to keep trying for growth, it will be value destructive, as shown in the figure below:

    The intrinsic value of Microsoft drops with every increment in growth and at a growth rate of 7% for the next decade, the intrinsic value converges on the actual market price. This may explain the horrific reaction that the market had to Microsoft's announcement that it would acquire Nokia for $7.2 billion, and Microsoft's market capitalization dropped by more than $15 billion. It may not have been the acquisition per se that triggered the drop off but the signal that it sent to investors that Microsoft with its new CEO (from Nokia) would keep trying to grow. The best news, if you buy int this analysis and you are a Microsoft investor, would be an announcement by the firm that they are disbanding their R&D department, stopping all new product development and appointing Larry the Liquidator as their new CEO.

    Stage 3: Acceptance
    Ultimately, no matter how hard you fight aging, reality sets in. For individuals fighting middle age, the moment of awakening may be a torn muscle from trying to run a fast break on a basketball court, but for businesses, it may take a longer time. In some cases, it may require pressure from activist investors and in some, a new top management who has no emotional connection to the company's history. In some, though, it will be forced upon the business by external factors, difficulty making a debt payment or an inability to retain employees. 

    What form will acceptance take? If the business is mature, it will start behaving like a mature firm, tilting its capital structure towards more debt and increasing cash returned to investors. For many followers of Apple, that capitulation seemed to happen in their March earnings report, where the company ratcheted down its forecasted growth, announced its first debt issue and increased its stock buybacks. 

    If the business is in decline, it may be the acceptance that the future will not only be less rosy than the past but also a plan for gradual or partial liquidation. That, to me, seems to be the message in the proposed Blackberry deal. Fairfax Financial is the largest stockholder in Blackberry and its chief executive, Prem Watsa, has been labeled the “Canadian Buffett”. His plans seem to be to focus on Blackberry’s business services and to throw in the towel on the smartphone and tablet businesses. Will he succeed? I hope so but I think he has his work cut out for him. The company has done significant damage to its orderly liquidation prospects in the two years since my last valuation and it may be too late to turn this ship around.

    It's really not too bad
    On a personal note, I am older today than I was yesterday but given the alternative, I am okay with that. I really don't want to be eighteen, twenty three or twenty five again, not because those were not great years, but so was my most recent year. I could tell you that I know more today than I did three decades ago, but that is really not true, but I do know more about what I don't know today than I did three decades ago (if that makes any sense). Keeping with the theme of this post, I know that my Tesla/Facebook days are way in my past (I am not sure that I had them), that my Google days are in my rearview mirror, that I am probably in the Apple days of my existence (which is really not too bad) and that I will one day be in my Blackberry/Microsoft phase of life. I can only pray that when that phase arrives,  I will have the grace to do an orderly winding down of my activities and not keep reaching back in time for the glory of bygone days. In the meantime, I will get my revenge on time by using it as productively as I can.




    Twitter announces IPO: The Pricing Game begins

    I have a Facebook account, but I almost never post. I also have a Linkedin account, but it is a not premium, largely because I am not that interested in finding out who is looking at my profile or endorsing me (often for skills I don't have). I do have a Twitter account and while I don’t post very often, I just like the ease with which it lets me bug thousands of people. All of this is of course a lead in to the story that I am sure will dominate the financial news for the next few weeks: Twitter is planning its initial public offering and everyone has an opinion on what it will be priced at.

    While I will try to value Twitter when the time is right, I am going to use this post to price Twitter, not value it, for three reasons. First, Twitter’s financial statements are still inaccessible, a consequence of the JOBS Act (passed last year) that allows “emerging companies” (with revenues < $1 billion) to use a confidential process for filing with the SEC. Unlike some who are worked up about the resulting lack of transparency, I am not in high dudgeon about this non-disclosure. The company will have to provide a full prospectus a few weeks before the shares are priced (and offered) and there will be plenty of time for me to do my due diligence. Second, the lead investment bank (Goldman Sachs) will be pricing the company for the offering, not valuing it, and I want to use this post to take a look at that process. Third, if you choose to play this IPO game, to win, you have to be able to play the pricing game well, not get the value right. 

    The tools/inputs of Pricing
    To value a business, you start with raw data from a company’s financial statements, draw on measures of risk and operating efficiency for the business in which it operates, make estimates for the future and use a valuation model (with my preference being for a discounted cash flow (DCF) model). To price a company, you draw on a different set of inputs and tools, with the following standing out:
    1. Current price: This may sound circular but the key input into the pricing process is the current price of the asset. After all, in pricing, you are accepting the market’s judgment of price as the only number that ultimately matters. With publicly traded companies, this dependence on the price takes the form of charts and technical indicators, which can then be mined for clues about future price movements.  Looking at a still private company like Twitter, this approach may seem like a non-starter, since it has no public market, but there have been transactions in the past that provide clues about its price. Some of these transactions involve venture capital investments, where you can extrapolate from the investment and the share of the company received by the venture capitalist to the overall price of the company is. Others involve private sales by one investor to another, where again the transaction price provides clues as to the the overall price. The following graph, drawn mostly from a Wall Street Journal news story on the company, imputes prices for Twitter based upon trades over the last few years on the company’s equity.

    Note that the imputed price of equity in Twitter was $100 million in 2008 and that the price has surged over the last three years, rising from $ 1 billion in late 2009 to $ 9 billion early this year and $10.5 billion a week ago. Much of the surge occurred in the latter half of 2011, after Linkedin went public to a rapturous market response in May of that year.

    Is it okay to extrapolate from isolated transactions to overall price? Yes and no. There is information in the transactions but the price estimate can be skewed by three factors. The first is that the transactions may not be at arms length, resulting in a price that has less to do with what the transactors think the business is worth to them and more to do with side objectives (control, taxes). The second is that even in an arms length transaction, the value that you impute may not be reflective of the fair price for a publicly traded company but may reflect instead the pricing of a private, illiquid business (which is lower). The third is unless the most recent transactions occurred very recently, the price you get is stale and will have to get updated to reflect both market and sector developments. With Twitter, none of these concerns rise to a serious level: the venture capital transactions are motivated by profit, the company has been priced as company that will go public for the last two or three years and there are at least two recent transactions from this year. The first reflects the sale of 15% of the company to Blackrock, with an imputed price of $9 billion for the company. That transaction was in January 2013 and both the market and social media companies have risen in price, since then; the S&P 500 is up 20%  since January and Facebook & Linkedin, the two social media companies that are viewed as closest to Twitter, have gone up even more over the same time period (Linkedin has doubled and Facebook has gone up about 67%). Applying even the market change (20%) to Twitter would yield a value of $10.8 billion, and applying the social media appreciation number would increase that value to $16-$18 billion.  In September 2013, just a few days ago, Twitter bought MoPub, a mobile advertising exchange, and issued stock to cover the transaction cost. Imputing the value of Twitter from the share issue leads to an imputed price for Twitter estimate of at least $10.5 billion. Thus, just based on these two private transactions, the price of Twitter should be at least $10.5 billion and perhaps a bit more.


    2. Relative value: The other commonly used tool in pricing is relative value, where you set the price for an asset by looking at the prices at which comparable companies are traded at in the market. The process of applying this approach to price a company like Twitter can be complicated by two factors. 
    a. Scaling variable: Since the units into which you divide value (number of shares) is by its nature arbitrary, you need to scale the price to a common variable. That, of course, is the role of a multiple, whether it be PE, Price to Book or EV/Sales. In the context of young, growth companies, where earnings and cash flows are often negative and book value is meaningless, analysts either focus on revenues, and/or scale the price to some measure of operating success (users, subscribers etc). With Twitter,  a revenue multiple can be utilized to estimate value, even if its financial statements report a net loss or EBITDA for the year. The table below provides the multiples estimated in September 2013 for Facebook and Linkedin in the first two rows, as well as a broader sample of firms that loosely derive their revenues from online services (though some like Netflix are subscription based and some like Pandora get a mix of advertising and subscription based revenue):

    All the normal caveats apply. The accounting numbers reflect trailing 12 month estimates, but in companies like these, these numbers will change dramatically from period to periods, as will the number of users and employees. The number of users disguises wide differences among them, with heavy, mild and completely idle users aggregated together and sometimes double or triple counted. The value per users will be skewed by differences in business models, with companies like Netflix that have subscription based revenues registering much higher values.

    Even with the very limited public numbers that you have for  Twitter, you can start estimating prices, using these multiples. For instance, if the news stories that peg Twitter's most recent twelve-month revenues at $583 million are right, you could apply the revenue multiple of 17.45, that its two closest competitors ($FB & $LNKD) trade at, to arrive at a value of $10.17 billion, fairly close to the most recent transaction price. (Twitter's cash balance would have to be added to this number to get to a market capitalization.) 
    Twitter's estimated enterprise value = $583 * 17.45 = $10.17 billion
    Before you get too excited about this convergence, recognize that applying the median EV/Sales ratio of 8.67 for the social media medley to Twitter's revenues yields a value of $5.05 billion, making the $10 billion plus numbers being bandied about look awfully high. 
    Twitter's estimated enterprise value = $583 * 8.67 = $5.05 billion
    Just to round out the estimates, you could always apply the multiple of $130.32/user that investors are paying collectively for Linkedin and Facebook to Twitter's 240 million users (I have seen wildly varying estimates of this number with some estimates ranging up to 500 million) yields a price of close to $25 billion.  
    Twitter's estimated market capitalization = $130.32 * 240 = $24.4 billion
    I have estimated a range of prices for Twitter based upon the different combinations (multiple, choice of comparable firms, averaging approach):

    Which one of these is the right price? That depends on what your priors are about Twitter and perhaps what you are trying to convince me to do. If you believe that it is a great company that will also be a great investment, you will go with the combinations that yield the higher number. If you are convinced that this is the next bubble that will burst, you will use the lowest values to justify selling short or warning people away from the company. It is no wonder that equity salespeople latch on to this approach. All you have to do is find the right mix of multiple and comparable firms and you can back up any sales pitch (that the company is cheap, expensive or correctly priced) you want to make about any company. If you are on the other side of this sales pitch, it has be caveat emptor.

    b. Current versus Forward Numbers: To the extent that your multiples are skewed or meaningless because current values for earnings, book value and capital expenditures are small and meaningless (in terms of forecasting future values), you can try to forecast the values for each of these items and apply a multiple (based usually on what other publicly traded companies are trading for today) to get the estimated value in the future. Getting from that future value to value today can be dicey, as I illustrated in my last post on Tesla, as risk, time value and dilution all eat into the terminal value. It is also worth noting that while this may be easy to do for a young growth company in a sector where most of the competitors are mature, it will be difficult to do with Twitter, where the lead competitors, Facebook and Linkedin, are also in high growth and will change over time.

    The Drivers of Price
    Just as the tools and drivers of pricing are different from those of value, the drivers of price vary from the drivers of value. Thus, while value is determined by cash flow, growth potential and risk, price is determined by a different set of variables:
    1. Momentum/Mood: Much as intrinsic value investors tend to disdain momentum, it remains true that momentum is one of the most powerful forces driving returns with stocks. Studies indicate that over shorter time periods, momentum based investing often delivers much better results than fundamental based investing. For some stocks, especially those in "hot' sectors, momentum is the key driver of prices, drowning out news about the fundamentals.
    2. Incremental news: Once you accept the pricing proposition that the market price is what it is, the key to winning at the pricing game becomes forecasting changes in price rather than assessing whether the current price is right. As a consequence, your focus on news stories will become incremental and each news story will be assessed in terms of how it will change the price, rather than how it will affect overall value. 
    3. Liquidity: If you invest based on long term value, you can afford to put liquidity on the back burner for two reasons. First, the cost of illiquidity (higher transactions costs) can be spread over your long holding period, reducing its impact on your returns. Second, since you are not investing on momentum and not as dependent on timely trades for your profits, you can afford to wait to buy or sell, rather than have to do so in the middle of market chaos. If you are trying to make money on pricing, liquidity or the lack of it can not only make the difference between making and losing money, but in extreme cases, can lead to disaster (especially if you have a pricing strategy accompanied with high high leverage). 
    The Dangers of Pricing
    The pricing game can generate large profits in short periods but it comes with a warning label. It is not for the faint hearted, since it is accompanied by risk. The market can make mistakes in the aggregate:
    1. Markets can be wrong in the aggregate: I know that active investors view those who believe that markets are efficient (I don’t…) as eggheads or worse. It is worth noting, though, that many of these same active investors are “pricers”, who pick stocks based upon multiples and comparable firms. In effect, they are assuming that markets are right in the aggregate, but make mistakes on individual companies, which would make them semi-believers in market efficiency. If markets are wrong in the aggregate, you can be right in your relative assessment (that a stock looks cheap relative to its competitors) and still lose large amounts (if they are all over priced).
    2. Mood shifts (inflection points): To the extent that price is driven by momentum and mood, shifts in that mood can very quickly turn profits to losses. The key to winning at the game therefore becomes detecting inflection points (where positive momentum turns to negative momentum) and altering your investment strategy. This is the promise of charting and technical analysis, where price and volume patterns yield clues about future momentum shifts. Even the best indicators, though, often fail at this task. It is also worth noting that momentum is fragile and based partly on illusions. If bankers show contempt for the process and its players (as I think Facebook and its bankers did at the time of their IPO), the momentum may very well shift.
    3. Taxes and transactions costs: As a general proposition, playing the pricing game requires you to have a shorter time horizon and to trade without regard to tax consequences. Thus, if you buy a momentum stock and profit over the ten months that you hold it but you detect a shift in momentum, you will sell the stock and take your profits, even though you face a much tax bill as a US investor (if you had held for a year, you could have qualified for capital gains). 
    4. Implied assumptions: Many analysts and investors who use multiples justify that usage by arguing that intrinsic valuation require too many assumptions and that pricing/relative valuation does not. I would argue that any multiple has embedded in the same assumptions but that they are more implicit than explicit. Take Twitter, where the key assumptions are about how much revenues will have to grow and what the target operating margins will be on these revenues. In the table below, I have estimated the multiple of revenues that you would be willing to pay for any company, given how your expect revenues to change over the next ten years and the operating margin in year 10. For simplicity, I have left the risk (cost of capital) and quality of growth (reinvestment) unchanged. (My hypothetical company had a cost of capital of 12% to start, moving towards an 8% cost of capital in perpetuity and a return on capital in 12% after year 10.)

    This table can be used in two ways. If you believe, for instance, that Twitter's revenues will increase ten-fold (from $538 million to $5.38 billion) over the next decade and that its target margin will approach 30%, you would be willing to pay 12.71 times Twitter's current revenues for the company (12.71*583 = $7,409 million). Conversely, if you are intend to pay 20 times current revenues (about $11.6 billion) for Twitter, you would need revenues to increase fifteen-fold over the next decade and margins to converge to about 32% in year 10. (I will update this table when Twitter's financial statements come out.)

    A Cynical View of the Twitter IPO Pricing Game
    If you decide to play the pricing game, you will have lots of company. In fact, I would argue that much of what passes for valuation in investing is pricing. In an IPO, in particular, how a company is priced for a public offering and what happens in the after market, at least in the months following the offering has more to do with pricing than value.

    So, here is my take on what will happen. Goldman Sachs will start with the latest transaction value for Twitter, approximately $10.5 billion, and adjust it up for the improvement in both the overall market and in social media companies (especially Facebook) since the start of the year. They will then create a sales pitch for that value, using the pricing of other social media companies (Facebook and Linkedin, in particular) to argue that Twitter is a bargain at their estimated price. (My guess is that they will focus on the number of users and how Twitter looks like a bargain on that basis.) That sales pitch will be tried out on institutional investors for effect, with the salespersons’ ears especially attuned to either too much enthusiasm from these investors (a sign that the price was set too low) or to little (a signal that it is et too high). The institutional investors, not having a clue about the fair value of Twitter, will talk to each other and ratchet up or down their own enthusiasm based upon what they sense in their compatriots. The investment bank, having tweaked the price based on investor reactions will then do a discounted cash flow valuation, reverse engineered to deliver that price as the final value. (A good test of their valuation skills will be in how well they hide this reverse engineering to make it look like the valuation led to the pricing rather than the other way around). Finally, having learned from the Facebook fiasco that it is better to under price rather than over, they will knock off about 15% off their estimated price/value to set the offering price. At the risk of being hopelessly wrong in hindsight, I would be very surprised if I saw Twitter priced lower than $10 billion or higher than $15 billion, unless there is a major market disturbance. (As a point estimate, I would guess that it will be priced around $12 billion. In fact, let's start a shared Google spreadsheet of our price guesses. They are based on nothing more than rumor and minimal information, but why let that stop us?)

    Am I being cynical? Perhaps, but I think we would all be better served if the process was stripped off its veneer of value. If we honestly faced up to the reality that this is an exercise in pricing and not valuation, the bankers can dispense with their quasi DCF models that they have no belief in, focus on pricing the stock and recognize that they will be judged on their pricing and deal making skills, not their valuation expertise. The issuing companies will recognize that their role in the process is to act as facilitators in the marketing, packaging the company like a shiny present and providing incremental news that pushes the price in the right direction. The investors who decide to play the IPO game or invest in the after market will not waste their time and resources estimating value, since their success or failure will come from how well they gauge momentum shifts and time their exits. I will value Twitter, when the financials are released and the time is right, but my advice to you is that you ignore my valuation, if you are playing the IPO game. The market for Twitter will little note nor long be concerned with my or anyone else’s assessment of value.



    The Twitter IPO: Thoughts on the IPO End Game

    The Twitter IPO moved into its final phase, with the announcement last week of the preliminary pricing estimates per share and details of the offering. The company surprised many investors by setting an offering price of $17 to $20 per share, at the low end of market expectations, and pairing it with a plan to sell 70 million shares. Having posted on my estimate of Twitter’s price when the IPO was first announced and following up with my estimate of value, when the company filed its prospectus (S-1) with Twitter, I thought it would make sense to both update my valuation, with the new information that has emerged since, and to try to make sense of the pricing game that Twitter and its bankers are playing.


    Updated valuation
    In my original valuation of Twitter, just over a month ago, I used the Twitter's initial S-1 filing which contained information through the first two quarters of 2013 (ending June 30, 2013) and the rough details of what investors expected the IPO proceeds to be. Since then, Twitter has released three amended filings with the most recent one containing third quarter operating details and share numbers that reflect changes since June 30. Incorporating the information in this filing as well as the offering details contained in the report leads me to a (mostly minor) reassessment of my estimate of Twitter’s value.

    Operating Results: Twitter’s third quarter report contained both good news and bad news. The good news was that revenue growth continued to accelerate, with revenues more than doubling relative to revenues in the same quarter in 2012, but it was accompanied by losses, which also surged. The table below compares the trailing 12-month values of key operating metrics from June 2013 (that I used in my prior valuation) with the updated values using the September 2013 reports:

    As with prior periods, the R&D expense was a major reason for the reported losses and capitalizing that value does make the company very mildly profitable. Note that while the numbers have shifted significantly, there is little in the report that would lead me to reassess my narrative for the company: it remains a young company with significant growth potential in a competitive market. Consequently, my targeted revenues in 2023 ($11.2 billion) and the operating margin estimates (25%) for the company remain close to my initial estimates (October 5).

    IPO proceeds: In the most recent filing, the company announced its intent to issue 70 million shares, with the option to increase that number by 10.5 million shares. In conjunction with the price range of $17-$20 that is also specified, that implies that the proceeds from the offering will range anywhere from $1.19 billion (70 million shares at $17/share) at the low end to $1.61 billion (80.5 million shares at $20/share) at the high end. In my valuation, I will assume that the offering will happen at the mid-range price ($18.50) and that the option to expand the offering will not be utilized, leading to an expected proceeds of $1.295 billion.

    Share number: As with most young companies, the share number is a moving target as options get exercised and new shares are issued to employees and to fund acquisitions. In the table below, I compare the share numbers (actual, RSU and options) from the first S-1 filing with those in the most recent filing:
    The share count has increased by about 8.02 million shares, since the last filing, while there has been a slight drop off in options outstanding. (Note: The most recent filing also references 80.3 million shares for future issuance to cover equity incentive & ESOP plans that I have not counted.)

    The final valuation is contained in this spreadsheet, but it has changed little from my original estimate, with the value per share increasing to $17.84/share from my original estimate of $17.36/share. The picture is below:

    Reading the pricing tea leaves
    Now that the company (and its bankers) have announced a price range ($17-$20) that is close to my estimate of value, my ego, of course, wants me to believe that this is a testimonial to my valuation skills but I know better. There is a fairy tale scenario, where my value is right, Goldman Sachs has come up with a value very close to mine and the market price happens to reflect that value. It is a fantasy for a simple reason. As I noted in my price versus value post, the IPO process has little to do with value and everything to do with price, and given how the market is pricing other social media companies, I find it difficult to believe that price and value have magically converged, with Twitter.

    Accepting that the closeness of Goldman’s pricing of Twitter to my estimate of value is pure coincidence frees me to think about what it does tell me about the bankers' (and the company’s) view of what they see as a “fair price” for Twitter. If Goldman and the banking syndicate are pricing Twitter at $17-$20, I am inclined to believe that they think that the “fair price” today is higher for the following reasons:
    1. The underwriting skew: The Twitter IPO, like most public offerings, is backed by an underwriting guarantee from bankers that they will deliver the agreed upon offering price. If the offering price is set too high, relative to the fair price, that creates a substantial cost to the bankers, whereas if it is set too low, the cost is much smaller. Not surprisingly, IPOs tend to be underpriced, on average, by about 10-15% as I noted in this prior post.
    2. The PR twist: There is a public relations and marketing component to what happens on the offering date that cannot be under estimated. To provide a contrast, look at the reactions to the Facebook and Linkedin offerings in both the immediate aftermath of and in the weeks after the offering. While both IPOs were mispriced by the same lead banker (Morgan Stanley), with Facebook being over priced and Linkedin being under priced, Morgan Stanley was bashed for doing the former and emerged relatively unscathed from the latter. In the months after the offering, Facebook saw its shares lose more ground, as institutional investors abandoned it, while LinkedIn shares were carried higher, at least partly because of the opening day momentum. 
    3. The feedback loop: I know that the bankers have been testing out the level of enthusiasm among investors for the Twitter offering and I find it difficult to believe that they are not incorporating that into their pricing. In other words, if they want excitement at the road show, it will come from investors thinking that they are getting a bargain and not from being offered a fair deal.
    My completely uninformed guess is that the bankers think that Twitter’s fair price is closer to $25/share and that they have set the range at roughly 20% below those estimates. If the offering goes as choreographed, here is how it should unfold.

    1. The road show will be well received and the bankers will announce (reluctantly) that the high enthusiasm shown by investors has pushed them to set the offering price at $20/share. 
    2. Institutional investors will start lining up for their preferred allotments at that offering price and the enthusiasm bubble will grow.
    3. On the offering date, the stock will jump about 20%-25%, leading to headlines the next day about the riches endowed on those who were lucky or privileged enough to get the shares in the offering.
    4. Some of the rest of us, who were not lucky or privileged enough to be part of the offering, will be drawn by these news stories into the stock, pushing the price higher, and keeping the momentum game going. 
    5. In a few months or perhaps a year, some of the owners of Twitter (big investors and venture capitalists) will be able to sell their shares and cash out. 

    So, what can go wrong with this script? The biggest actor in this play is Mr. Market, a notoriously moody, unpredictable and perhaps bipolar (though that may require a clinical judgment) character. As was the case in Facebook, a last minute tantrum by Mr. Market can lay waste the best laid plans of banks and analysts. 

    Winners and Losers
    Some of you may take issue with my cynical view of the IPO process, arguing that this is not a play or a game and that there are real winners and losers in the process. While this is generally true for any investing process, who are the losers in this process? By under pricing IPOs, the existing owners of the company going public are leaving money on the table. In the aftermath of the Linkedin offering, where the offering price doubled on the opening day, there were stories that the company had been scammed by bankers. Before you feel too sorry for Evan Williams and the venture capitalists, who are the primary owners of Twitter, you should take into account two facts:
    1. Only a small fraction of the equity is being offered to the public on the offering date: If all of Twitter being offered for sale on the offering date, an underpricing of 20% (selling the shares at $20, when the fair price is $25) would cost investors almost $3 billion in value (since the company would be priced at $12 billion instead of $15 billion). However, as noted earlier, only $1.2 to $1.6 billion will be offered to investors in the IPP. Even if you take the upper end of this amount ($1.6 billion), a 20% under pricing would translate into a loss of $400 million to the owners. While that may be a lot of money to most of us, it would work out to about 3% of overall value for the existing owners.
    2. The existing investors in Twitter are neither babes in the wood nor naïve fools: The current owners in Twitter are a who's who of venture capital investing, entirely capable of watching out for their own interests and just as likely to use bankers as they are to be used by them. Rather than being victims here of the under pricing, they are willing accomplices in this pricing process, who view the loss on the opening day as a small cost to pay for a more lucrative later exit.
    There are some winners, though none of them emerge unscathed from the process. The first are the bankers, who by under pricing the offering enough, render the underwriting guarantee moot and get paid for it anyway. Here again, though, issuers are not entirely helpless and Twitter managed to get a discount on the underwriting fees. The second are those investors who are allotted shares at the offering price, many of whom are preferred clientele for the banks. They generally tend to be wealthier investors (institutions and individuals) who bring in revenues in other ways to the banks (as private banking clients or through trading). Since banks are not altruistic, I am not sure that these preferred clients end up with a bargain if you count the other fees they fork out to banks. The third is the financial media (and that includes bloggers) that can use the IPO as grist for the mill, churning out endless stories (and blog posts) about the IPO.

    Cut out the bankers?
    If you buy into my cynical view of the Twitter IPO, it does make the whole process seem like a charade and raises questions about whether it is needed. What if we could skip the bankers, the offering price, the road shows and the endless debate about what will happen on the offering date and just go directly to the offering?  It is true that bankers play other roles in the process that may be difficult to replace in some IPOs, but I am not sure that can be said about their role in Twitter.




    Banker's role
    The Twitter IPO
    Credibility
    If investors have never heard off or know little about a company, the banker may provide credibility to the company with investors.
    Not only is Twitter as recognized a name as Goldman Sachs, it may have more credibility with investors.
    Pricing
    Bankers can price the stock, not only by looking at what the market is paying for similar stocks, but also by testing the price with investors.
    Since the stock has had VC transactions as well as acquisitions where the stock has been effectively priced, the banker has less work to do.
    Selling
    Use their sales forces and road shows to get investors interested in the stock and excited about the offering.
    The sector is already "buzzed" and if you set the price at 25% below the “fair” price, you don’t really have to sell it very much.
    Post-offering price support
    In the months after the offering, the bankers may step in and provide  price support in the face of selling.
    With a $12 billion company, banks don’t have the capital or deep pockets to provide more than surface support.
    Corporate Finance advice
    Guide the company in financing & dividend policy and in interactions with markets.
    Bankers know little about running social media businesses, which don't use much debt and have no cash to pay dividends/ buy back stock.

    Looking at the facts, I think that Twitter could have saved itself some money and time if it had followed Google and chosen an auction process for its public offering. After all, if your job is pricing, who does it better than the market? On the other hand, the ceremony and ritual of the IPO process, useless and predictable though it might be in most cases, may play a role in easing the transition of the company to the public market place and setting a narrative for the momentum game.

    What now?
    So, now that we have a sense of where Twitter will be priced and what will happen on the offering date, what next? Here are the four options:
    1. Try to get an allotment of shares at the offering price:  While the odds may be in your favor, it is definitely not a risk free or costless strategy and please do pay heed to some of the suggestions in this post
    2. Wait until the offering date and play the momentum game: The trading game begins on opening day and stocks like Twitter are a momentum investors' dream (and nightmare) as prices are moved up and brought down by wisps of information and mood changes. If you are good at this game, you can play it for profit, as long as you do not let delusions of being an investor get in the way.
    3. Buy the stock as a long term investor: I do not have a  deep rooted aversion to buying young or money losing companies, if the price is right. Given my estimate of value ($18/share), the stock would be, at best, a fair value at the offering price and I can think of far less ulcer-inducing investments that earn their fair value. That does not mean that Twitter will never be on my radar. If the momentum game turns against the stock and the price drops to $10/share, I will be ready to buy.
    4. Entertainment/ educational value: I am enjoying and will continue to enjoy every moment of this IPO for sheer entertainment value, as I listen to analysts make hilariously ill conceived arguments for or against the stock and portfolio managers act as if they are making reasoned judgments about value while desperately checking out momentum indicators. This is the ultimate reality show and I am just waiting for Ashton Kutcher, Kanye West and Lady Gaga to show up as Twitter IPO experts on CNBC.



    Valuing Athlete Earning Potential? Tracking Arian Foster!

    In a week during which both Google and Netflix hit all-time highs, you would think I would pick one of these high fliers for special valuation attention. While I still plan to look at these companies, I am going to spend this week on a quirky valuation challenge: valuing tracking stock on a star athlete’s future income. Last week, a company called Fantex filed an S-1 (prospectus for a forthcoming security issue) with the Securities Exchange Commission, making public its intention to issue tracking stock on Arian Foster, a star running back for the Houston Texans in the National Football League (NFL). In the filing, Fantex reported that it had paid $10 million in early October to Mr. Foster in return for 20% of all contract and endorsement income that he will earn after February 28, 2013. The S-1 also specifies that Fantex plans to raise approximately $10 million (thus covering its outlay) from the issuance of 1.055 million Arian Foster tracking shares to the public, and use its share of Mr. Foster’s income to pay dividends to these shareholders. The picture below captures the initial set up: 

    Fantex intends to use its platform to attract more athletes and celebrities into the mix, thus creating a portfolio of tracking shares that can be traded by investors. 

    Arian Foster: Background 
    Arian Foster was born on August 24, 1986, and is a running back for the Houston Texans. He played college football at the University of Tennessee and was signed as an undrafted free agent by the Texans in 2009. In 2010, he had a monster year, leading the NFL in rushing, yards from scrimmage and touchdowns. He continued with impressive performances in 2011 and 2012, as can be seen in his career statistics page

    Arian is also clearly a self-promoter (in the best sense of the word) and has aspirations beyond the gridiron. He has his own website, where he characterizes himself as an all-pro running back, entrepreneur, philosopher and father. 

    On March 5, 2012, Arian signed a five-year contract with the Texans worth $43.5 million. The contract had a guaranteed payment of $20.75 million, including a signing bonus of $12.5 million, his first year salary (2013) and $3.25 million of his second year salary (2014).  He is also entitled to bonus payments, based on performance in games, of up to $5.25 million in 2013, $5.75 million in 2014, $6 million in 2015 and $6.5 million in 2016. He is a free agent in 2017. 

    Claim and Contract details 
    To value the claim on Arian Foster’s income, you need to break down the cash flow claims that you have on the income. Note that while Fantex has a contractual claim on 20% of Foster’s future income, investors in the tracking stock don’t have that direct claim. Instead, they are dependent on the dividends that Fantex chooses to pay out from that income. 

    As noted in the figure, there are at least two expenses that Fantex will incur that will make the dividends paid less than the income that they get from Foster. The first is that a portion will be set aside to cover the expenses associated with managing and maintaining the Fantex platform. The second is that Fantex views its role as not just a contractual intermediary but also as a brand building organization. Effectively, that implies that Fantex can and will use some of the Foster income to market him better (and hopefully increase endorsement income). 

    To value the Foster tracking stock, we will go through three steps. In the first, we will lay out broadly the risks faced by investors in the tracking stock. In the second, we will value the cash flow claim that Fantex has on Foster’s contract and endorsement income. In the third, we will evaluate the claim that investors in the Foster tracking stock have on the dividends they receive from Fantex.

    The Risks 
    The S-1 goes to great lengths to emphasize the point that this is a speculative investment, but since that should have been obvious to anyone thinking about the investment, it is important that we break down the risks at each stage of the process: 

    Working the risks through the pipeline, here at the layers of risks that we see, starting with risks to the earning stream and then moving on to risks in the intermediary and ending with risks at the investment level.
    Earnings Risks
    1. Player Risks
    The most immediate impact on player earnings comes from the athlete with two big risks to earnings: injuries that are career ending or a drop off in performance skills, either as a result of age or earlier injuries.
    1.1. Player Skills/Longevity
    A. Player Injuries: If you are laying claim on a professional athlete’s future earnings, you are exposed to any injury/event risk that impedes his or her capacity to perform on the field. Part of this risk can be mitigated at the contract level, if you have guaranteed income (that will be paid even if the athlete is injured) but it will still affect the athlete's earnings power in terms of getting contract renewals & bonus income.
    Arian Foster shares: Foster's guaranteed income on his contract has dwindled down to $3.25 million and almost all of his remaining income will be at risk if he is injured. While Foster has been durable through his early years, there are two reasons to worry. The first is that he just hurt his hamstring this season, an injury that may keep him out for a portion of the season and may be a harbinger of things to come. The second is that injuries tend to climb as athletes age, and especially so for running backs whose bodies take significant punishment on the field. 

    1.2. Player performance
    While a player’s current contract may be unaffected by declining performance, there are two reasons why it will feed through into the earnings claims. First, if there are bonus payments, as is the case with Arian Foster, they will clearly be put at risk, if performance deteriorates. Second, to the extent that you are counting on a continuation of earnings from a contract renewal (from the current team or another team), future earnings will be lower, if the player’s performance deteriorates. 
    Arian Foster shares: Age has to be factored into the equation since he is 27 in a sport where running backs seem to age faster than everyone else in the field. One assessment of running back output based on age yielded the following graph on production for running backs (and quarterbacks): 

    Note that output for running backs peaks early (24-25), levels off until about 27 and starts deteriorating after that age. Foster may very well be the exception to this rule, but it is dangerous to bet against history. 

    2. Macro Factors
    There are two macro level risk factors that can affect a player’s earnings. 
    2.1. Collective Bargaining Constraints
    In most sports, there is a players’ union that negotiates with team owners on both contract rules and constraints. While individual players may negotiate on their own behalf with teams, the constraints imposed by collective bargaining agreements may affect earnings potential for individual players. For instance, the hard caps on team payrolls imposed in the NBA and NHL and even the soft caps in the MLB (soft, because they can go over the cap as long as they pay the penalty tax) have affected player negotiations and contracts. 
    Arian Foster Tracking stock: The NFL’s current salary cap is $123 million per team and each team is required to spent more than 95% of that cap. Both teams and players, though, have become adept at evading the cap constraints by loading more of the payment into future years. With Arian Foster, I am going to assume that this will be a minor factor. 

    2.2. Economic factors
    The magnitude of a player’s earnings may be affected by the overall economy, especially if a large proportion comes from endorsement income and that income is expected to grow over time. The growth in the aggregate economy can also affect revenues to a sport in the aggregate and thus indirectly affect how much can be paid out in contracts to players. 
    Arian Foster Tracking stock: Since only a small portion of Foster’s current earnings (less than one million) came from endorsements in 2013, the impact of the overall economy on his earnings is likely to be small. 

    3. Player Default 
    Even if the athlete in question generates high earnings, the earnings stream to investors is dependent upon that athlete carrying through his side of the contractual agreement and delivering the promised portion of earnings to investors. If the athlete defaults on that obligation, your earnings down stream are at risk. You could, of course, seek legal recourse but given that an athlete who defaults is also likely to have other financial problems, it is unlikely that you will get much of your promised payback. 
    Arian Foster shares: We have little evidence on Arian Foster’s default history. The strongest case that can be made for him is that he is ambitious and hopes to parlay his pro career into entrepreneurial ventures. Presumably, that will mean that he will not be cavalier in defaulting on contract obligations. That does not mean that there is no default risk but we will assume low default risk. 

    4. Intermediation Risks
    Investors don’t have a direct claim on Arian Foster’s earnings, since those earnings will be first collected by Fantex, which will then decide how to much of these earnings will be returned to investors as dividends. Consequently, there are three additional risks to factor into the assessment: 

    4.1. Poor brand building investments
    Fantex views itself as a brand builder for the athletes who decide to use it. That would imply that some of the earnings collected from the athlete will be spent in trying to increase earnings in the future, primarily from endorsements. There are no guarantees, though, that this trade off will be a positive one. Thus, it is possible that Fantex will expend 20%, 30% or even 50% of Foster’s earnings, trying to increase his marketability, with no discernible effect on endorsement earnings. 

    4.2. Spillover risks
     One of the stranger features of the Arian Foster stock is that investors in the stock may be called upon to bear losses incurred by Fantex on other athletes that it may have in its portfolio. Thus, if Fantex makes a big up front investment in a potential superstar (Andrew Luck) and that star suffers a career ending injury, investors in the Foster stock may take a hit. 

    4.3. Corporate governance risk
    The nature of tracking stock is that holders of the stock are onlookers when it comes to corporate governance, since they have no power to change or even influence managers. This is going to be a factor on two levels. The first is that Fantex will take a portion of the collective revenues it gets from player earnings to cover management expenses & fees; if it keeps “too large a portion” of the earnings for these expenses, there is little recourse for you as an investor. The second is that Fantex is not required to pay the residual earnings (after brand building expenses, management expenses and other portfolio charges) to investors) as dividends. While this is always a problem with publicly traded company stock, investors in conventional shares get a claim on the cash balance which may compensate (at least partially) for the unpaid dividends. There is no such compensating claim with tracking stock. 

    5. Investment Risk
    If you are an investor who decides to buy Arian Foster tracking stock, there is one final risk that has to come into the picture. Since there is no ready market (yet) for these shares, it may be difficult and expensive to liquidate these investments. In valuation, that is generally a reason for either charging a “illiquidity premium” in your discount rate (increasing the discount rate) or attaching an “illiquidity discount” to the value. The extent of the effect will depend upon how much you value liquidity as an investor and how easy/difficult it is to trade these shares. 
    Arian Foster tracking stock: Since this is the first set of tracking stock, I will assume that there is substantial illiquidity risk. That risk may decline over time as more athletes get listed and the Fantex trading market becomes more liquid, but neither is a reality yet. 

    Valuing the Fantex Claim 
    To value the claim on Arian Foster's earnings, I began by forecasting aggregate earnings to Arian Foster. In making these forecasts, I assumed that:
    1. Expected playing time: I will assume that Foster will play for nine more years, until the age of 36, at which point both his contract income and his endorsement income will end.
    2. Current contract: The current contract would deliver on the remaining $23.5 million due between 2013 and 2016. On average, that works out to $5.875 million a year. During the current contract period, I will also assume that he will earn approximately $2 million in bonuses each year, approximately a third of his overall potential bonus payments.
    3. Contract renewal: At the end of the current contract period, I am assuming that Arian Foster will get resigned to a new contract for the rest of his, worth $4 million a year, assuming that his age (31) and the production decline that comes with age with affect his earning power. I will also assume a step down in bonus income to $1 million a year for the rest of his career.
    4. Player fines/penalties: Given Foster's clean history and the position he plays, I will assume no dollar penalties will be imposed on his during his lifetime.
    5. Endorsement Income: Arian Foster's endorsement income in 2013 was $687,750 (though some of it is contingent on performance). I will assume that there is substantial growth potential (10% annual growth rate) in this income.
    To value the cash flows, I have to make assumptions about player and default risk. For player risk, I will assume that there is a 5% probability of a career ending injury each year, resulting in cumulative probabilities that will increase over time (to 37% by the last year). For default risk, I will assume that Arian Foster's history & desire for commercial success will keep default risk low (a default spread of 1.50% and a discount rate of 4.1%). will be added to the risk free rate. For endorsement earnings, I will assume that there is low exposure to macroeconomic risk, resulting in an equity risk premium of 3% (and a discount rate of 5.60%). The table below captures the cash flows, discounted value and the value today (with the link to the spreadsheet).

    The value of the claim on Foster's earnings to Fantex, based on these assumptions, is $10.06 million (before accounting for expenses and injury probabilities).  Fantex paid $10 million to get these claims, this looks like a break even deal for both sides of the transaction, with Arian Foster having the slight edge.

    Valuing the Tracking Stock
    To value the tracking stock, I have to factor in the drains on the cash flows from management expenses and branding investment, as well as the additional risks from not getting a direct claim on the earnings. For the first, I will assume that management expenses will consume 5% of the flow through earnings (as specified in the S-1) and branding investments will account for 15%, leaving 80% of the earnings as residual earnings. While I will assume that all of the residual earnings will be paid out as dividends, Fantex has no history (good or bad) in this respect and I will add an extra 3% to my discount rates to capture my absence of any corporate governance power (over either expenses or dividends). Finally, I will incorporate an additional premium of 3% in my discount rate for illiquidity, since it is unclear to me how I would exit this investment, without bearing significant costs. The value of my claim is illustrated below (with the link to the spreadsheet):

    Specifically, I will be willing to pay $6.11/share for the Adrian Foster tracking shares, with my assumptions. There is a conversion feature on these shares, but it can be exercised only by the company to convert these tracking shares into Fantex platform shares; that option will make my claim less valuable, not more so. Consequently, I would not be a buyer at the $10 share price that Fantex has tentatively tagged the shares as worth in the S-1 filing.

    Update: In both the Fantex and tracking stock claim valuations above, I did not incorporate the injury probabilities. Since I have an estimated probability that Foster will be playing in future years, I decided to incorporate that probability into the value and not surprisingly, it brings both numbers down:
    Note that there is only a 63% chance that Foster will be playing in year 9 and the value of the Fantex claim drops to $8.2 million, giving Foster the clear edge on the deal, and the value per claim drops to $5.07. 




    Chill, dude (Part II): Debt Default Drama Queens

    When I took my first finance class, I was taught that the government bond rate in the currency in question is the risk free rate. Implicit in that teaching was the assumption, misplaced even then, that governments do not default on their local currency borrowings, since they control the printing presses. When confronted with evidence of government defaults in the local currency in prior decades, the defense offered was that these defaults occurred in tumultuous emerging markets but would never happen in developed markets. I took that teaching to heart and for almost three decades used the US Treasury bond unquestioningly as the risk free rate in US dollars. With the government default looming tomorrow, you would think that this would be a moment of reckoning for me, but my faith in governments being default free was lost a while back, in September 2008. For those who do remember that crisis (and it is amazing how quickly we forget), there were two events that month that changed my perceptions of government default. The first occurred on September 17, 2008, where money market funds (supposedly the last haven for truly risk averse investors) broke the buck, essentially reporting that they had lost principal even though they had invested in supposedly risk free, liquid securities. The second happened a week later, when the nominal interest rate on a US treasury bill dropped below zero, an almost unexplainable phenomenon, if you believe that the US government has no default risk. After all, why would investors pay more than a thousand dollars today for a T.Bill for the right to receive a thousand dollars in the future, unless they perceive a chance that they will not be paid?

    That last question is the key to understanding default risk. It is not a zero-one proposition, where it shows up only after you have defaulted. If an entity is truly default free, the question of whether there is default risk will never come up, and if it does come up, that entity is not default free. Put in specific terms, I believe that markets have perceived and built in some default risk in the US Treasury since 2008, though it is perhaps small enough to ignore. The issue was crystallized two summers ago, when S&P announced its ratings downgrade for the US, to screams of protest from politicians in DC. At the time, I posted my reaction to the downgrade and advised investors to take it down a notch and that while the downgrade was definitely not good news for any one, it was not the end of the world that it was made out to be. 

    Market Assessments of US default risk
    To back up my point about how default risk is not a zero one proposition to markets and investors, I will start with a graph of credit default swap spreads for the US on a monthly basis from January 2008 through today. While I have posted about the limitations of the CDS market, it provides a barometer of market views on sovereign default risk that are much more timely than sovereign ratings.

    Looking at the chart, it is clear that the crisis is 2008 changed market perceptions of default risk in the United States. The US CDS spread increased from 0.105% in January 2008 to 0.73% in January 2009. While that number dropped back for a while, it started climbing again in late 2010 and the S&P downgrade in August 2011 had little impact on the spread, suggesting that as always, ratings agencies follow markets, rather than lead them. Updating the numbers through this year, the US CDS spread has dropped over the course of the year and the debt default drama has had little impact on that number, suggesting again that while the recent events in Washington may have increased investor concern about default risk, the effect is not as large or as dramatic as it has been made out to be.

    If you are concerned that the month to month graph might not be indicating day to day volatility in the market, this graph should set that fear to rest:

    Some analysts have pointed at the increase in the T.Bill rate as evidence of market concern about default and there is some basis for that.

    The one-month T. Bill rate has climbed from zero in mid-September to 0.35% yesterday. However, note that the US T.Bond rate actually declined over the same period, again indicative that if there is a heightened sense of worry about default with the US Treasury, it is accompanied by a sense that the default will not last for long and will affect short term obligations by more.

    Valuation Implications
    What are the implications of heightened default risk in government bonds for risky assets? In the immediate aftermath of the 2008 crisis, I worked on a series of what I call my "nightmare" papers, where I took fundamental assumptions we make about markets and examined how corporate finance and valuation practice would have to change, if those assumptions were not true. The very first of those articles was titled, "Into the Abyss: What if nothing is risk free?" and it looked at the feedback effects of  government default into valuation inputs. You can download the paper by clicking here, but I can summarize the effects on equity value into key macro inputs that affect the value of every company:

    1. Risk free rate: How will a default or a heightened expectation of default by the US government affect the risk free rate in US dollars? It is tough to tell, but my guess is that the risk free rate in US dollars will decline. That may surprise you, but that may be because you are still equating the US treasury bond rate with the risk free rate in US dollars. Once government default become a clear and present danger, that equivalence no longer holds and the risk free rate in US dollars will have to be computed by subtracting out the default spread for the US from the US treasury bond rate. Thus, just as a what if, assume that there is default and the US T.Bond rate jumps from 2.60% today to 2.75% tomorrow and that your assessment of the default spread for the US (either from a newly assigned lower sovereign rating or the CDS market tomorrow) is 0.25%.
    Risk free rate in US dollars = 2.75% - 0.25% = 2.50%
    Why do I expect the risk free rate in US dollars to drop? A pure risk free rate is a composite of expected inflation and expected real interest rate, and as I have argued before, reflects expectations of nominal growth in the economy. A default by the US treasury will affect both numbers negatively, since it may tip the economy back into a recession and bring lower inflation with it. In fact, looking back at the daily T.Bond rates and CDS rates over the last month, I tried to break down the T.Bond rate each day into a risk free US $ rate and an estimated default spread. To estimate the latter, I compared the CDS spread each day to the CDS spread of 0.20% on August 31, 2008.
    If you go along with my estimates, the US $ risk free rate has dropped from 2.67% to 2.42% over the last 30 days, while the default spread has widened from 0.19% to 0.28%.

    2. Equity Risk Premiums and Corporate Default Spreads: Lest you start celebrating the lower risk free rate as good for value, let me bring the other piece of the required return into play. If the default risk in the US is reevaluated upwards, it is also very likely that investors will start demanding higher risk premiums for investing in risky assets (stocks, corporate bonds, real estate). In fact, I think that the absence of a truly risk free alternative makes all risky investments even riskier to investors and that will show up as higher equity risk premiums. The same argument can be applied to the corporate bond market, where default spreads will increase for corporate bonds in every ratings class, as sovereign default risk climbs. To get a measure of how equity risk premiums have behaved over the last month, I can provide my daily estimates of the implied ERP from September 16 to October 16 for the S&P 500.

    Note that I have computed the implied ERP over my estimated US$ risk free rate (and not over the US T. Bond rate). You can download the spreadsheet and make the estimates yourself. The net effect on equity will therefore depend upon whether equity risk premiums (ERP will increase by more or less than the risk free rate decreases. If default occurs, the ERP will increase by more than the risk free rate drops, which will have a negative effect on the value of equity. However, that effect will not be uniform, with the negative impact being greater for riskier companies than for safer ones.

    The End Game
    By the time you read this post, I would not be surprised if Congress has stitched together a last minute compromise to postpone technical default to another day. In a sense, though, it is too late to put the genie back in the bottle and while it is easy to blame political dysfunction for this debt default drama, I think that it is reflective of a much larger macro economic shift. With globalization of both companies and markets, even the largest economies are no longer insulated from big crises and in conjunction with the loss of trust in institutions (governments, central banks) over the last few years, I think we have to face up to the reality that nothing is truly risk free any more. That is the bad news. The good news is that the mechanism for incorporating that shift into valuation and corporate finance exists, is already in use in many emerging market currencies and just has to be extended to developed markets.



    When the pieces add up to too much: Micro Dreams and Macro Delusions

    A few years ago, my family and I spent two weeks on a summer vacation in San Clemente in Southern California and acquired a new vice. Every afternoon, we would stop at a frozen yogurt (FroYo) store in town and eat astonishingly large portions, secure in our misguided delusion that the “ healthy yogurt” would overcome the sugar and calories in the mix. When we got home to New Jersey, we scoured the neighborhood for FroYo stores and found none close by and only one within five miles. My kids suggested that I quit my day job (since they cannot believe that anyone would pay to hear me talk) and start a new store nearby, pointing to the untapped market potential. I am glad that I did not take them up on the suggestion, because that market gap must have been observed by others as well, some of whom took the next step and opened up stores. Today, my search on Yelp provides a listing of twenty five frozen yogurt stores within five miles of my house, a number far too large for the number of frozen yogurt fans in the neighborhood. As we drive by the sparsely filled stores, it is quite clear that a large number of these stores will not make it through the winter. 

    This phenomenon of individual decision makers behaving rationally, given the information they have at the time of their decisions, but creating a collective irrationality is not restricted to frozen yogurt business. In fact, you often see it play out in the valuations of young companies in a market with significant growth potential. In the late 1990s, it was the promise of online retailing riches that drove the market values of dot-com companies to unsustainable heights. In today's market, we see this process repeated at social media companies, where as each new company enters the public market,  the vast potential of online advertising is used to justify a lofty valuation. While each company’s valuation, standing alone, may be defensible, given the market potential, the question that is worth examining is whether the collective valuation of these companies is consistent with the size of the overall market. 

    The Online Advertising Market
    Before embarking on an assessment of the collective revenues that the market is imputing to online advertising companies, let's start by looking out the market as it exists today. In the figure below, I look at the total advertising market globally, broken down by type in 2011, 2012 and 2013:
    Source: Zenith Optimedia

    Broken down by geography, I can add to that story:
    Source: Zenith Optimedia

    The basis for the macro story being told about social media companies is visible in this graph. Advertising is growing as a business, driven by growth in emerging markets, and an increasing proportion of the revenues comes online. The biggest losers are newspapers and magazines, but television and other conventional outlets (radio, cinema & outdoor) have held up surprisingly well under the online assault.  The prediction is that this shift to online advertising will continue into the future, though the rate of growth will slow down as online advertising becomes a larger and larger slice of total advertising. In the table below, I look at expected online advertising revenues (in billions of US dollars) in 2023, with different assumptions about annual growth in the market and the online share of that market.

    Thus, in the optimistic scenario for online ad spending, I assume that it continues to gain market share at the same rate as it did between 2011 and 2013 (to get from 19.83% today to 40% in 2023) and that ad spending grows at 4% a year for the next decade and arrive at a value of $303.04 billion in spending on online advertising in 2023.

    Imputed Future Revenues in Market Values
    To assess what investors are anticipating as expected revenue growth in online advertising companies, I started with the current financials of the company and its revenues and operating income in particular. I then looked at the enterprise values of these companies, computed based upon current market capitalization (market value of equity), debt outstanding and current cash/investment balances.
    Enterprise value = Market Capitalization + Debt – Cash and ST investments 
    If you are willing to make assumptions about the target operating margin of the company (whether it will be higher, lower or equal to the current margin) a cost of capital for the firm and how much you will need to reinvest to grow (sales to capital ratio, in my model), you can then solve for the imputed revenues that you will need in year 11 (2023) to justify today’s market capitalization. 

    To illustrate, consider Google, the biggest player in the online advertising market. Its enterprise value on October 14, 2013 was $240,579 million:
    Enterprise value = $291,586 m (Mkt Cap) + $4,989 m (Debt) - $55,996 m (Cash) = $240,579 m
    In the most recent twelve months, the company generated a pre-tax operating margin of 22.49% on revenues of $56,594 million. If I attach a cost of capital of 10% to the company’s cash flows, assume that the current operating margin does not change and that the sales to capital ratio will be the industry average of 1.50, I can use the current enterprise value of the company to back into the imputed revenues in year 10:

    Thus, with my assumptions, the imputed revenues in 2023 for Google will have to be $168,336 million to justify today's market value. Clearly, if you change my assumptions about operating margin, cost of capital and sales to capital ratio, you will get a different imputed value; decreasing margin & sales to capital ratio and increasing the cost of capital will all push up the imputed revenues in 2023. If you are interested, you can download the spreadsheet which contains Google’s numbers and change the inputs.

    I used this spreadsheet, with standardized numbers (cost of capital of 10%, sales to capital ratio of 1.50 and a target operating margin of 25% for most of the companies, to get imputed revenues for all of the publicly traded companies in my social medley list. The table below summarizes the imputed revenues for an incomplete list of companies that derive their revenues from online advertising, with four large non-US companies thrown into the mix.
    All of the break even DCFs area available in this folderIt is true that not all of the revenues at each of these companies is from online advertising. Using the most recent annual reports, I estimated the percentage of overall revenues from advertising and backed out the portion of the imputed online advertising revenues keeping that percentage unchanged. If you add up the imputed revenues across companies, the total online advertising revenue across just these companies of $319.2 billion, higher than my estimate of the overall online advertising market in 2023. Note that I erred on the  conservative side in my assumptions to generate lower imputed revenues; shifting to a 12% cost of capital for all companies increases imputed revenues in 2023 to over $400 billion, as does using a target operating margin of 20%. Given that there are other online advertisers that have not been counted in this list, that there are a whole host of private companies like Pinterest and Snapchat waiting in the wings, ready to go public, and still more brewing in the fertile imaginations of creative people somewhere, it is safe to say that the market collectively has a macro problem that is difficult to explain away.

    Implications
    1. Social media companies are collectively over valued: As in other young sector booms - PC companies in the 1980s, dot-com companies in the 1990s - the market seems to be getting the macro story right but the micro valuations wrong. Diversification as a strategy may be a good one in sectors where the law of large numbers work in your favor, but not in sectors like social media, where you have "bias upwards" in the valuations. A social media ETF may be a good momentum play but it is unlikely to be a good investment.
    2. One or two of them will be the winners over the next decade: If you are an investor with a social media company in your portfolio, is that investment doomed? Not necessarily, because while these companies may be collectively over valued, there will be winners among these companies that will emerge as the sector matures. Using the dot-com sector as the template again, an investor in Amazon even at the peak of the boom in January 2000 would have little to complain about today. The key to investment success in this sector then becomes tagging the winners early in the process. While Google and Facebook are the early leaders in this race, those standings will change as technology and customer behavior change over time.
    3. The valuations may be put at risk if entry into this business is “easy”: The PC business from the 1980s should offer a cautionary note for investors who assume that a market that is growing fast will also deliver high value to investors in companies in that  market. If the barriers to entry are low, you can have high revenue growth in conjunction with low margins and little value creation.  
    What can investors do?
    1. Less macro story telling: As investors, we should be wary of story tellers, who use the same macro argument (the online ad market is getting bigger, there are a billion people in China) to justify one company valuation after another. Stories are a useful starting point but they have to be linked to specifics.
    2. Longer time horizons: While I understand the desire of analysts to frame their assessment of companies around the near term (next quarter’s earnings, next year’s revenues), you have to attempt to look at where the firm will end up over the long term. (I use ten years, but it does not have to be that long). It is tough to introduce any macro discipline in your thinking with short time horizons. 
    3. Winner and Losers: If we start off with the presumption that the pie, defined broadly (as advertising and not online advertising), is limited, high revenue growth for one company often has to come from competitors and it behooves us to be explicit about winners and losers. For instance, in my Twitter valuation, where I estimate revenues will grow from $448 million right now to $11 billion in 2023, I should have tried to explain how much of this additional revenue will come from old-world media (newspapers, magazines, cinema), how much from other online advertisers (Google, Facebook) and how much from growth in the market. 
    4. Transparency: While revenue growth and operating margins are both critical inputs into valuation, they are interconnected and often require that you look at trade offs. Thus, going for higher revenue growth will generally mean lower operating margins and the net effect can be positive or negative.
    It is easy to develop tunnel vision when valuing companies and forget that the rest of the world does not remain static, while the company being valued plots its path to success. Unless we consciously step back and look at the big picture, we will continue to create micro valuations that don't up aggregate to create viable macro environments.



    Value in the eye of the storm: Why you should welcome uncertainty!

    One of the responses to my last post on valuing young companies was that even if you can value companies early in the life cycle, you cannot do so with any degree of confidence. I concede that point, but that is exactly why I would try to value them! I know that statement makes little sense, but to solidify my argument, take a look at the following list of five assets/entities and rank them on the basis of the confidence you will feel in valuing each one (I have provided my rankings and the reasons in the table).
    Valuation Setting Your precision ranking My precision ranking My reasons
    $20 in an envelope

    (1) Absolute  Nothing to forecast & no risk to adjust for.
    A mature, money making company in a stable macroeconomic environment

    (2) Very high You can use both company & macroeconomic history in making forecasts.
    A mature, money making company in an unpredictable macroeconomic environment

    (3) Average While company is stable, macroeconomic shifts can cause earnings/cash flows to change.
    A young, money losing company in a stable macroeconomic environment

    (4) Low You have no history and know little about market. Lots of unknowns, at least at the company level.
    A young, money losing company in an unpredictable macroeconomic environment

    (5) Very little The uncertainties you face at the company level are multiplied by uncertainties about interest rates and economic growth.
    My guess is that your rankings will match closely to mine. Cash in an envelope is easier to value than an ongoing business, an ongoing stable business is easier to value than a young, growing business and valuations in general are easier when interest rates and economic growth are stable/predictable than when they are not.

    Now that we have dispensed with that formality, I think it is worth asking a more complex question. If valuation is designed to find investment bargains, what is the payoff to doing valuation in each of these settings? Note that the game is now different, since your advantage does not come from the precision of your valuation but in its relative precision: How much more precise is your estimate of value for a given asset is than the estimates of others valuing exactly the same asset? Here is my attempt to look at my potential differential advantages (and I would encourage you to do the same).
    Valuation Setting
    Differential Precision
    $20 in an envelope
    (5) None.
    A mature, money making company in a stable macroeconomic environment (4) Very little (unless I cheat and use inside information, which would of course bring the SEC's wrath to bear on me). The estimates come from historical data and are unlikely to shift very much, since the macroeconomic setting is stable. Valuation modeling is trivial and you can use historical PE ratios or stable growth cash flow discount models to value the company.
    A mature, money making company in an unpredictable macroeconomic environment (3) Your differential advantages can come from being able to incorporate the macroeconomic uncertainty into company forecasts and valuing the company. If the macroeconomic uncertainty is large enough (say, at crisis levels), other investors may stop trying to value even mature companies (remember late 2008), essentially conceding the game to you.
    A young, money losing company in a stable macroeconomic environment (2) Your differential advantage comes from researching the business the company is in, understanding the company's products and being willing to make forecasts (knowing that you are going to be wrong). Again, with enough uncertainty, other investors will not even try to value these companies , focusing instead on rules of thumb, unusual value metrics (value per user) or short term numbers (earnings next quarter).
    A young, money losing company in an unpredictable macroeconomic environment (1) Your differential advantage will come from just trying to make estimates, in the face of immense uncertainty, when everyone else has long since given up any attempt to estimate value.
    My motto is that you don’t have to be right to make money, but just less wrong than everyone else in the market. That makes my odds best in exactly those environments where I am uncomfortable and uncertainty is overwhelming.

    Wielding Ben Graham’s tome on security analysis as a weapon, old-time value investors will probably take issue with this argument, pointing to the efficacy of the time-tested value investing conventions, where you are told to stay focused on companies with solid earnings and cash flows, with superior management. I would be inclined to concede the argument, if active value investing, as practiced today, actually worked, but there is little evidence that it does, at least in the aggregate, as I argued in this paper. In fact, there is evidence, albeit weak, that the average active growth investor beats a growth index more frequently and by more than the average active value investors beats a value index. That does not surprise me in the least, since it is in keeping with my thesis that the best investment opportunities are in the volatile, growth sectors.

    I think that Ben Graham, if he were writing his book today, would be much less rigid in his view of value than the classicists. The real lesson that I get from reading Graham’s writings is that value is determined by fundamentals and that markets sometimes misread or ignore those fundamentals. My addendum is that investors are more likely to misread and/or ignore fundamentals, when they are faced with large uncertainties than with small ones.

    In closing, there are three general propositions about valuation that flow from my view of uncertainty.
    1. The more comfortable you are in valuing a company, the less point there is to doing that valuation. After all, the factors that comfort you are just as likely to comfort others valuing that company.
    2. If you wait for the uncertainties to resolve themselves before you value a company, it is too late for a valuation. In the midst of crises or uncertainty, it is human nature to want to wait, until there is resolution, before committing to valuation or investing. It is precisely at the moment of crisis, though, that your valuation skill set will provide the biggest payoff, if employed. So, you should have been valuing banks in November 2008, Greek companies in 2009 and 2010 and emerging market companies earlier this year. Using a specific example, many global investors are holding back on investing in India, waiting for the election that is scheduled next year, making me more interested in valuing Indian companies today, and especially those that are more likely to be affected by the election results.
    3. If most investors contend that something cannot be valued, you should try to value it. As I noted in my last post, I think that the status quo (where young companies are not valued) suits both investors and traders, the former, because they can stay above the fray, attributing any profits to be made in in these companies to gambling, and the latter, because they feel no obligation to even pay lip service to fundamentals.
    If you have found conventional valuation to be an extension of accounting and therefore boring (I am sorry! My biases are showing!), you should try valuing young, growth companies instead, to see how much fun it can be to connect stories to numbers and narratives to value. So, rather than value 3M or Coca Cola for the hundredth time, why not try valuing Tesla, Yelp or Pandora? And if in the process, you make some money, that is just icing on the cake, right?



    Valuation Myths: Young companies cannot be valued

    Twitter is now officially a publicly traded company, and I am glad that we no longer have to debate the IPO price and what will happen in the aftermath. While the opening may have veered a little off script, to the extent the price popped a little more than “desirable”, I am sure that the bankers, the preferred clients who were able to get the shares at $26/share and even the owners who left money on the table (just over a billion dollars) are all happy with the outcome, at least so far. While they may be tempted to claim “mission accomplished”, I think that there are a few more rounds to go before we make that judgment.

    In an earlier post, I noted the divergence between investors, who trade based on value, and traders, who make judgments about price movements, and how they often talk past each other. If you have been following the conversation about Twitter online or in the financial media, the last week has also brought reminders about enduring myths about the valuing and pricing of young, growth companies that both sides seem to hold dear. At the risk of irking both groups, I would like to argue that they are holding on to preconceptions that are not only shaky and self serving, but also damaging to their portfolios.

    Investor Myths
    Let’s start with the three misconceptions that some “value” investors have about young, growth companies.
    1. Young, growth companies cannot be valued: How often have you heard someone say that young companies cannot be valued because there is too much uncertainty about the future? This rationale is used by value investors not only to avoid entire segments of the market but as a shield against even discussing the value of young, growth companies. While it is true that there is more uncertainty about the future prospects of a young company than for a mature business, you can still make estimates of expected earnings and cash flows into the future and value the company, as I tried to do in these spreadsheets to value Tesla and Twitter. You can and should take issue with my assumptions and come up with your own values for both companies but you cannot argue that these companies cannot be valued.
    2. Even if you can value companies, that value will change significantly over time (making it pointless): As you learn more about a new company, from its early operating successes and failures, you will reassess value and your estimates will change, often significantly over time.I know that bothers some value investors, because they have been taught (wrongly in my view) that intrinsic value is stable and should not change over time. I am not bothered by the volatility in my value estimate, since the information that causes my estimate of value to change will also cause the price to change, and generally by far more. As an illustration, let me point to Facebook, a company that I have valued a half dozen times since its initial public offering in March 2012. My initial estimate of value for the company on the day of the offering was $27.07, well below the offering price of $38. A few months later, after a disappointing earnings report that suggested that their mobile advertising revenues may be lagging, I re-estimated the value of Facebook to be $23.94, a drop of approximately 13%, but the stock was trading at just under $19 (a drop of 50%). In fact, my value for Facebook has ranged from $24 to $30, while the price has fluctuated from $18 to $51. If your payoff in value investing is in finding mispriced stocks, I think that your odds are much better with stocks like Facebook and Twitter, where both your estimates of value and the market prices are subject to change, than in mature companies like Exxon Mobil or Coca Cola, where there is more consensus about the future, and fewer uncertainties.
    3. Young, growth companies are always over valued. This is an insidious myth that can be attributed to one of two forces. The first is that some value investors are born pessimists, who seem to believe that making bets on the future is a sign of weakness. The second is that some value investors rely on approaches for estimating value that are not only outdated, but simplistic. If your measure of value is to apply a constant PE (say 12) to next year’s earnings or to use a stable growth dividend discount model to value equity, you will never find a young, growth company to be a bargain. If you are creative in estimating value, willing to make assumptions about the future, persistent in tracking that value and patient in terms of timing (your buying and selling), there is no reason why you should not find growth companies to be bargains. I did not like Facebook at $38/share in March 2012 but I loved it at $18/share in September 2012, and while I would not touch Twitter today at $42/share, I would be interested at $15/share.
    Trader Myths
    On the trading side, there are two broad misconceptions about “value” that are just as misplaced and as dangerous as the three myths that value investors hold on to.
    1. With young growth companies, value does not matter. This is, of course, the mirror image of the value investors’ lament that a young growth company cannot be valued. While value investors use it as a reason to not invest in the company, traders use it as a reason to ignore value, arguing that if no one can value a company, its price is entirely a function of what the market thinks it is, rather than fundamentals. Perception may be all that matters if you are pricing a piece of art (like this one that just sold for $142 million), but it cannot be with a share of a publicly traded business. After all, no matter what the promise or potential of a company, the stories eventually have to show up as numbers (revenues and earnings), and if perception is at odds with reality, it is perception (price) that will change, not reality.
    2. Even if value does matter, it is best determined by focusing on the short term, where you have a chance of estimating numbers, rather than on the long term. With young, growth companies, analysts seem to prefer that the focus stay on the short term – next quarter, next year or perhaps two years out, using the excuse that going beyond that is an exercise in speculation. Ironically, it is the end game (the long term) that determines the value of young companies, rather than the near-term results. Put differently, it is not how Twitter does in 2014 that will be the arbiter of its value, but how the choices it makes in 2014 affect its long-term growth path. 
    I know that you are probably still skeptical about whether you can value young, growth companies and I empathize. I have struggled with young company valuations both technically (in coming up with cash flows, growth rates and discount rate) and psychologically (in fighting the instinct to flee from uncertainty) and I know that I will never quite master the process. However, each time I value one of these companies, I learn something new that I can incorporate into my tool kit. I have taken some of these lessons and put them into this paper on dealing with uncertainty that you are welcome to read (or ignore). Better still, pick a company that you are convinced cannot be valued and try valuing it. You may find it difficult, the first time around, but I promise you that it will only get easier. And it is so much more fun that valuing a utility or a bank!




    Experiments in online teaching: My Spring Classes and an Online Valuation Class

    In my last two posts, I talked about the big picture, focusing on why I think MOOCs stumbled in the last year and the moat that gives universities their power to offer a "bundled product" at a premium price. In this one, I want to get back to the theme of experimentation and the future of online education.

    Let me start by noting that there is far more that we are still learning about how to teach online. While MOOCs captured the public consciousness a few years ago, they did so more because of their numbers (of students) and less because of their effectiveness. A couple of years into this experiment, it is clear that there are problems: the drop out rates are astronomical, there are questions of effectiveness and even Sebastian Thrun, one of the earliest cheerleaders for the concept, seems to be having second thoughts.

    This semester, I will be teaching my regular corporate finance and valuation MBA classes at the Stern School of Business at New York University, and like the last few semesters, I will be offering those classes on iTunes U and online for those of you who are interested.

    Corporate Finance class: This is my big picture class in finance and sequentially comes ahead of the valuation class (though I don't think of it as a pre-requisite). It is  a business finance class that looks at the financial principles that should govern how we run businesses (small or large, private or public, developed or emerging). Here are your choices for taking it, if you are interested:
    a. On my website: I will be posting all of the class webcasts, lecture notes and sundry material at the links below.
    Link for the class: http://www.stern.nyu.edu/~adamodar/New_Home_Page/corpfin.html
    Link for webcasts: http://www.stern.nyu.edu/~adamodar/New_Home_Page/webcastcfspr14.htm
    There will be no protective gates around the class and you should be able to download the webcasts and other material.
    b. On iTunes U: If you want a smoother experience, the same material will be posted on the iTunes U site in a public course (that anyone should be able to watch on an Apple device, if they have the iTunes U app, which is free)
    Link for class: https://itunes.apple.com/us/course/id806212423
    Classes start on February 3 and will go on until May 12, though the class will stay online for months afterwards.

    Valuation class: This is a class about valuation, more valuation and still more valuation. As I describe, it is about valuing any type of asset or business, using any valuation technique and in any kind of setting. The choices for taking it are listed below:
    a. On my website: All of the material for the class will be at the links below:
    Link for the class: http://www.stern.nyu.edu/~adamodar/New_Home_Page/equity.html
    Link for webcasts: http://www.stern.nyu.edu/~adamodar/New_Home_Page/webcasteqspr14.htm
    b. On iTunes U: If you want a smoother experience, the same material will be posted on the iTunes U site in a public course (that anyone should be able to watch on an Apple device, if they have the iTunes U app, which is free).
    Link for class: https://itunes.apple.com/us/course/id806212442
    This class also starts on February 3 and lasts until May 12.

    If you are interested in joining in, please do so. I would love to have you along for the ride. I know that many of you have tried to take these classes in the past and have had a difficult time making it past the first few sessions, and I entirely understand. Juggling family, friends, a full course schedule at your regular college and life's other challenges is difficult enough, without having to add two more 80-minute sessions each week, as well as all of the work that goes with these classes. If you can pull it off, I admire you, but if you don't have the time, I not only understand but I do have a offer for you that reflects four lessons that I have learned in my exposure to online learning.
    1. Online learning is different from in-class learning: A classroom lecture of 80 minutes is long enough, but it is doable. An online lecture of 80 minutes is torturous. In fact, studies during the last two years suggest that an online lecture that lasts for more than ten minutes may very quickly end up losing its audience. Online classes have to be shorter, punchier and accompanied by fewer distractions than regular classes.
    2. There is too little interaction: Online classes offer too little interaction, not only between faculty and students but also among students. Online classes need to find ways to increase interaction especially among students, not only to allow questions to be answered but to provoke discussion that can enhance learning.
    3. There is limited or no feedback: Much as students like to complain about exams in their classes, it turns out that they miss not having them (as is the case in many online classes), since they provide tangible feedback on whether you are absorbing the material in the class. Online classes need to find ways to let students confirm that they are assimilating the key concepts of the class.
    4. There is no hands-on experience: Ultimately, you learn by doing, not listening, and online classes seem to give short shrift to hands on experience. Online classes need to figure out ways of getting students to try what they learn in class on real world questions.
    For the last few months, I have wrestled with how best to create an online class that tries (and perhaps fails) to overcome these problems. My first experiment was with my investment philosophies iTunes U class, tied to my book, that I posted on a few months ago. My second experiment is now ready to go and I would love to have your feedback on what parts of it work and which ones don't. It is my valuation class, restructured and redesigned for an online audience, with the following components. You can find it on iTunes U by going to the following link:
    Online valuation class: https://itunes.apple.com/us/course/id780803998
    If you have an iPad, this should be easy to do. If you have an Android, you will need to download an app that allows you to access iTunes U courses.  If you do try this class, you will find the following changes.
    1. Less is more: I compressed each of my MBA classes (80 minutes) into a 10-15 minute session. Thus, this class is composed of 25 sessions, averaging around 15 minutes each. I tried to get the core of each class into the shorter session. You can be the judge!
    2. Easier on the eye? Stern was kind enough to provide me with a professional cameraman and editor for the sessions and I think they are much more watchable. My thanks go to Kristen Sosulski, Brian O'Hagan and David Schumacher for making these videos look great, though I retain responsibility for anything stupid that was said during any of them.
    3. Post class tests and solutions: Like the investment philosophy class, each session in this class comes with a post class test and solution to allow you to test your understanding of that session.
    4. Discussion boards: Kipin Hall is a business started by some very bright young people at NYU that offers a discussion board online. I have added a link to each session, with a discussion forum for that session. You can use it to ask questions about the material that someone else taking the class may be able to answer or which I may, from time to time, be able to provide input on.You can also use it to chat with others in the class, post links about the topic or in any other creative way that you want. You will need to register the first time you use the discussion board, and if you any questions or issues, you can contact Kipin Hall at info@kipinhall.com
    5. In-practice webcasts: Since you learn valuation by doing, I have added number of in-practice webcasts on practical questions ranging from how you read a 10K to how you adjust earnings for leases or compute a cost of debt. You can use this to take the material from the class and value companies.
    6. Blog post valuations: In an ongoing part of the class, I plan to take the weekly company valuations that I do this semester in my regular class and do short blog posts on how I approached the valuation, accompanied by my spreadsheet containing the valuation.

    I am not ready to give up on online learning yet. If they have not worked well so far, it is not because they can never work but because we have much to learn about how people learn online and what works and what does not. I plan to keep trying and with your help, I hope to get better over time.





    The barbarians are at the gate! Of universities, moats and disruption!

    In my last post, I attempted to break down the bundled product that comprises a college education into its component parts, and closed by arguing that the future of universities rests on their ability to preserve the competitive advantages that have allowed them to get premium prices for these bundles and that of online education entrepreneurs on their capacity to find chinks in the university armor. 

    In this one, I would like to look at the competitive advantages that colleges/universities have on each component and how close (or distant) the online threat is on each of them. Borrowing from the terminology of value investing, universities have moats around their “educational castles” and the online barbarians (at least as seen by the members of the educational establishment) are trying to breach the establishment. Since so much of this debate comes from one side of this divide or the other,  I decided that it would be good to try to look at both sides. In the table below, I take a look at each piece of the bundle, what colleges/universities bring as a competitive advantage on that piece and the challenges faced by online disruptors.

    The University Moat and the Online Challenge
     Bundled item
    The “University” Moat is deepest at
    The Online Challenge
    Screening
    More selective” schools that have reputations based on long histories and tradition. It is also self-perpetuating, since your selectivity allows them to attract the best students who burnish their reputations further. 
    In softer disciplines, where it is difficult, if not impossible, for an outsider to observe output or make judgments on quality.
    Online entities have a "chicken & egg" problem, since they need good reputations to be selective and need to be selective to generate those reputations.  However, they may have a much better chance of breaking through 
    (a) if they can team up with an entity that has a reputation (a university like Stanford/MIT or a pure screener like the College Board) or
    (b) in areas where the skill sets of graduates are measurable and observable. (Engineering, software coding etc.)
    (c) in disciplines where there is a common certification exam (accounting, law).
    Structuring
    Colleges that help students create customized study or degree programs, built around their interests and objectives. 
    Online education is currently chaotic when it comes to structuring. While course offerings proliferate, guidance for novices on structuring & sequencing these courses is limited or non-existent. 
    Classes
    Colleges that offer classes that are well taught by “star” faculty and built around interaction, group learning, individualized feedback and informative grading systems (that measure learning and not attendance/memorization) have an edge.
    Online classes are often too passive, focused on delivering content and mechanized testing/grading. Creating more interactive, dynamic online classes as well as hybrid variations, which are online much of the time, but have in-person meeting components, may help bridge the gap.
    The Network
    Colleges that create networks among students that continue long after they graduate, augmented by small group networks such as sororities/ fraternities and campus clubs/activities.
    Fostering close networks when your interactions are all online is more difficult ( but as Facebook and Linkedin's success show, it is not impossible) and serendipitous contact (like the ones you have on the college green with strangers) is very limited.
    Career Advice/ Placement
    Colleges that provide career guidance early in college life, followed by access to good placement services (with exclusive and privileged access to prized employers) .
    Getting employers to trust your “products” as much as they trust established institutions (colleges & universities) will take time, though it should be easier in professions where the proof of competence can be tested.
    Entertainment
    Colleges with strong sports teams and cultural activities on campus.
    Entertainment options online are getting richer but it will be difficult to match the real thing. Online universities don't have basketball teams or play bowl games.
    Education
    Colleges that try to students how to learn & prepare them for life.
    Same challenge, but magnified because you are restricted to do this online.

    I know that I am probably being simplistic in some of my assessments, but the key is to get this conversation started. 

    Last year, I gave this talk at a few schools about the future of education, and I tried an experiment, making one half of the audience play the role of the university (and giving them the job of defending the moat) and the other half of the audience the role of online disruptors. I created worksheets for each group to try to get them to be specific about gauging the state of the moat at their institutions and potential challenges. If you are interested, the links to each side are below:
    1. Worksheet for the University side (on how to make the moat deeper) (Download as pdf file)
    2. Worksheet for the Online disruptor side (on how to get across the moat) (Download as pdf file)
    If your sympathies lie with the university side or your future depends upon it's survival (because you are a faculty member or administrator), you can see that keeping the education monopoly will require work and changes in the way universities are structured. Lifetime tenure, a low teaching load and research freedom may all be viewed as inalienable rights by university faculty today (at least at the top research schools) but they will all have to be reexamined in light of the competition. 

    If you are an online education entrepreneur, this exercise will be a reality check. Universities will not cede their power easily and have the means to make it difficult for online disruptors to challenge them, since they not only get to define what comprises education but are backed up by licensing/accreditation bodies that have bought into the system. . To wean consumers away from traditional universities, online educators have to think broader, be more creative and use guerilla warfare where necessary. 

    I believe that change is coming to education but that it will come in stages and be under-the-surface. The first to feel the heat (if they have not already) will be colleges that have loose or non-existent screens, mechanized degree programs, content-heavy but learning-light classes and nonexistent networks. As they fall prey to online or alternative education systems, it is an open question as to how schools further up the food chain will react. I won’t claim to know the mindset of faculty/administrators at the top schools but my interactions with them suggest that many of them will, for the most part, resist change (especially if it inconveniences them) and argue that there is no chance that their civilized citadels will fall to the barbarians. But they are fooling themselves, since the disruptors have the luxury of being able to experiment, with nothing to lose, until they find the weapons that work. It is only a matter of time!



    The MOOC stumble: Lessons from Napster and the Music Business!

    I have been a long time proponent of online education and have been offering webcasts of my classes since 2001. However, I was a little skeptical about the news stories that appeared a couple of years ago about Massive Open Online Courses (MOOCs) being the next "big thing" in education. If a class were only about delivering content, a MOOC may do the job, but a good class should be (though it often is not) more than that. It has to foster hands-on experience, interaction, excitement and "aha'" moments, and MOOCs (including mine) have not paid enough attention to these pieces. Thus, as the initial buzz about MOOCs has faded, we are discovering the achilles heels of online classes: high drop out rates and poor retention of knowledge. It is therefore not a surprise to read stories like this one about the failures of and financial troubles faced by MOOCs.

    As is often the case, some journalists and analysts are over reacting to these news stories to conclude that online education is a failed venture. Some of the more reactionary university administrators and faculty are gleeful and are ready to go back to what they have done for decades: take students for granted and cater to the other interest groups that feed at the higher education trough. That would be a mistake, analogous to music companies reacting to the demise of Napster more than a decade ago by going back to their old modes of business (selling CDs through music stores), only to be swept away by Apple iTunes a few years later. The MOOC model represented the first serious foray of online entities into education and like Napster, it failed because it not only came with flaws but because it's promoters failed to fully understand the business it was trying to disrupt.

    It is also worth noting that the failure of MOOCs really rests on your definition of the word "fail".  My corporate finance MOOC, offered on iTunes U, YouTube and online last spring had 50,000+ people registered in it. By my count (and it is unofficial), about 10% of them have finished the class, as of now, and a significant portion took more than a year, and another 5% or 10% may get around to completing the class in the next few months. While that represents only 15% to 20% of the overall total, that works out to 7500-10000 people taking the class, a number that I would find impossible to reach in  a physical classroom, even over many years. If that represents failure, I will take it!

    One reason for the inability of MOOCs to penetrate the education market is that they started with the faulty premise that the core of what you get for the college tuition that you pay is classroom content. As my third child went off to college last year, I had a chance to revisit the question of what it is that you get in return for that check you write out to the educational institution of your choice. The first thing to note is that universities operate like cable companies (and other monopolistic entities) and force you to buy a "bundled product", whether you want the individual pieces or not. The second is that classes are only a piece, and perhaps not even the most critical piece, of the "education" bundle. As I see it, here are the ingredients of the bundle:
    1. Screening: It can be argued that the most value-added day of your education at a selective school (say an Ivy League, Stanford, MIT or Caltech in the US or the equivalents in other countries) is the day that you receive your admissions letter from the school. The rest is purely academic (in the truest sense of the word), since the fact that you were able to make it through the screen becomes the most noticed part of your education. 
    2. Structuring: For better or worse, universities have been able to define the content of an education for centuries. This includes not only a specification of how long it takes to get a degree (in terms of time and courses) but also the breakdown of courses into required or core classes and the sequencing of electives thereafter. 
    3. Classes: Within the course structure are classes, delivered by faculty (generally exclusive to that university) in restricted settings (physical classrooms) owned by the university and with an infrastructure of exams, tests and grades that affirms to outsiders that students have taken and mastered the content in these classes. Students in these classes learn from interactions (usually live) with the faculty and other students and can get help from tutors or teaching assistants for these classes. In special cases, students that have an intense interest in a topic may be get mentoring and advice from faculty who are (presumably) experts on that topic.
    4. Networking: Even those of you who have been victimized by the "old boy (or old girl)" network have to admit that it works remarkably well at taking care of those who are lucky enough to be part of it. The networks that are created when you are a student at an educational institution may provide you with job openings, employment options and business opportunities later in life. This can be augmented by smaller networks also created by sub-groups (fraternities & sororities, clubs) at schools.
    5. Career advice: Recognizing the economic imperatives that most students face in terms of getting employment after their education, universities have invested (some more than others) in providing both career advice and placement services. 
    6. Entertainment: While this may sound irreverent, it is reality that a portion of the college experience is entertainment. Whether it be going to football games at Alabama or Notre Dame, enjoying a concert on campus or just people-watching on Sproul Plaza on Berkeley, you don't realize how much fun you have in college, until you graduate (and get into the real world, where such entertainment is more difficult to find, more expensive and expose you to more danger). At the risk of sounding cynical, I would also include as part of entertainment, the semester abroad programs that schools love to tout as a "bargain educational experience in exotic foreign locales" , since there is generally more fun to be had in your semester abroad in Spain/France/Brazil/Italy than learning.
    7. Education: There is a final fuzzy component that universities claim to aspire to deliver, though there is no way of measuring whether they deliver on the promise. "Send your 18-year old to us", they say, "and and we will turn them into educated people".  A Harvard panel defined educated people as those who “leave school with a deep understanding of themselves and how they fit into the world and have learned how solve complex problems, be creative & entrepreneurial, manage themselves and to be life long learners". Well, good luck with that!!!
    There are undoubtedly other bits and pieces that I am not including in the bundle, ranging from on-campus food/housing (which is now a requirement and not an option at most schools) to an implicit belief (misplaced or not) on the part of some foreign students that getting an undergraduate degree at a US university will improve their odds of being able to work and live in the United States. (If I have missed pieces of your specific college bundle, please do let me know and I will add it in).

    The value of this bundle and its components will clearly vary from school to school. With some highly ranked, research universities (that I will leave unnamed), the screening, networking and career advice may be the predominant parts, with classes a distant fourth. That is perhaps the admission that Wharton was making when it put a large chunk of its first-yar MBA classes online, for free. With small, teaching oriented colleges, the tilt may be towards classes and structuring (with customized programs), with small but very strong networks, as a bonus. Of course, you could end up at a college that is not particularly selective, has a one-size fits all for coursework, indifferent faculty/content-heavy classes, weak networks and little or no career advice/placement and unwatchable sports teams. If so, I hope that you are not paying $50,000/year for an education, because you certainly are not getting your money's worth.

    If you are or were a consumer of the education bundle, some introspection may be called for. If your college education was in the past, was it worth the money you paid for it and the time you spent acquiring it? If so, what part of the bundle has paid off the most? Was it the screening, the class content, the connections (network), the entertainment value or that unquantifiable secret ingredient (personal growth)? If you or your child is in college right now, ask the same questions about your ongoing experience. In particular, are there parts of this bundle that you are paying for that you have no use for? The one thing you cannot do is assume that the threat has passed, just because an immediate threat (MOOCs) may have dissipated.

    If you are a faculty member or a college administrator, you have to ask the same questions and your future may ride on the answers. In particular, you have to look at what it is that you offer (as a college or university) that makes your education bundle unique, different and difficult to replicate (either online or in another institution). If you are an online education entrepreneur, your task is to figure out ways to unbundle the product and probe its weakest points. That will be the subject of a companion post.



    Numbers Time! Data update for 2014

    In 1992, I had just finished a spreadsheet that contained the average PE ratios for companies in different sectors in the United States. There was little of substance in it, but I decided that since I had it, I might as well share it. I posted that spreadsheet for students in my class to download and made it available to others who visited my website (more hopeful thinking than an actual plan, since there were relatively few people looking for data online). Each year since, I have added to the data collection, initially expanding my list of data items for US companies, and in the last decade, adding to the collection by looking at non-US companies. It is my first task each year and it takes up the first week of the year, and I just uploaded the data today for the 2014 update. 

    I never imagined that my initial foray into data sharing that started with one spreadsheet of a single statistic would expand to cover 285 spreadsheets in 2014, with more than a thousand data items and that my universe of stocks would include 40,906 listed companies in 131 markets.

    While you can find them all by going to the data section on my website, I won’t bore you with the details in this post, but focus instead on the what, why and what next of data.

    The “what”: It starts with raw data!
    In the last three decades, we have witnessed a revolution in data access that we need to step back to appreciate. In the 1980s, unless you worked at a university or an investment bank, your access to data was not just limited but often non-existent. I remember trekking to the library (yes, the place with real books and reference stacks and the Dewey decimal system) to review Value Line summary sheets for individual companies and the industry averages that S&P published at the start of every year. I had access to Compustat through the university but it was accounting-focused (with very few market numbers) and dated. 

    The first glimmers of the data revolution were in the 1990s and for me, it began with Value Line offering an electronic version of the data, delivered on a CD every month by mail. That was the basis for my first data updates and Value Line data remains my base for US data, more because of my familiarity with it and its history than any special characteristics. In fact, there are databases that have richer detail, not just in terms of having more data items for US companies, but in bringing in listings in other markets. My decision to expand my data updates from US to global companies was triggered by my access to Bloomberg terminals that were installed at the Stern School of Business about a decade ago. About five years ago, I started tapping into Capital IQ, an S&P product, that is one of the more comprehensive databases for global companies today. In addition to accounting data, it includes market data and corporate governance data on individual companies and an easy interface for screening and downloading data.

    My focus in data analysis is to consolidate the data into a form where it not only less overwhelming but also more usable in valuation and corporate finance endeavors. To that effect, I compute averages on key statistics (profitability measures, risk measures and financial leverage measures) across industries and geographical groupings. I also use the raw data to put my spin on corporate finance measures (cost of capital, excess returns) for individual companies.

    The why: It is purely self-interest!
    While I am gratified that there are some out there who use my data in their analyses, I want to be clear that there is very little that is altruistic about my efforts. So, in case you are curious, here are the reasons why I think that the week that I spend at the start of each year is well spent.
    1. Anchor Angst: Behavioral economists, starting with Kahnemann and Tversky, have noted that investors and analysts look for anchors, starting points for making judgments, when making decision. They also noted that these anchors are often either skewed (by an investor's own experiences and history) or based on fiction, leading to bad decisions. So, what is a low PE ratio in today’s market or a high revenue multiple? Rather than make those judgments based on bad information, I find it useful to look at the data each year and let it inform my assessments. It is this theme that I used for my update last year, where I used one of my favorite books/movies, Moneyball, to illustrate the power of data.
    2. It is a time saver: This may seem like an odd claim to make, after I have spent a week collecting and processing the data, but I am convinced that the net effect of my efforts during the last week will be a time saving over the course of the year.  As some of you are aware, I not only teach a valuation class but I also value companies frequently, both in the context of the class and to satisfy my curiosity. While the starting data for my valuations comes from the company’s financial statements, the key inputs in valuation are often industry-wide risk and profitability measures. The industry averages that I computed this week will often be the numbers that I return to over and over again, during the course of this year.
    3. Go global: It is easy to talk “global” but it remains true that we are most comfortable with staying “local”. This is not only true for investors, who continue to have a home bias in investing (over investing in their domestic markets) but it also applies to businesses and academics. In fact, much of finance research, while paying lip service to the global market, continues to have a US focus. One reason that I have extended and deepened my analysis of global companies over time is to fill in the empty spots in my knowledge on listed companies in many of the smaller markets. It is telling that 80% of the time that I spent in the last week was on non-US data, a significant jump from the cursory efforts I made a decade ago when I started reporting global numbers.
    The what next: Caveat emptor!
    If you do decide to download and use any of the data on my website and use it, here are a few things that I hope that you will keep in mind:
    1. Data can be subjective: Contrary to the widely held view that numbers are objective, the statistics that you will see in my datasets reflect my judgments and points of view, some of which you may agree with, but some that you may disagree with, perhaps vehemently. Thus, my estimates of equity risk premiums for individual countries are largely based upon sovereign ratings and CDS spreads, both bond market measures of default risk. Similarly, my estimates of costs of capital for individual companies are built on my estimates of relative risk (beta) for these companies, which are in turn estimated from the sectors that they operate in and their policies on debt.
    2.  Bludgeon, not scalpel: One of the key differences between analyzing one company and trying to assess tens of thousands of companies is that you cannot have too much nuance in the estimation approaches that you use for the latter. For example, for an individual company, I will try to estimate the cost of debt, based on an actual or synthetic bond rating. With multitudes of companies, I use a much looser approximation, where I tie the cost of debt to the variability in the stock price. Bottom line: If you are valuing an individual company, go to the source (the annual report and financial filings) and not the line data that you see for that company on my data set. If you are analyzing an entire sector, you can use my approximated data in your analysis.
    3. There will be mistakes in the raw data: I am incredibly grateful to Value Line, Bloomberg and S&P for giving me access to the raw data on companies, but it is also true that there is potential for human error at the date input stage. While I run my own tests to try and catch data input errors , I will miss a few. Thus, if you do find a company in my data base that has a return on equity of 20,000% or a PE ratio of 0.1, odds are that there is something wrong in the raw data of the company. 
    4.  The outlier conundrum: Even if the raw data is accurate, the ratios and multiples computed from that data can sometimes yield absurd values. Thus, the PE ratio for a company with earnings fading towards zero can converge on infinity. With individual companies, you notice these absurdities and either adjust for them or look for alternative statistics. With large samples, though, that oversight is again difficult and while I could have arbitrarily set limits (ignore PE ratios greater than 200, for instance), I was reluctant to put my imprint on the data. So, if you see strange numbers for some statistics, it is what came out of the data.
    5. The law of large numbers is your ally: The other side of large samples is a positive one, since the advantage of having very large samples is that the outliers have less of an impact on your statistics. Thus, I am comforted by knowing that I have hundreds of firms in each sector, when I compute my averages and that strange numbers on the part of a few companies will have only a small impact on the averages.
    I know that there is little earth-shattering that I have said about what I learned from the 2014 data update, but I think those lessons will be better covered in a series of posts that I plan to make in the next  couple of weeks.

    P.S: As always, there are dozens of links and data sets in my data page and I am sure that I have screwed up on some of them. If you find any missing links or have issues with the data, please let me know and I will fix them as soon as I can. 



    A good year ends, but what's next for stocks?

    As an exceptionally good year for stocks comes to an end, the talk of stock market bubbles fills the air.  Among others, Robert Shiller warns us, that based upon his market measure of value, that we are in "bubble" territory and almost  every acquaintance that I have starts off by asking me whether I think that US equities are ready to pop. I have great respect for Shiller, but I also know that the market is bigger than any of us, Nobel prize winners or not. As the the new year begins, and we all turn our attention to the state of our portfolios, I am sure that this discussion will only get louder. You may be accuse me of being "chicken" but I am loath to get into this guessing game, since market timing is not my strength. However, the scattered nature of the debate, where each side (bubble or no bubble) finds something in the market that supports its thesis reminds me of the story about the blind men who are allowed to touch an elephant and come to very different conclusions about what it looks like. Perhaps, the only contribution I can make to this discussion is to provide a framework that can be used to make sense of the different perspectives on the future of stocks and at lease provide some perspective on how investors can look at the same numbers and come to such different conclusions.

    Standard Pricing Metrics: In the eye of the beholder?
    Most of the arguments about whether we are in bubble territory still are built around the standard metrics, where equity multiples are compared across time and markets. In fact, a surprisingly large number of arguments, pro and con, are based on the PE ratio, with variants on earnings used by each side to make its case.  Those who remain optimistic about the market focus on trailing or forward earnings and note that the trailing and forward PEs, while high can be explained by low interest rates. Those who are pessimistic about markets either make their comparisons to the historic averages for the PE ratio for the market or argue that earnings for the market are high today (in both absolute levels and stated as a percent of revenues) and are ripe for adjustment. Thus, it is no surprise that those who use cyclically-adjusted PE (CAPE) are sounding alarm bells about the market.

    Valuing the market
    Like any other investment, the value of a market is determined by cash flows, growth (level and quality) and risk in stocks. Consider an investor who buys the equity index. That investor can lay to claim to all cash paid out by the companies in the index, composed of both dividends and stock buybacks. If we forecast out these composite cash flows, the value of the index in intrinsic terms can be stated as a function of the following variables:

    Holding all else constant, higher base-year cash flows and higher growth rates lead to higher values for equities, whereas higher risk free rates and equity risk premiums result in lower values for equities.

    The status quo
    Given these drivers of equities, where do we stand right now? The S&P 500 starts the year (2014) at 1848.36, up almost 30% from it's level of 1426.19, a year prior. While that jump in stock prices makes most investors wary, it is also worth noting that the cash paid out to equity investors in the twelve months leading into the start of 2014 amounted to 84.16, up 21.16% from the cash flows to equity in the twelve months leading into the start of 2013. As the economy strengthened over 2013, the US treasury bond rate also climbed from 1.76% at the start of 2013 to 3.04% at the close of trading on December 31, 2013.  To estimate the cash flows in future years, we used the estimates of earnings from analysts who track the aggregate earnings on the S&P 500 (top down estimates), resulting in an earnings growth rate of 4.28% a year for the next five years, which we also assume to be the growth rate in the cash flows paid out to equity investors (thus keeping the payout stable at 84.13% of earnings). As a final input, we set the growth rate in cash flows beyond year 5 at 3.04%, set equal to the risk free rate.

    The simplest way to bring these numbers together is to look for a discount rate that will make the present value of the cash flows (i.e., the intrinsic value of the index) equal to the traded value of 1848.36. That discount rate works out to be 8.00% and can be viewed as the expected return on equities, given my estimates of cash flows. Netting out the risk free rate from that number yields an implied equity risk premium of 4.96%.

    Are we in a bubble?
    One way to evaluate whether stocks are collectively misplaced is to compare the implied equity risk premium today to what you believe is a reasonable value. That "reasonable value" is clearly up for discussion but to provide some perspective, I have reproduced the implied equity risk premiums for the S&P 500 from 1961 to 2013 in the figure below.
    The equity risk premium of 4.96% is clearly down from its crisis peaks (6% or higher), but it is still higher than the average of 4.04% from 1961-2013 and slightly above the average of 4.90%, from 2004-2013. Market optimists would point out that unlike the market peak in early 2000, when the implied equity risk premium of 2.00% was well below the historic norms, the equity risk premium today is at acceptable or even above acceptable levels. Market pessimists, though, will note the equity risk premium in September 2008 was also just above the historic norms and that it provided little protection against the ensuing crash.

    Stress Testing the Market
    The assessment of the equity risk premium above is a function of the risk free rate and my estimates of expected cash flows and growth. Since all of these can and will change over 2014, it is prudent to evaluate which of these variables pose the greatest threat to equity investors.

    1. Risk free rate
    While the US T.Bond rate has rebounded from its historic lows, it remains well below its norm, as indicated in the figure below:

    While there are many who attribute the low rates in the last few years primarily through quantitative easing by central banks, I remain a skeptic and believe that low economic growth was a much bigger contributor. In fact, as economic growth rebounded in 2013, interest rates rose, and if expectations of continued growth in 2014 come to fruition, I believe that rates will continue to risk, no matter what the Fed decides to do.  While that rise in rates may seem like an unmitigated negative for stocks, the net effect on stocks will be a function of whether the economic growth also translates into higher earnings/cash flow growth. It is only if interest rates rise at a much steeper rate than earnings growth rates increases that stocks will be hurt.

    2. Equity Risk Premium
    While the equity risk premium today is not low, relative to historic standards, the last five years have taught us that market crises can render historic norms useless. Thus, there is always the possibility that 2014 could bring a macro crisis that could cause equity risk premiums to revert back to 2009-levels. In the following table, I estimate the intrinsic value for the S&P 500 at different equity risk premiums.
    If, in fact, we saw a reversal back to the 6.4% equity risk premiums that we observed after the crash, the index would be valued at 1418, making it over valued by about 30% today.

    3. Cash flows
    It is clear that US companies returned to their pre-crisis buyback behavior in 2013 and there are some who wonder whether these cash flows are sustainable. To answer that question, we looked at dividends and buybacks from 2001 to 2013 in the figure below, and compare them to the earnings on the index each year.


    Are US companies returning too much cash to investors? It is true that the 84.13% of earnings paid out in dividends and buybacks in 2013 was higher than the average of 79.96% from 2004-2013, but the difference is not large.  The bigger danger to cash flows to equity is a collapse in earnings. In fact, using the CAPE rule book, we estimated the inflation-adjusted earnings on the index each year from 2004 to 2013 and computed a ten-year average of these earnings of 82.64. Applying the average payout ratio of 79.96% to these earnings results in a much lower cash flow to equity of 66.08. Using those cash flows, with an equity risk premium of 4.90%, results in an intrinsic value for the index of 1467.89, about 20.6% lower than the index level on January 1, 2014. Thus, it is no surprise that those analysts who use PE ratios based on average earnings over time come to the conclusion that stocks are over priced.

    4. Growth Rates
    The use of analyst estimates of growth can make some of you uneasy, since analysts can sometimes get caught up in the mood of the moment and share in the "irrational exuberance" of the market. While using top down estimates (as opposed to the estimates of growth in earnings for individual companies), provides some insulation, there is a secondary test that we can use to judge the sustainability of the predicted growth rate. In particular, when the return on equity is stable, the expected growth in earnings is a product of the retention ratio (1- payout ratio) and the return on equity:
    Sustainable growth rate = (1 - Payout ratio) (Return on equity)
    Using the 84.13% payout ratio and the return on equity of 15.790% generated by the market in 2013, we estimate an expected growth rate in earnings of 2.67%, lower than the analyst estimate of 4.28%. Substituting in this growth rate lowers the value of the index to 1741, making it over valued by about 6%, at its current level.

    Try it yourself
    I know that you will probably have your own combination of fears and hopes. To help convert those into an intrinsic value for the index, I have the spreadsheet that I used in my analysis for download. When you open the spreadsheet, you will be given a chance to set your combination of the risk free rate, equity risk premium, cash flows and growth and see the effect on value. The spreadsheet also has historical data on risk free rates and equity risk premiums embedded as worksheets.

    Bottom Line
    As I look at the fundamentals and the possibilities for 2014, I am wary but no more so than in most other years. There are always scenarios where the intrinsic value of the index will drop and the biggest dangers, as I see them, come from either a global crisis that blindsides markets or from a precipitous drop in expected earnings.  Can I guarantee that these scenarios will not unfold? Of course not, and that is precisely why I would require an equity risk premium for investing in stocks and will continue to diversify across asset classes and markets. You may very well come to a different conclusion, and whatever it is, I wish you only success in the coming year, even if it comes at my expense. Happy New Year!

    End of the year (2014) data update posts

    1. A good year ends, but what's next for stocks?



    If we don't do it, our competitors will! Defensive Dealmaking or Panicky Preemption?


    My last post on Facebook’s acquisition of Whatsapp brought a whole host of responses, some of which took issue with my argument that it is easier to explain the deal using pricing metrics, especially ones that are used in the social media sector (# users) than with valuation models or logic. One of the arguments made by some of the commenters was that I was missing the real reason for the deal, which was that it was a defensive maneuver by Facebook, designed to both protect its profitability and to keep a prime competitor (Google) from acquiring Whatsapp. Many of these commenters also emphasized that these defensive deals cannot be assessed using conventional valuation techniques and that we have to trust management to make the right judgments on them. I don't have a bone to pick with the logic of defensive deal making, but as a valuation person, I don't agree with the claim that defensive deals cannot be valued. If preemption is the primary rationale behind an action, I believe that it not only can be valued but it should be valued. 

    A Valuation View of Preemptive Actions
    If you adopt a stilted  view of valuation models (and DCF, in particular), it is possible that preemptive actions cannot be valued. However, I would argue that conventional discounted cash flow models provide more than enough flexibility to value preemption in all of its forms. To illustrate, let me set up a simple example. Let’s assume that Company A has $10 million in after-tax income (and cash flow) that it expects to generate in perpetuity on invested capital of $50 million and that it has a cost of capital of 10%. This company can be valued as a standalone entity at $100 million.
    Value of company (stand alone) = $10/.10 = $100 million
    Now, assume that this company is faced with Company B, a young company that has a product that has no revenues right now, but if allowed to develop or in the hands of a competitor, could eat into Company A’s market and lower its after-tax cash income to $ 6 million. Even though company B has little income potential on its own, company A should be willing to pay up to $40 million to acquire it.
    Value of preemption = Lost after-tax CF/ Cost of capital = (10-6)/.10 = $40 million

    I know that you are looking at this example and arguing that it is far too simplistic to be used to explain Facebook’s acquisition of Whatsapp. While estimating the cash flows may be more complex with Facebook, you are, in effect, making the same argument. In fact, working through my discounted cash flow valuation of Facebook, I can work out the impact of that a potential competitor will have on the company's revenue/margins and the value of those cash flows, and by extension, how much Facebook should be willing to pay to remove that competitor from the game.


    The table, while looking at a wide range of outcomes, does provide some interesting insights into Facebook's vulnerabilities. First, the company's value is far more sensitive to margin erosion than it is to revenue loss, partly because the company has astounding high pre-tax operating margins (about 50%). Second, there are clearly combinations of revenue decline/margin drop that yield values greater than $19 billion. Note that this number will not be the total value of Whatsapp because it does not include the direct income and cash flows that you can generate from Whatsapp's business. You are welcome to try your hand on my spreadsheet that builds off the Facebook base case valuation to compute the effect on value of declining revenues and dropping margins.

    Defensive Value Creation: Necessary & Sufficient Conditions
    While it is easy to construct discounted cash flow valuations to justify acts of preemption, there are four conditions that have to be met for preemptive spending  to be justified.
    1. The business you are defending is worth defending: Acting in defense of a business makes sense only if that business is a good one, and the measure of a good business is whether it generates returns on invested capital that exceed the cost of funding that business. If you own or run a bad business, spending money to defend that business strikes me as a pointless and expensive exercise. Lest this sounds like a weak precondition, note that by my calculations in 2013, about 60% of all listed companies (40,000+) globally generated returns that were below their costs of capital, and more than a third of them under performed by substantial margins (>5%).

    2. The threat is real, not imaginary: Spending preemptively to ward off a threat makes sense only if the revenue loss/ margin decline that is anticipated is real and is not just in the fevered imagination of the top management. While you can argue that this is a business judgment that should be left to the top managers of a firm, a paranoid CEO, egged on by “strategic” consultants and aided and abetted by bankers, eager to get the deal done, will find a hundred potential threats for every real one.
    3. The preemptive action is the most efficient (and cheapest) way to ward off the threat: Even if the threat is to a valuable business and is imminent, there may be less expensive and simpler ways to deal with the the threat then the chosen action. Thus, if you can acquire a technology from a company or exclusive licensing rights for a billion, you should not be spending $10 billion to buy the whole company.
    4.  The threat is unique and not easily recreated: Spending money to eliminate a potential threat makes sense only if the threat is unique and not replicated easily/quickly. If the threat can be replicated easily, the spending company will find itself repeatedly spending larger and larger amounts of its depleting stock to make subsequent threats go away. These are companies with fragile business models with shallow ditches rather than competitive moats separating them from mediocrity.
    The question on the Facebook/Whatsapp deal is whether these conditions are met. As I see it, the first condition is easily met since Facebook clearly has a very profitable (and high return) business to defend. On the second and third, Facebook investors are, in effect, trusting Mark Zuckerberg's judgment that Whatsapp is a platform that may threaten Facebook's profitability and that buying out the company for $19 billion is the cheapest way to avoid that threat. It can be argued that he has earned their trust with the company's performance over the last two years.  It is the fourth condition that should be most worrisome to Facebook investors. While Whatsapp may be a truly unique platform, the price tag on this deal is sure to entice young programmers, huddled around tables in Mumbai, Moscow and Menlo Park, to come up with new ways to breach Facebook defenses, knowing that they too will become wealthy beyond their wildest dreams, if they succeed. Looking at Facebook's short history, the price of preemption seems to be escalating at an exponential rate, going from $1 billion for Instagram more than a year ago to $ 3 billion for an attempted (and failed) acquisition of Snapchat to $19 billion for Whatsapp. (I know... I know.... There might have been other motives for the Instagram and Snapchat acquisition bids, but the price tag is climbing).

    The Preemptive Strategic Stupidity (PSS) Syndrome
    For every company that comes out ahead, in terms of value, with a preemptive strike, there are probably a dozen that end up worse off, often because they have bought into three adages that we accept as conventional wisdom. One is that companies have to do whatever they need to do to survive, as if survival is the be all and end all of business. The second is that doing nothing is not an option or that it is always the worst option. The third is that if you don't act, your competitors will and that their actions will hurt you more, even if those actions are not sensible. At the risk of getting some blowback from readers, here are my adaptations of these adages:
    1.  Survival is not the end game: As I have noted in my prior posts, there is no glory in growth for the sake of growth or business survival for the sake of survival. A business is a commercial enterprise and if you cannot generate sufficient returns, given the risk you face and the capital you have invested, you should shut the business down. 
    2. Doing nothing is not only an option but it may sometimes be a better one than doing something: We live in a world where activity is not only prized more than inactivity, but one in which there is far more money to be made by people from promoting activity (consultants, bankers) than from promoting inactivity. At the risk of sounding like stodgy, I believe that it is better sometimes to do nothing instead of doing something, especially if that something is ill advised or expensive.
    3. If your competitors are planning on doing something stupid, let them do it: If your competitors want to overpay for companies or take investments that generate substandard returns, your best option is often to let them do it. Especially with acquisitions, the winners of the deal making contest are not necessarily winning for their stockholders:
      This graph looks at winners and losers in multiple-bidder acquisitions and looks at the returns that investors would have made in the 40 months after the deal is done. The stock price, on average, declines by about 35% in the deal winners and increases by 25% in the deal losers in that period. 
    Wrapping up
    Companies often justify paying too much on acquisitions or making bad investments by using the preemption argument: if we don't do it, we will be hurt more than if we do. While that argument sometimes has economic merit, it deserves to be scrutinized just as much as any other investment decision. The tools for assessing the financial impact of these decisions not only exist but are straightforward. It is the will to make the assessment that is lacking at most businesses.

    While I have framed this post in terms of the Facebook/Whatsapp deal, I continue to believe what I said in my first post. I don't think that Facebook's management is doing this deal for defensive reasons or because they have explicit plans for generating value, at least as of now. It is Whatsapp's large, growing and engaged user base that makes it so attractive to Facebook, especially given how much the market is pricing all of those factors. You may find it difficult to believe that someone as smart as Mark Zuckerberg would pay $19 billion without a clear vision of how he plans to make money off the deal, but I don't. 



    Facebook buys Whatsapp for $19 billion: Value and Pricing Perspectives

    This week, I was at the Tuck School of Business at Dartmouth, talking about the difference between price and value. I built the presentation around two points that I have made in my posts before. The first is that there are two different processes at work in markets. There is the pricing process, where the price of an asset (stock, bond or real estate) is set by demand and supply, with all the factors (rational, irrational or just behavioral) that go with this process. The other is the value process where we attempt to attach a value to an asset based upon its fundamentals: cash flows, growth and risk. For shorthand, I will call those who play the pricing game “traders” and those who play the value game “investors”, with no moral judgments attached to either. The second is that while there is absolutely nothing wrong or shameful about being either an investor  (No, you are not a stodgy, boring, stuck-in-the-mud old fogey!!) or a trader (No, you are not a shallow, short term speculator!!), it can be dangerous to think that you can control or even explain how the other side works. When you are wearing your investor cape, you can be mystified by what traders do and react to, and if you are in your trader mode, you are just as likely to be bamboozled by the thought processes of investors. So, at the risk of ending up with a split personality, let me try looking at Facebook’s acquisition of Whatsapp for $19 billion, with $15 billion coming from Facebook stock and $4 billion from cash, using both perspectives.

    The Investor/Value View
    I will start wearing my value cap, mostly because I feel more comfortable in it and partly because I understand it better. Looking for fundamentals to justify the price paid but I realized very quickly that this would not only be futile but frustrating and here is why. To justify a $19 billion value for a company in equity markets today, you would need that company to generate about $1.5 billion in after-tax income in steady state. 
    Value of equity = $19 billion
    Implied required return on equity, given how stocks were priced on 1/1/14 = 8.00% (a 5% equity risk premium on top of a 3% risk free rate)
    Steady state earnings necessary to justify value = $ 19 billion *.08 = $1.52 billion
    Steady state pre-tax earnings needed to justify value, using an effective tax rate of 30%= $1.52 billion/(1-.30) = $2.17 billion
    That would translate into pre-tax income of about $2.2 billion and it is a lowball estimate of break even earnings, since the break even number will increase, the longer you have to wait for steady state and the more risk there is in the business model. Using a 10% required return (reflecting the higher risk) and building in a waiting period of 5 years before the income gets delivered increases the break-even income to $4.371 billion. You can try the spreadsheet with your inputs, if you so desire, to see what your break-even earnings estimate will be.

    There are three pathways to delivering these break-even earnings:
    1. If the company continues its current business model of allowing people to try the app for free in the first year and charge them a dollar a year after that (99 cents) and has zero operating costs (completely unrealistic, I know), you would need about 2.5 billion people using the app on a continuing basis.  
    2. It is possible that the app is so good that you could charge more per year and not lose customer. At their existing user base of 450 million, that would translate into about $5/year  per user, if you have no costs, and more, if you have costs (which you clearly will).
    3. The value may be in the form of advertising revenues from Whatsapp’s users but that will be tricky. On the home page for the app, here is what the app’s developers say about advertising:


    While they may not be legally bound by this statement, it will be awkward to walk it back and start sending text ads. However, there is a back door that Facebook may be able to user, if they can draw Whatsapp’s users (who tend to be younger) into the Facebook ecosystem and advertise to them there. Whatever the model, though, you would still have to generate at least $2.2 billion in after-tax income from advertising to Whatsapp users to break even.

    As an investor, the fact that a significant portion of Whatsapp's customer is teenagers is terrifying as a business proposition. While it is unfair to generalize based on anecdotal evidence, as the father of four children, two of whom used to be teenagers and two of whom are in the full throes of the disease (with symptoms ranging from extreme self-centeredness to volatile mood swings), it seems to me that the only group that is less dependable (and predictable) than teenagers is a group of teenagers who text a lot.

    At this stage, if you are an investor, you have two choices. The first and less damaging one is to accept that social media investing is not your game and move on to other parts of the market, where you can find investments that you can justify with fundamentals. The second is to go from frustration (at being unable to explain the price) to righteous anger or indignation about bubbles, irrationality and short term traders to trading on that anger (selling short). I would strongly recommend that you not go down this path, since it will not only be damaging to your physical health (it is a sure fire way to ulcers and heart attacks) but it may be even more so for your financial health. While you may be right about the value in the long term, the pricing process rules in the near term. 

    The Trader (Pricing) View
    Wearing my trading hat, though, the Facebook acquisition for Whatsapp may not only make complete sense, but it may actually be viewed as a positive. To understand why, I had to change my mindset from thinking about fundamentals (earnings/cashflows, growth and risk) to focusing on what the market is basing its price on. To find that “pricing” variable, I looked at the market prices of social media company, multiple measures of their success/activity and tried to back out the drivers of both price differences and price movements.


    These companies have different business models and may even be in different businesses but remember that the pricing game may not be about what you and I (as investors) think makes sense but what traders care about. Though the two (what makes sense and what markets focus on) may sometimes converge, they don’t have to, at least for the moment. My simplistic attempt at making sense of market prices was to look at the correlation between the market's assessment of corporate values and each of the measures for which I had data:


    Based on this correlation matrix, here are the conclusions I would draw:
    1. Number of users is the dominant driver: The key variable in explaining differences in value across companies is the number of users. While the value side of you may be telling you that you cannot pay dividends or buy back stock with users (you need cash flows), remember that the pricing game is not about what you or I think makes sense but what traders care about. This is reinforced by market reactions to earnings announcements, with Zillow seeing its stock price climb 12% when it reported earnings on February 14, 2014, primarily on the news that they added more users than expected and Twitter seeing its stock price drop 25% last week, again primarily on news that the user base grew less than expected.
    2. User engagement matters: The value per user increases with user engagement. Put different, social media companies that have users who stay on their sites longer are worth more than companies where users don’t spend as much time. While making comparisons across companies is difficult, since each company often has its own "measure" of engagement, there is evidence that markets care about this statistic. For instance, another reason Twitter was punished after its last report was that investors believed that the "timeline views per average user" and the "revenues per 1000 timeline views" reported the company were lower than they had anticipated.
    3. Predictable revenues are priced higher than more diffuse revenues: Some of the companies on this list derive revenues entirely from advertising, some from a mix of advertising and subscriptions and some from just subscriptions. In fact, some like Zynga make their revenues from retailing (in game purchases). While the sample is too small to draw strong conclusions, the value per user of $577 attached to Netflix's users suggests that the market values predictable subscription revenues more than uncertain advertising or retail revenue.  
    4. Making money is a secondary concern (at least for the moment): Markets (and investors) are not completely off kilter. There is a correlation between how much a company generates in revenues and its value, and even one between how much money it makes (EBITDA, net income) and value. However, they are less related to value than the number of users.
    So, what's next?
    Following in the footsteps of my favorite baseball general manager, Billy Beane, its time to play some Moneyball, where we let the data drive our actions, rather than our intellects. Here is what I take out of these numbers:
    1.  If you are an investor, stop trying to explain price movements on social media companies, using traditional metrics – revenues, operating margins and risk. You will only drive yourself into a frenzy. More important, don’t assume that your rational analysis will determine where the price is going next and act on it and trade on that assumption. In other words, don’t sell short, expecting market vindication for your valuation skills. It won’t come in the short term, may not come in the long term and you may be bankrupt before you are right.
    2. If you are a trader, play the pricing game and stop deluding yourself into believing that this is about fundamentals. Rather than tell me stories about future earnings at Facebook/Twitter/Linkedin, make your buy/sell recommendation based on the number of users and their intensity, since that it what investors are pricing in right now.
    3. If you are a company and you want to play the pricing game, I think that the key is to find that "pricing variable" that matters and try to deliver the best results you can on that variable.
    Returning to the Facebook/Whatsapp deal, it seems to me that Facebook is playing the pricing game, and that recognizing that this is a market that rewards you for having a greater number of more involved users, they have gone after a company (Whatsapp) that delivers on both dimensions. Here is a very simplistic way to see how the deal can play out. Facebook is currently being valued at $170 billion, at about $130/user, given their existing user base of 1.25 billion. If the Whatsapp acquisition increases that user base by 160 million (I know that Whatsapp has 450 million users, but since its revenue options are limited as a standalone app, the value proposition here is in incremental Facebook users), and the market continues to price each user at $130, you will generate an increase in market value of $20.8 billion, higher than the price paid. Are there lots of "ifs" in this deal? Sure, but it does simplify the explanation. 

    Are there dangers in this deal? Of course! First, it is possible (and perhaps even probable) that the market is over estimating the value of users at social media companies across the board. However, Facebook has buffered the blowback from this problem by paying for the bulk of the deal with its own shares. Thus, if it turns out that a year or two from now that reality brings social media companies back down to earth, Facebook would have overpaid for Whatsapp but the shares it used on the overpayment were also over priced. Second, as social media companies move up the life cycle, the variable(s) that even traders user to price companies will change from number of users/user intensity to revenues, earnings and cash flows. When that happens, there will be a repricing of social media companies, with those that were most successful in turning users into revenues/earnings being priced higher. This, after all, is what happened in an earlier iteration with dot com companies that went from being priced based on website visitors (analogous to number of users) to being priced based on how long those visitors looked at your website (paralleling user intensity) to how much they generated in revenues before settling into earnings. The problem for companies (and investors) is that these transitions happen unpredictably and that markets can shift abruptly from focusing on one variable to another. For Facebook, the path to success with this deal is therefore simple, albeit not easy. Start by trying to attract Whatsapp users to the Facebook ecosystem, and hope and pray that the market's focus stays on the number of users for the near term. Follow up by trying to monetize these users, with advertising revenue being the obvious front end but perhaps other sources as well.

    Closing Thoughts
    My experience with markets has been that no one has a monopoly on virtue and good sense and that the hubris that leads to absolute conviction is an invitation for a market take-down. To investors who view deals like the Whatsapp acquisition as evidence of irrational exuberance, remember that there are traders who are laughing their way to the bank, with the profits that they have collected from their social media investments. Similarly, for traders who view fundamentals and valuation as games played by eggheads and academics,  recognize that mood and momentum may be the dominant factors driving social media companies right now, but markets are fickle and fundamentals will matter (sooner or later).



    Comcast bids for Time Warner Cable: Synergy, Reverse Synergy or Ego Trip?

    In December 2012, I did a series of posts on acquisitions that reflected my dyspeptic view of their impact on value. In perhaps a test of my cynicism about the M&A process, Comcast last week announced that it was making an offer to buy the equity in Time Warner Cable for $45.2 billion. As the two largest players in the market contemplated consolidating their cable operations, “synergy” reared its head again as a potential rationale for the premium being paid by Comcast for TWC's shares, just as consumer groups and anti-trust regulators warily eyed monopoly power. While the market's initial reaction to the announcement was not favorable to Comcast, it does provide a test case of how synergy affects value and what acquirers should pay for it.

    The status quo: Comcast and TWC
    The first step in assessing the merger is to go back and look at the state of play at the two companies, run independently, prior to the acquisition bid. Using the 2013 financial statements that are available for both firms, that is where I started the analysis.

    Financial Mix & Cost of Capital
    Both firms use debt widely to fund their capital needs, though Time Warner is a heavier user, in proportional terms:




    To compute the cost of capital, I incorporated two additional inputs. The first was a beta(s) for the business(es) that these companies were in, which in conjunction with estimated values for each business, yielded business (asset) betas of 0.896 for Comcast (because it derives a significant portion of its revenues from broadcasting, through its ownership of NBC) and 0.71 for TWC.


    The second were the bond ratings for the two firms: Moody's gave Comcast a bond rating of A3 (with a default spread of 1.30% associated with it) and TWC a bond rating of Baa2 (with a default spread of 2.25% over the risk free rate).


    Operating Cash flows & Expected Growth
    To estimate the cash flows generated by the two firms, I worked with the 2013 financial statements that were released recently by both companies. The values are summarized below:


    Note that the numbers are adjusted for the capitalizing of leases. Both firms generated healthy cash flows in 2013.
     Rather than make the expected growth my estimate, I tied it to how much the companies were reinvesting and how well they were going so, captured in the reinvestment rate (the proportion of the after-tax operating income being put back in the business) and the return on invested capital in 2013:


    Based on the 2013 numbers, Comcast is investing a healthy portion of its after-tax operating income back into the company (perhaps in NBC Universal) and can be expected to grow 5.10% a year. TWC seems to be just maintaining its capital base (with a reinvestment rate of only 5.88%) and its expected growth is minimal (0.61% a year).

    Valuation
    To complete the valuation, I bring these inputs together, giving both companies a five year transition period period, before putting them in stable growth. The growth rate during the stable growth period is set to 2.75% and both firms are assumed to generate a 9% return on capital in perpetuity. The valuations of the two companies as stand alone companies is presented below:


    Based on my estimates, it looks like Comcast was over valued by about 7.1% prior to this deal and Time Warner was undervalued by about 12.6%.

    These stand alone valuations also provide us with a measure of what the combined firm's operating assets would be worth, if there were no synergy, since values are additive. 
    Combined firm's operating asset value (no synergy) = $176,574 + $72,827 = $249,409 million
    This is the base value that we can compare the value of the combined firm, with any foreseen synergy.

    Synergy Potential
    Is there potential for synergy in this merger? There is always in some potential in almost every merger, especially if you cast your net wide to include both financial and operating synergies. With

    Financial synergy
    With financial synergies, you are looking at the possibilities of recapitalizing the combined firm to generate a cost of capital that would be lower than the one you would arrive at by just aggregating the existing capital mixes of the two firms.. Looking at the combined firm, there seems to little potential for significant changes in value from altering financing mix. Both companies use healthy amounts of debt, with Time Warner perhaps a little over levered and Comcast a little under levered. At best, the combined firm may be able to generate marginal savings on its cost of debt and perhaps a slightly higher debt ratio than 30.3%, which is the combined firms aggregated statistic.

    Operating synergy
    With operating synergies, you can roam wider and look for the potential for added value by either operating income in the near term, increasing expected growth or both.
    I. Operating income
    1. Increased revenues: On the cable part of the business, this would mean increasing cable or broadband bills at a rate higher than they would have, if they remained independent firms. While there has been some talk (from analysts) of this happening, the combined firm will be stymied by two factors. The first is that the regulatory authorities will be reviewing the effects on competition of this merger and it is very likely that increasing bills right after a merger will be viewed as a monopolistic act. The second is that while there is some talk about the absence of competition, it is worth noting that ___ of Americans under the age of 30 no longer have cable and are increasing getting their entertainment from Hulu, Netflix and other providers though they are still dependent on broadband. Increasing cable rates will only accelerate that flight. We will assume that there will be no near term increase in the combined firm's base revenues.
    2. Higher operating margins: For the combined firm to be able to increase margins, it has to be able to cut costs. To the degree that they have overlapping costs, that is certainly feasible but large portions of their businesses do not overlap and cost cuts are likely to be difficult. In addition, both firms are reporting healthy operating margins, in excess of industry averages, removing the easy cost cuts that may have existed, if one or both firms had bloated cost structures. We will assume that the combined firm's pre-tax operating margin will increase slightly from 21.50% to 21.75%.
    3. Lower effective tax rates: Both firms pay 32-33% of their income in taxes, much higher than the average effective tax rate across all US companies (closer to 28%). However, one reason that they pay these higher taxes (and may be unable to change easily) is that they generate the bulk of their income in the United States. We will assume that there is no potential for tax savings at the combined firm.
    II. Expected Growth
    The framework for estimating growth that we used for the standalone valuations was based upon how much the firms were reinvesting (the reinvestment rate) and the return that they generated on that invested capital. To the extent that the combined firm is able to reinvest more or reinvest better, it may be able to deliver synergy from growth.
    1. Reinvestment rate: The aggregated reinvestment rate for the combined firm is 41.45%, weighed down by the low reinvestment at Time Warner Cable. While we have no basis for the contention, it is possible that the low reinvestment at TWC may be driven by capital constraints and that Comcast may be able to reinvest more, though the nature of the cable business will restrict how much. We will assume that the reinvestment rate for the combined firm will be 45%, up from 41.45%.
    2. Return on capital: The aggregated return on capital for the combined firm is 9.68%. While there may be some marginal benefits from the merger, we will assume that the increased reinvestment will act as a counter weight. We will leave the return on capital unchanged at 9.68% for the combined firm.
    Valuing Synergy
                With the marginal change in capital structure and a slight increase in pre-tax operating margins, we re-estimated the value for Comcast/TWC, relative to the status quo value:



    The good news is that even small changes in operating margin or tweaks in the cost of capital translate into large changes in combined value. With the changes I assumed, the increase in value at the combined firm is $4.82 billion, an increase of 1.9% over the status quo (no synergy) combined value. The bad news is that even these small changes will take effort and time. The former will require commitment on the part of Comcast’s management (and accountability) and the latter will reduce the value of the synergy (by the time value factor). In the graph below, I summarize the value of synergy as a function of the improvement in operating margin and the number of years spent waiting for synergy to show up.

    I am not a Comcast stockholder, but if I were, this analysis would leave me feeling a little more comfortable with the acquisition than I would have been a few days ago. The under valuation of Time Warner (at least based on my estimates) in conjunction with even small improvements in operating margins provide enough surplus to cover the premium. In fact, the under valuation of TWC prior to the merger (at least based on my estimates) provides some buffer for Comcast. In fact, the numbers can also be used to make a judgment on whether Comcast's stockholders are begin ill served by the proposed exchange ratio on this deal. 
    Intrinsic value per share (Comcast) = $130,303/ 2606.5 = $49.99/share
    Intrinsic value per share (TWC) = $47,585/ 277.9 = $171.23/share
    Intrinsic exchange ratio = $171.23/ $49.99 = 3.43 Comcast shares/ TWC share
    At the proposed exchange ratio of 2.875 Comcast shares/TWC share, the deal is tilted in favor of Comcast shareholders, at least based on my estimates.

    The bottom line is that while this is a high-priced deal and there is plenty that can go wrong (from a regulatory and business standpoint) in the future, it does not strike me as a value destructive deal and may, in fact, create value for Comcast stockholders. As always, please do feel free to download the spreadsheet that I used to value the synergy, tweak it or modify it and come up with your own assessments that you can put into this shared Google spreadsheet.

    The market’s view
    When large acquisitions are announced, it is natural to focus attention on the target company and shareholders in that company are generally celebrants. This acquisition was no exception, as TWC’s market capitalization increased by $2,779 million on the announcement of the merger, an increase of 7.4% over the pre-merger value, but well below Comcast's offer of $45.2 billion. To me the more interesting side of the action is on the acquiring firm, since stockholders  in the firm get a chance to pass judgment on  whether they see themselves as winners or losers, from the deal. In this merger, Comcast’s market cap dropped by $4,509 million, a decline of 3.13% in value. In sum, if you combine the market capitalizations of the two companies, there was a decline in $1,730 million in value after the announcement. 

    I don't know whether this reflects pessimism on whether the regulators will allow the merger to go through or synergy benefits, but it does seem like the reaction is not warranted by the facts.


    Bottom line
    I continue to believe that growing by acquiring publicly traded companies at a premium is a difficult game to win. However, I also believe that some acquisitions can create value, if you can target under valued firms and generate some synergy benefits in the process.
    1. Spreadsheet to value Comcast/TWC merger synergies
    2. My paper on valuing synergy
    3. Google shared spreadsheet on synergy value



    Stock-based Employee Compensation: Value and Pricing Effects

    In my last post on Twitter, I argued that the firm's claim that it actually made money in the last quarter of 2013 was fiction. That may sound like an exaggeration, since the company is transparent about the adjustments that it made to get to its adjusted numbers and the practice it uses is widespread not just among companies, trying to better a better face on their operating results but also among analysts who track these companies. In particular, the biggest factor in the earnings transformation was the company's treatment of stock-based employee compensation, which was added back to arrive at the adjusted earnings.

    From GAAP Earnings to Adjusted Earnings: The Twitter Adjustments
    To get from their reported losses to profits and from reported EBITDA to Adjusted EBITDA, Twitter made the following adjustments:

    Twitter's adjustments shifted a fairly substantial loss exceeding half a billion into both net profits ($9.774 million) and positive EBITDA ($44,745) in the fourth quarter.

    The dominant add-back in both adjustments is the stock-based compensation of $521.2 million and while it may be sanctioned by accountants, I am struggling with the logic of why. Attempting to give Twitter, the benefit of the doubt, the rationale for adding back the expense to get to adjusted EBITDA is that it a non-cash expense (though I will take issue with that claim later in this post), but that cannot be the rationale for adding it back to get to net profit, since net profit is an accounting earnings number, not a cash flow. One possible explanation that can be offered (and it is a real stretch) is that Twitter views stock-based compensation as an extraordinary expense that will not recur in future years and that the adjusted net income should therefore be viewed as a measure of continuing income.  I will believe this explanation, if I see Twitter stop using stock-based compensation, but I don't see how they can afford to. They have a lot of employees, some of whom are highly paid, and they cannot afford to pay them cash. The other explanation is that the adjusted net income is being divided by the fully diluted number of shares outstanding, which includes the shares that are being offered as compensation. This "consistency" argument is used by many analysts, and while it may offer the fig leaf of matching , it is an extremely sloppy way of dealing with stock-based compensation.

    Stock-based Employee Compensation: A long & tortured road
    To understand where we are with stock-based compensation, let's start with a quick review of its history. While businesses with cash flow problems have always used equity based compensation to attract employees, there was a quantum leap in the use of stock-based compensation by publicly traded companies in the 1990s, driven partly by bad legislation (limiting executive compensation), partly by the entry of young, technology firms into the public market place and partly by bad accounting practices. 

    In particular, accounting rules allowed companies to grant options to employees and show no cost, at the time of the grant, if the options were at the money. Not surprisingly, companies treated as options as free currency and gave away large slices of equity in themselves to employees (and, in particular, to the very top employees), while claiming to be spending no money. If and when the options were exercised later, companies would report a large expense (reflecting the difference between the stock price at the time of the exercise and the exercise price) and show that expense either as an extraordinary expense in the income statement or adjust the book value of equity for it. 

    After a decade of fighting to preserve this illogical status quo, the accounting rule makers finally came to their senses in 2006 and changed the rules on accounting for option grants. Companies were required to value options, as options, at the time of the grant and expense them at the time (with the standard accounting practice of amortizing or smoothing out softening the blow). This is the law that is triggering the large stock-based employee option expenses at Twitter and other companies like it, that continue to compensate employees with equity. It is worth noting that the change in the accounting law has also resulted in many companies moving away from options to restricted stock (with restrictions on trading for a few years after the grant), since there is no earnings benefit associated with the use of options any more.

    Stock-Based Compensation: Expense or not? Operating or Capital? Cash or non-cash?
    Stock-based compensation is embedded in  many US corporations and it is increasingly finding a place in companies that are incorporated in other countries as well. Two decades after they became part of the landscape, there still seems to be a lot of confusion about their place in the financial statements and how exactly they should  be viewed.

    1. Is it an expense?
    This is an easy one. Of course! If you look at why and where companies use stock-based awards, it is more used early in a company's life cycle and it is used to compensate employees. As Warren Buffet is famously quoted as saying, "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And if expenses should not go into the calculation of earnings, where in the world should they go?"

    The timing of the expense is also clear. It is at the time of the grant, and arguments that use uncertainty about whether these options will be exercised in the future to justify not expensing them are specious. We are uncertain about almost everything that has to do with the future, but that does not stop us (or should not stop us) from making our best estimates at the time that we encounter them.

    2. Is it a capital or operating expense?
    This is trickier, since it really depends upon who gets the options and what function they play at the company in question. In the case of Twitter, for instance, the bulk of the options were granted to employees in the R&D department:


    An argument can be made that R&D expense is a capital expense, not an operating one, and that it should treated as such. I concur with the sentiment (though I don't know the classification system that Twitter used to determine the breakdown of stock-based compensation). and I did capitalize R&D expenses in my Twitter valuation. However, that does not give you a license to just add back the expense, since capitalizing it will result in an asset that has to be depreciated; see this paper that I have on capitalizing R&D, if you are interested. Thus, if Twitter wanted to use this rationale, it should have added back just the R&D portion of the stock-based compensation and then subtracted out the depreciation on the synthetic asset it creates. 

    3. Is it a non-cash expense?
    Many equity research analysts seem to think so, but then again, their judgment on a number of fundamental valuation issues remains questionable. Let's be clear on what it is not. It is not an expense like depreciation, which is truly non-cash and should be added back to get to cash flow. It is closer in spirit to an in-kind compensation than a non-cash compensation. To explain my reasoning, let me use an analogy. Let's assume that you own and run a business that has an overall value of $100 million and generates $10 million in annual income. Let's assume that you hire me as your manager and that  my compensation is $1 million and that rather than pay me with cash, you give me 1% of the business as compensation (1% of $100 million is $ 1 million). While you may maintain the fiction that this is a non-cash expense and that your income is still $10 million, you are now entitled to only 99% of that income in perpetuity. In effect, your share of the business is worth less and it will get even smaller over time, if you continue to compensate me with equity.

    I would argue that as common stockholders in any company that grants options or restricted stock to its employees, we are in exactly the same position. The stock-based compensation may not represent cash but it is so only because the company has used a barter system to evade the cash flow effect. Put differently, if the company had issued the options and restricted stock (that it was planning to give employees) to the market and then used the cash proceeds to pay employees, we would have treated it as a cash expense.

    In closing, then, we have to hold equity compensation to a different standard than we do non-cash expenses like depreciation, and be less cavalier about adding them back. To those analysts who argue that using the diluted number of shares to compute per share numbers will take care of the problem, my response is that it will do so only by accident (as I hope to show at the end of this post).

    Stock-based Compensation and Value
    In discounted cash flow valuation, the safest way to deal with stock-based compensation is to recognize its two-layered impact on value per share:
    a. Continuing Earnings/cash flow impact: If you are valuing a company that is expected to continue paying its employees with options and/or restricted stock, your forecasted earnings and cash flows for the company will be lower than for an otherwise similar company that does not follow the same practice. These lower cash flows will reduce the value of the business and equity today.
    b. Deadweight effect of past compensation: If a company has used options in the past to compensate employees and these options are still live, they represent another claim on equity (besides that of the common stockholders) and the value of this claim has to be netted out of the value of equity to arrive at the value of common stock. The latter should then be divided by the actual number of shares outstanding to get to the value per share. (Restricted stock should have no deadweight costs and can just be included in the outstanding shares today).
    While it may seem like you are double counting options, by first reducing earnings for their grants, and then again reducing the overall value of equity for outstanding options from the past, you are not. In fact, if a company stops using equity-based compensation after years of option grants, the first effect (on earnings/cash flows) will stop but the second effect will continue until all of the options either expire or are exercised.

    If you look at my Twitter valuation in February 2014, you will see both effects in play. Since I don't follow Twitter's practice of adding back stock-based compensation, I forecast losses/negative cash flows for the company for the first few years before the scaling effects kick in: as revenues get larger, employee compensation will become a smaller percentage of those revenues (just like other fixed costs). The value that I get for the operating assets today incorporates these negative cash flows and is thus lower because of the generous stock-based compensation at Twitter. Once I get the value of the operating assets, I deal with the deadweight cost of past option grants by valuing the 42.71 million options outstanding at $2.182 billion, primarily because the options have an average exercise price of $1.84 (well below the current stock price) and subtracting this value from the overall value of equity of $13.6 billion, before dividing by the actual number of shares (including restricted shares) of 555.2 million. 

    Stock-based Compensation & Pricing
    If you are a fan of using multiples and comparables, you are probably congratulating yourself at this point for having avoided the complications that ensue from stock-based  compensation in intrinsic valuation. However, you would be celebrating too early. All multiples are affected by stock-based compensation, in small and big ways. Assume, for instance, that you are comparing PE ratios across technology firms that are big users of stock-based compensation. At the risk of stating the obvious, the PE is the market price divided by the earnings per share, but the per-share values can be impacted by how they are computed. Assume, for instance, that analysts are computing earnings per share  by adding the stock-based compensation to the stated earnings and then dividing by the fully diluted number of shares and that you are comparing three companies.  All three companies have 10 million shares outstanding, trading at $10/share currently and their GAAP net income is $10 million.  The first pays $ 5 million in cash compensation and uses no stock-based compensation, the second grants 2 million at-the money options with a value of $5 million to compensate employees and the third has set aside 0.5 million restricted shares with a value of $5 million to compensate employees.  The table below computes and compares their PE ratios, using the standard (dilution-based approaches):

     



    Based on this comparison, company C would look cheapest and company A most expensive but only because of the way that we deal with stock-based compensation. In fact, the biases become worse as companies continue to grant options and the disparity between primary and diluted shares grows.

    So, what should you do, if you have to use multiples? First, stop adding back stock-based compensation to net income. There is no logical or financial rationale for doing so. Second, stop playing around with the denominator. If there are shares outstanding, restricted or not, count them. If there are options outstanding, value them and add them to the numerator (the market capitalization) and don't adjust the shares outstanding for in-the-money, at-the-money or out-of-the-money options. 
    Option-adjusted PE = (Market capitalization + Estimated value of options outstanding)/ GAAP Net Income
    The same rationale applies if you are using EV/EBI/TDA or price to book ratios. 

    Bottom line
    Analysts, accountants and appraisers seem to still be struggling with how best to deal with stock-based compensation, whether in the form of options or restricted stock. I think the answers lie in going back to basics. There are no free lunches and if a company chooses to pay $5 million to an employee, that will affect the value of my equity, no matter what form that payment is in (cash, restricted stock, options or goods). There are reasons why one form may be better for some companies and another for different companies but these should not be cosmetic or based on adjustments (real or imaginary) that companies and analysts may make to earnings and per share values.



    Return to the firing line: Revisiting Tesla and hopefully living to tell the tale!



    In September 2013, I valued Tesla on my blog at about $67 and learned a lesson about how passionate its stockholders were in defending it, viewing it less as an investment and more as a calling. I guess the lesson did not stick, because I am back for more punishment with an updated valuation of the company. Preempting some of the criticism that I may get for my post (and the views that it contains), I would like to put some basic facts on the table before I put down my valuation.
    • No, I don’t hate Tesla and Elon Musk. In fact, I think Tesla is one of the most innovative companies that I have seen emerge in a while and not only is it changing the automobile business, but it is doing so with style. As for Elon Musk, I wish that the CEOs of other companies were as passionate and visionary in promoting their companies' mission and products, as Musk is with Tesla.
    • No. I still have not driven a Tesla. I do live in New Jersey, a state that is attempting to use twentieth century regulations to stop a twenty-first century company. I also live five minutes away from Short Hills Mall, where Tesla just opened a showroom. So, I have seen the car, sat in it, but unless I want to create a disaster inside a mall, I don't think I can drive it out of the showroom.
    • No, I have not sold or plan to sell Tesla short. I also do not work for anyone who has sold short on Tesla, have not been paid (and will not be paid) for this post and won't be cheering if the stock retreats. In the interests of fairness, I do know one person who has sold short the company's shares with some success, but have not partaken in his profits.
    • No, I don’t believe that my valuation of Tesla is the "right" valuation of the company. It is mine, with my assumptions, estimates and views embedded in it, wrong or misguided though they might be. 
    • No, I don't think you are crazy, if you own or recently bought Tesla. I am a firm believer that each of us has to make our own judgments on what to invest in and why, though we all share the same end-objective, which is to make money on our investments. So, if you have good reasons to believe that Tesla is the right investment for you, I hope it works out for you.
    Having dispensed with the formalities, let me move to substance. 

    Valuation: Then and Now
    In my September 2013 valuation of Tesla, I came up with a value per share of $67. At the time, the narrative I provided for the company was that giving it the revenues of Audi (about $65 billion) and the margins of Porsche (about 12.5%), in a decade, still yielded a value below the market price (about $170 in September 2013). Rather than rehash the assumptions I made in this post, you can find them in my original post

    Since that valuation, there have been earnings reports that have contained substantial information about the growth trajectory and profitability of Tesla, as well as other news stories about the company, some positive (Consumer Report awards for its cars, the $5 billion investment in the world's largest electric battery factory) and some negative (Tesla car fires). All of these news stories provided information that led me to reassess some of the key inputs that I used in my valuation. 
    1. Revenue growth: Tesla continues on its path to higher revenues, reporting revenues of $615 million in the fourth quarter of 2013, doubling its revenues from the same quarter a year ago. The annual revenues in 2013 amounted to just over $2 billion, an almost five-fold increase over the $413 million in revenues in 2012. 
    2. Operating margin: In further good news, the operating losses (based upon GAAP) at the firm decreased over the period, down to -$13.4 million in the last quarter of 2013. In fact, adjusting for R&D expenses (capitalizing and amortizing), I estimate an operating profit of $15.46 million in the last quarter of 2013, vindicating the company’s claim that it turned the corner on profitability for the year (albeit with a very different rationalization). 
    3. Quality of Growth/Reinvestment: The measure that I used to estimate reinvestment and the quality of growth was the ratio of sales to invested capital. On this measure, as well, Tesla reported improvement in the last quarter of 2013 as the ratio improved from 0.66 in the third quarter to 0.87 in the fourth quarter; a dollar of invested capital generated $0.87 in revenue in the last quarter. (Higher values not this statistic indicate bigger payoffs to investment.)
    4. Risk: There are mixed signals in whether Tesla is getting less risky over time. The volatility in the stock price has actually increased over the last few months, as the stock first dropped on the news about car fires and then recovered quickly and decisively. However, the announcement that the company would raise $2 billion in convertible bonds is an indication that it is opening access in other markets and that will stand it in good stead, if it needs more capital to either grow or survive. 
    The table below lists the key assumptions in my September 2013 valuation, the changes in the March 2014 valuation and my explanation for the changes.




    September 2013 
    March 2014
    Rationale
    Spreadsheet
    See the gory details.
    Base Revenues
    $1,329 m
    $2,014 m
    Base Operating Income
    -$22 m
    -$17 m
    Expected Revenue in year 10
    $65,422 m
    $79,215 m
    Added revenues from the electric battery business to auto revenues.
    Expected Operating Margin in year 10

    12.50%
    12.00%
    Battery margins are likely to be lower (competitive business), pushing down the target margin.
    Expected Operating Income in year 10
    $8,178 m
    $9,505 m
    Comes through from higher revenues.
    Sales/Invested Capital ratio (to compute reinvestment)
    1.41
    1.55
    Reflects improvement in last quarter of 2014.
    Cost of capital
    10.03%
    8.86%
    Decline in market ERP from 5.8% in 9/13 to 5% in 3/14. Increase in auto sales led to make it slightly more automobile (60% to 70%) and slightly less technology (40% to 30%).
    Probability of failure (Proceeds from failure)
    10% (50% of estimated value)
    0%
    Increased access to capital (bond market), lower losses and larger market capitalization should allow company to survive even major shocks.
    Value of equity
    $8,152 m
    $16,681 m
    Increase of 105% in nine months.
    Value per share
    $67.12
    $99.85/ $118.47
    The value per share is lower ($100), if options get exercised at current price or close to it, and higher ($118), if option-holders wait and value converges on price.

    Note that while the increase in year 10 revenues of $13.8 billion, largely the effect of increased revenue potential from the electric battery market, is substantial, it falls short of what you would expect to see if this were a ‘disruption” of the electric utility market. The improvement in margins in 2013 is encouraging, but they are in line with the expectations built into the September 2013 valuation, and entering the electric battery market is likely to lead to lower margins, not increase them. (The pre-tax operating margin for global electronics companies is 5.67% and that of power companies globally is 11.62%; neither is a perfect fit but you can download the industry average margins by clicking here). The decline in the cost of capital is more the consequence of change in the overall market environment, where the rise in overall stock prices in the last few months, has lowered the equity risk premium. Tesla’s foray into the bond market, with its $2 billion convertible bond issue, suggests that the company has opened up access to more capital, if it needs it, and shows up in the setting up of the probability of failure at 0%. 

    Overall, the effects of these changes is to increase the value of equity by about 105%. The effect on the value per share is smaller, largely because the company has 22.64 million options outstanding in addition to its 123.19 million shares outstanding. If we value these options, using the current stock price as the basis, we obtain a value per share of $100, but using the estimated value per share (I know.. I know.. there is circularity and that is why the excel spreadsheet is set to iterate) yields a value per share of $ 118. The danger with using the latter approach is that the option holders, assuming that they see what we see in this valuation, will be inclined to exercise when the price is high. Splitting the difference, the value per share estimate that I would attach to Tesla is between $110 and $115 per share. 

    Can the intrinsic value per share of a company close to double within a nine- month period? Yes, and with young growth companies, you should expect your estimates of value to be volatile over time, as you learn more (good and bad) about the company and its business. Does it bother me that value is so volatile? No, because it is not how volatile the value is, but how volatile it is, relative to price, that drives investment decisions. This is after all a company whose stock price has quadrupled, halved and doubled again all in the period of two years. 


    Price and Value
    Tesla is a perfect case study for the dilemma that I posed for “value” investors in my post on buzz words, where you reject a stock as over valued, only to see the stock price increase even further. In September 2013, I valued Tesla at $67, when the stock price was $170, and concluded that it was over valued. Nine months later, the stock has gone up to $220, and even with my more optimistic outlook on the company, I have a value of $115-120, well below the market price. The trader ranks beckon, but as an investor, I have three choices with Tesla:

    1. Delusion: Do a quasi DCF!
    There is widely held presumption that if you have a set of cash flows on a spreadsheet, and you estimate a discount rate, you have done a DCF, which is the equivalent of  claiming that wearing tights and ballet shoes makes you a ballerina. There are simple tests you can run to differentiate between good, bad and indifferent DCFs (and I will have a post dedicated to that topic), but in the context of Tesla, there are tweaks I can make to the model that can very quickly alter my value. For instance, if I set the sales to capital ratio at 10.0 (i.e,, that I can generate $10 of revenues for every dollar invested), the value per share goes to $302/share. Magical, right? The only problem is that I would then be assuming that Tesla will generate about $68 billion in incremental revenues and $9 billion in incremental profits, over the next decade, without building any factories or making acquisitions. Unless Tesla has discovered a way to build cars and batteries on virtual assembly lines, manned by Oompa Loompas, I don't see a way to justify this. In fact, Tesla's announcement that it would be investing $5 billion in its new electric battery factory suggests that the company knows that it has to make substantial infrastructure investments over the next decade, to deliver its growth potential.

    2. Disruption and China: Attaching value to buzzwords
    The last earnings report from Tesla was followed by the announcements that the company would start selling its cars in China and that it would be building a gigafactory to produce electric batteries. If you were working on a checklist for buzzwords, you would have hit the trifecta with this announcement: a company with growth potential announcing that it would enter China and disrupt an existing business. These announcements have valuation implications, but they have to be made explicit, if they are to the taken seriously.

    Take, for instance, the argument that the electric battery investment represents the entrée into the market for supplying electric power for other uses (homes, businesses etc.). If the argument holds, it could be a value-changer, since the electric utility market is an immense one, in terms of revenues, albeit with much lower returns on capital. For disruption to justify today's stock price, the change in revenues will have to be far larger than the estimates in my valuation. If you believe that Tesla has the capacity to disrupt the electric utility business, the table below should give you a sense of the break-even points (to justify a $220 stock price):

    There are a couple of interesting details in this table. The first is that while there is tremendous upside potential, the break even points to get to a $220 value are daunting. If the pre-tax operating margin converges on 12% (as assumed in my base case), you would need total revenues of more than $150 billion to justify the current market price. In other words, your battery business will have to add about $90 billion to Tesla's annual revenues by the tenth year. If margins drop, the current market value is not only unreachable, but growth can become a value destroyer. For instance, with a 4% operating margin, given the reinvestment needs in these businesses, increasing growth makes your value become more negative. If you buy into the disruption model, the challenge then becomes determining how much that disruption will create in additional revenues (in the electric utility business) without damaging profit margins. It is worth noting that Tesla is not the only player in this disruption game, with Honda having already jumped into the fray (albeit with their smaller and less powerful electric batteries) and Hyundai and Toyota getting ready to enter. 

    There is also the possibility that there are companies that would be interested in either acquiring Tesla (a tough task, since Elon Musk has been insistent that he will not sell) or partnering with it to create value on joint products. Given Tesla's burgeoning market capitalization, the list of potential acquirers/ JV partners does get smaller, but it is possible that the promise of a Google/Tesla driverless car could tempt Google to invest some of its substantial cash balance in Tesla. 

    3. Keep the faith
    My investment philosophy is built on the foundation that you should buy an asset only if trades at a price less than your estimated value for that asset, error-prone and uncertain though the latter may be. It is true that I can offer no proof that my value is right, that the price is wrong or even if the first two assertions are true (right value, wrong price), that the price will adjust to the value, but is that not the essence of faith? That you believe, without proof! If I stay true to my philosophy, I cannot justify buying Tesla at the current price. Of course, a year from now, the stock may be at $400, but I will have no regrets, because I also believe that if you don't stand for something, you will fall for anything. 

    Your philosophy on investing may be different from mine, and probably better (or at least more lucrative). If you are a Tesla stockholder, though, I hope that you are one for the right reasons. That would include being a trader (whose focus is price, not value), buying into the disruption model or investing on the expectation of an acquisition, but it would not include investing because others have been making money on the stock, equity research analysts are bullish or just because you love the company, its products or its CEO.

    Thoughts on markets
    It is easy to become cynical about markets and to cast those who have different views than you do into the "irrational" or "crazy" camp. Even if the Tesla run-up turns out to be overdone, look at the bigger picture, which is that a company that was non-existent five years ago has shaken up a sector where there have been no new entrants for decades. I have nothing but admiration for what Elon Musk has built over these few years and I hope he succeeds. In fact, I will keep valuing Tesla, every few months, and there will be a time, sooner rather than later, where I know it will be part of my portfolio. Just not yet!

    Note: If you don't like my assumptions or inputs, use the valuation spreadsheet below, change my assumptions to yours and make it your valuation. If you are so inclined, share your views in the Google shared spreadsheet that I created for this valuation.

    Additional links




    Watch the Gap: Apple's long and twisted pricing journey

    Apple’s earnings call on April 23 contained some information about the company’s operations, but that news has largely been drowned out by other announcements that Apple made during that call; that it would increase dividends, add to its stock buyback program and split its stock. The market seems to like the bundle, with the stock up more than 13% from its close before the report. But what exactly did we learn about Apple in the report that we did not know already? Is the price rise merited? After the post-report price jump, is Apple fully priced? To address these questions, I am going to draw on some of my earlier posts on Apple and look for a narrative that may explain the market reaction.

    Setting the stage: Price and value - Apple from December 2011 to April 2013
    As some of you who have been reading this blog for a while know, I have a long standing obsession with all things to do with Apple. My first post on Apple was in January 2011, and it was focused on the narrow question of whether companies holding cash should be penalized for holding cash, and I argued otherwise. My next post in March 2012 commemorated two landmarks for Apple, its market capitalization exceeding $500 billion and its cash balance going over $100 billion. I valued Apple at about $700/share but conceded that I was biased both because I loved Apple products and had been a long-term holder of Apple stock. A month later, I got a fair amount of heat for selling my Apple stock at $600/share, though I continued to believe that its value was about $700/share, partly because of what readers viewed as an inconsistency. Value investors are supposed to continue to hold under valued stocks, not sell them. I rationalized my decision in that post and the next one, by presenting a theme that I have returned to several times since, which is that the pricing of a stock can be very different from its valuation and that when a stock becomes a momentum play, value will take a back seat to other factors.

    Apple’s stock continued to surge in the months after, and in August 2012, I valued just the iPhone franchise, just ahead of the launch of the iPhone 5, just as the stock price crested at $700/share, ahead of that announcement. The market reacted negatively to early news about the iPhone 5, even though it was the most successful smartphone launch in history. My post in October 2012 was centered around how the expectations game for Apple had become skewed to the point that no achievement of the company would be good enough for a market that kept waiting for the next great blockbuster product. At the end of 2012, I revalued Apple, reflecting my downgraded assessments of Apple’s revenue growth and arrived at a value per share of $610/share, about 22% higher than the market price of $500/share at the time. A month later, with the stock at $450/share, I used Apple as a test of my faith in value and argued that my reaction to the market would be a good indicator of whether I was truly a value investor. In the days that followed, I also posted on what Apple could do in response to the pricing collapse and how investors could view and profit from the gap

    In February 2013, David Einhorn made a push for Apple to return more cash to its stockholders. Though I disagreed with his plan to use preferred stock to monetize the under valuation,. I agreed with his argument that Apple should return more cash to its stockholders. In April 2013, I revalued Apple at about $590, after their earnings report, where they surprised markets by announcing both an increased stock buyback and their first debt issuance, well above the stock price of $420 at the time of the announcement. The stock continued to slide, hitting a low of $385/share in April. In September 2013, I posted on Apple in the context of separating your love for a company from your assessment of its stock as an investment, and revalued the stock at more than $600/share. The stock had recovered to $500/share by then, but it was still looked under valued to me.

    Price and Value: Watch the gap!
    Last week, I valued Apple at $675, just before the earnings report came out, using the information from the 2012-13 annual report (ending September 2013) and the first quarter report that came out in February 2014. Superimposing my twelve valuations across time for the company on a pricing graph, here is what I get:


    In January 2011, the value that I obtained for Apple was $385 about 13% higher than the price as of that date ($339). Between January 2011 and July 2012, my intrinsic value estimates continued to climb to hit a peak of $686 in July 2012, reflecting primarily the success that Apple was showing in overcoming scale, i.e., managing to grow its revenues and maintain margins, in spite of its size. While the price initially lagged my estimate of value (with the under valuation increasing to 21% in September 2011), it surged thereafter closing the gap in July 2012. In September 2012, the stock price ($667) exceeded my value estimate ($639) for the first time during this period and that represented the pricing peak, as momentum shifted dramatically in the weeks after. The lower revenue growth and margin pressure also reduced my value estimate to $595 in April 2013, but the price dropped to $385 by April 2013 (creating a percentage under valuation of more than 25%). In the months, since there has been a slight uptick in my value estimates to $627 in January 2014 and about $675 in April, partly because of improvements in market mood (a lower equity risk premium) and partly because of reduced share count (due to Apple's buybacks). The price-value gap has closed a little since April 2013, albeit in fits and starts, with the gap standing at about 19.6% just before the last earnings report.

    If you are interested in delving through the valuations in detail, I have posted all twelve valuations I have done of Apple since January 2011 at the end of this post.  If you are suspicious (and you should always should be) that I have back-fit the numbers, you can also check the valuations I posted in my blog in real time.

    Apple's struggles with the gap
    I understand that my valuations reflect my assumptions about the firm and Apple's managers may have very different views about the company. Whatever their perceptions, though, it seems quite clear to me that Apple's managers have believed that the market was undervaluing their stock though their reaction has evolved from an initial indifference to radical (and perhaps even desperate) action.

    In the first few months, after the iPhone 5 launch, Apple seemed to operate on the conviction that the truth would prevail and that the market would come to its senses and reflect fundamentals. That conviction was tested in early 2013, partly by the continuing drop in the stock price and partly by activist investors (like David Einhorn and Carl Icahn) arguing that Apple should do something with its cash. In April 2013, Apple abandoned its do-nothing stand and announced, in conjunction with its earnings, that it would expand its stock buyback program and borrow money (about $17 billion). The initial market reaction was positive but it quickly faded. In the months since, Apple has tried to stay the course and talk the price up, to mixed effect.

    The latest earnings report, on April 23, in many ways, reflects Apple's frustration with the persistent gap between price and value. It included almost every catalyst that companies that believe that they are under valued use to attack the gap between price and value: a dividend increase, an increase in the stock buyback program and a 7-for-1 stock split. The market reaction has been euphoric, as the stock price jumped from $525 before the report to $594 (as of today), which raises interesting questions about what investors saw in this report that made them reassess the price.
    1. There was little value effect: I revalued Apple, the day after the earnings report, and arrived at a value per share of $648, effectively unchanged from the $649 that I estimated on the day before. That may surprise you, but there was little in the earnings report that changes my view of Apple's operating future: it reported low revenue growth (5%) and continued pressure on margins. The stock buyback and dividends reflect how Apple plans to return cash to its stockholders and has no effect on operating asset value. The stock split is a purely cosmetic event, from a value perspective), since it just changes the number of units (shares) in the company.  (In just the last day or so, Apple has announced an additional $17 billion bond issue, which will have a increase the value per share by about $5/share).
    2. There was a price effect: While we can make the standard arguments for why the price changed after the report, i.e., that the dividends make investors feel more secure about future cash flows from their Apple stockholdings and that the stocky buybacks are a signal that the company believes that its stock is under valued, those arguments are undercut by the fact that Apple has tried both moves before, with little success in moving the pricing needle. In fact, it may be the stock splits, the one action that almost certainly has no value effect, that may have caused the mood shift. I know that one story that will make the rounds is that the stock split will allow investors who were hitherto unwilling or unable to buy the stock to be able to do so, thus expanding the investor base and improving liquidity. While that story may make sense for a lightly-traded, small cap company, I don't see it holding up to scrutiny when the company that in question is the largest company in the world. In fact, if it turns out (as some news stories are suggesting) that much of the price increase in the last four days has come from institutional holdings expanding, the liquidity argument becomes even weaker.
    So, here is my explanation, for what its worth. There are lots of reasons for why a gap exists between price and value (as was the case with Apple) and why it persists for long periods but I believe that that the gap is largely driven by investor psychology and market momentum, two forces that are immune to rationality. That is also why it is difficult, if not impossible, for companies to devise plans to make price gaps go away, because these plans are generally based on the assumption that investors will react sensibly to them. If the reaction to the latest earnings report is the shift in momentum that Apple (and its activist investors) have been seeking for the last two years, it is ironic (but not unexpected) that it happened in response to the stock split, the least impactful of Apple's many tries during the period, and not to the more momentous events over that period (which included the launch of new products, acquisitions, buybacks, a debt issue and dividend increases).

    What next
    In my earliest posts on Apple, I argued that the company's success in the last decade and a few missteps, especially in the early part of 2011, had made it a magnet for stockholders of every type: growth, value and momentum. Consequently, the company had a stockholder base that it could never keep happy, since their views of its future (and what it should do with its cash) were contradictory. The last two years have been a painful adjustment process for all of these groups, and the stock price has reflected their turmoil. Growth investors in Apple have reluctantly come around to the point of view that Apple cannot keep growing its revenues at double-digit rates, value investors have found that the stock, in spite of the company's financial strength and profitability, continues to be volatile and momentum investors have discovered that momentum shifts are real and unpredictable. There are some in each group who have moved on to greener pastures and stocks better suited to their investment philosophies and Apple may be benefiting from this pruning of the base.

    Given my estimate of value of $648/share, I will continue to hold Apple but I have learned to remain vigilant. If the institutional herd thunders back in, now that momentum looks like it is in Apple's favor, they may very well do what they did in the last iteration and drive the price right through the value (or at least my estimate of it). If my biggest problem as an investor is that the price of something I already hold may go up too much, I am blessed!

    Update: I updated my April 2014 valuations to reflect the current share count of 861.38 million shares, rather that the weighted average share count of 885 million shares that I had used before. That pushes up the current estimate of value to $675/share.


    Previous posts on Apple
    1. Apple: Thoughts on Bias, Value, Excess Cash & Dividends (March 1, 2012)
    2. Apple: Know when to hold 'em, know when to fold 'em (April 3, 2012)
    3. Emotions, Intrinsic value and Dividend Clienteles: The Apple postscript (April 6, 2012)
    4. Apple's Crown Jewel: Valuing the iPhone Franchise (August 29, 2012)
    5. Winning by Losing: The power of expectations (October 9, 2012)
    6. The Year in Review: Apple's Universe (December 27, 2012)
    7. Are you a value investor? Take the Apple test (January 27, 2013)
    8. Market Mayhem: Lessons for Apple (January 31, 2013)
    9. Back to Apple: Thoughts on value, price and the confidence gap (February 7, 2013)
    10. Financial Alchemy: David Einhorn's value play for Apple (February 8, 2013)
    11. Apple: News, Noise and Value (April 30, 2013)
    12. Love the company! Love the product! Love the stock! (September 9, 2013)
    Valuations of Apple



    Yahoo! A puzzle, a mystery and an enigma

    In my last post, I estimated Alibaba's value and concluded that its growth and profitability put it on a pathway to make it one of the most valuable IPOs in history. In this post, which I view as a companion, I am looking at Yahoo, a company that has effectively become a proxy for Alibaba, especially leading up to the initial public offering. To illustrate, Yahoo’s quarterly earnings came out on April 15, and it reported flat revenues and declining earnings. Bad news, right? However, its stock price jumped on the earnings report, as embedded in it was good news about Alibaba's revenue growth in the last quarter of 2013. In fact, in the context of valuing Yahoo! in my valuation class, I borrowed phraseology from Winston Churchill and described Yahoo! as a puzzle, coupled with a mystery and wrapped up in an enigma. Yahoo!, the parent company, is the puzzle (especially in how quickly it lost its dominance in the United States, and why), with a mystery (its 35% stake in Yahoo! Japan, which is prospering while the parent struggles) and an enigma (the 22.1% share of Alibaba). 
    Note: Press stories estimate Yahoo's holdings at 22.6% or 24%, depending on whether you use diluted or primary shares. I used the 523.6 million shares that Yahoo owns in Alibaba and my estimate of 2368.67 million shares outstanding in Alibaba, including restricted stock units, in Alibaba to arrive at 22.1%.

    Setting up the valuation
    To value shares in Yahoo, you have to estimate the value of its US operations, but that is only a small piece of the overall value, since Yahoo owns 35% of Yahoo Japan and 22.1% of Alibaba. Neither holding is consolidated, and the way in which the accounting works effectively means that the key operating numbers that you see in Yahoo’s financial statements (revenues, operating income) will not reflect either of these holdings. To illustrate the tangled web of values, here are the steps to get to the value of equity in Yahoo:

    Yahoo: The sum of the parts
    Thus, to value equity in Yahoo, you have to value Yahoo, Yahoo Japan and Alibaba separately, and after aggregating your holdings in each company's equity (100% of Yahoo, 35% of Yahoo Japan and 22.1% of Alibaba), you also have to net out any taxes that will come due on capital gains if Yahoo plans to or is required to sell any of its holdings. In the case of Alibaba, it has no choice, at least on a part of the holding, since it will be required as part of a prior agreement to sell 208 million shares after the IPO

    If you are interested in Yahoo as an investment, there are three ways in which you can approach the analysis.
    1. You can estimate an intrinsic value for each of the three pieces and add them together to come up with a composite intrinsic value. Now that Alibaba has filed its prospectus, you have the financial statements for all three companies.
    2. You can price each of the three pieces, by looking at a key metric (revenues, earnings, book value) and applying a multiple to it, based on how other companies like it (and that is a subjective call) are being priced in the market. 
    3. You can cheat and use the market pricing of one or more pieces to see how much you are paying for the rest of the company. In other words, you can check to see if the market is being internally consistent in its pricing of the pieces.
    The Puzzle: Yahoo and its fall from dominance
    I started with the parent company, a pioneer in the online search/advertising business that has long since been pushed to the sidelines by Google. Revenues have been declining at Yahoo! (US) over the last few years, going from $7.2 billion in 2008 to $4.68 billion in 2013 and the contrast with Google over the last decade is striking:

    Yahoo versus Google: No mas!
    The much heralded ascension of Marissa Mayer to the top of the company has not resulted in a turnaround in revenues, though the company continued to be profitable, generating $590 million in 2013 (translating into a pre-tax operating margin of 12.6%). If there was any positive news about Yahoo! in its most recent report, it is that ad revenues have stopped falling and that they increased 1.7% over the same quarter in the last year, though total revenues declined slightly and operating income dropped; the company generated $422 million in operating income on revenues of $4672 million in the twelve months ending March 31, 2014.
    Intrinsic valuation: Assuming that Yahoo! will return to dominance or even get back to moderate growth is a reach. I will, however, assume that Ms. Mayer will find a way to stop the bleeding and that the company will muddle along as a mature company with stagnant revenues and stable margins. I assume a nominal growth rate of 1% for the next 5 years for Yahoo!, increasing to 2.75% in year 10, I estimate a value of $4.38 billion for its operating assets, but adding its substantial cash balance of $4.6 billion and netting out its debt of $1.6 billion, I derive a value of equity of $7.37 billion for the parent company.  You can download the parent company valuation by clicking here. (I used the last 10K filed by Yahoo and updated the numbers using the most recent 10Q).
    A relative valuation (pricing): You can anchor your relative valuation of Yahoo! to revenues, EBITDA or operating income. Perhaps, the simplest way to do this would be to apply the median EV/Sales or EV/EBITDA  multiple for the sector (internet software and services) to Yahoo's metrics to estimate a value for just the parent company's operating assets. 
    Yahoo: Estimated Enterprise Value using Median Multiples from Internet software & services
    While it is tempting to apply these median multiples in the sector in internet software & services business to Yahoo’s revenues, you will get absurdly high values, since most of the companies in this sector are expected to have high revenue growth in the future,  and Yahoo! has little or no expected growth. In particular, we would expect Yahoo to trade at a much lower revenue multiple than its competitors. To get an adjusted revenue growth, we plotted EV/Sales against revenue growth for all internet stocks in the chart below:

    EV/Sales versus Expected revenue growth: Internet software & services
    There are outliers in this relationship, with higher revenue growth companies trade at higher multiples of revenues. (Twitter is one of the outliers in the graph, but this graph was prepared before Twitter's fall from grace last week. It is not as much of an outlier any more.)  In fact, the best fit line yields the following (and you can download the raw data used for the regression here):
    EV/Sales = -0.94 + 21.21(Expected revenue growth) + 15.06 (Operating Margin)
    R squared = 54.5%
    Given Yahoo's expected revenue growth rate of 1% and current operating margin of 9.02%, we would forecast an EV/Sales ratio of only 0,63 for Yahoo .
    EV/Sales Yahoo = -0.94 + 21.21(.01) + 15.06 (.0902) = 0.63
    Applying this multiple to Yahoo’s revenues ($4.672 billion) yields $2,948 billion for Yahoo’s enterprise value, and adding the cash balance ($4.6 billion) and subtracting out debt (1.6 billion) yields a value of equity of $5.9 billion. Note that this is the value of only the parent company, since the revenues from the cross holdings (Yahoo Japan and Alibaba) are not incorporated into Yahoo’s revenues.)
    Market price: Given the stock price of $33.76 at the time of this post, we have a market capitalization of $34.8 billion for Yahoo in May 2014, but that reflects the market’s assessment of the value of equity in the company with its cross holdings.

    The Mystery: Yahoo! Japan
    While Yahoo! has struggled in the US market, Yahoo! Japan has had more success in the Japanese market, as evidenced in the graph below:
    Yahoo! Japan - Historical Performance
    While there was a slowdown in 2012 and 2013, the company has been able to post a compounded annual growth rate of 22% in revenues and earnings in the last decade.
    Intrinsic valuation: Estimating an intrinsic value for Yahoo! Japan, with a 5% growth rate in revenues for the next 5 years and much higher operating margin (40%) than Yahoo, yields an intrinsic value of $17.9 billion for the operating assets and $21 billion for its equity. You can download the valuation of Yahoo Japan by clicking here.
    Relative valuation/pricing: Using the same regression on online companies that I used to value the parent company, I estimate an EV/Sales multiple of 7.91 for Yahoo! Japan, based on its expected revenue growth of 5% and operating margin of 51.72%.
    EV/Sales Yahoo Japan = -0.94 + 21.21(.05) + 15.06 (.5172) = 7.91
    Applying this multiple to the revenues of $3,929 million in 2013, we estimate a value of $31.1 billion for Yahoo! Japan’s operating assets. Adding cash and subtracting debt yields a value of equity of $34.2 billion for Yahoo! Japan.
    Pricing: Yahoo! Japan is a stand alone and publicly traded entity, with a market capitalization of $23.2 billion in May 2014.

    The Enigma: Alibaba
    The final piece of the valuation is Alibaba, in whom Yahoo! has a 22.1% stake. Until last week, we were valuing Alibaba primarily through the financials that Yahoo was reporting for the company, since it was private and unlisted. With the prospectus now in the public domain, we can be more specific in both the intrinsic and relative valuations of the company.
    Intrinsic value: Rather than rehash the intrinsic valuation of Alibaba, I will direct you to my last post, where I valued Alibaba's equity at $145 billion, post IPO. That valuation is built on the assumptions of revenue growth slowing to 25% (on an annual, compounded basis over the next 5 years) and a target operating margin of 40% (below the current operating margin of 50%). You can download the Alibaba IPO valuation spreadsheet by clicking here.
    Relative valuation/Pricing: The second is to use the revenue and net income numbers, in conjunction with estimates multiples obtained by looking at other companies in the business and adjusting for Alibaba’s higher growth and profit margins. The table below lists PE and Price to Sales (which is a inconsistent multiple, but one we are stuck with since we have no debt and cash numbers) for sectors that may or may not match Alibaba’s business model:
    Median Multiples: Advertising, Retail and Online Retail
    The range of values that you obtain, using these multiples for Yahoo!, is immense, from a low of $6 billion (using EV/Sales of general retail) to a high of $285.6 billion (using a PE ratio of US online retailers). The bankers will undoubtedly gravitate towards earnings-based multiples and samples of internet firms as comparable firms during their roadshow. Using the EV/Sales regression that I used to value Yahoo! and Yahoo! Japan, with an expected revenue growth of 27% (from valuation) and operating margin of 49.07%:
    EV/Sales Alibaba = -0.94 + 21.21(.27) + 15.06 (.4907) = 12.18
    Applied to Alibaba's revenues of $7,911 million in 2013, adding the value of cash, cross holdings in Weibo & other online ventures and expected IPO proceeds of $27,963 million and netting out debt ($6,670 million) yields a value for Alibaba's equity of $117,623 million.
    I would not be surprised if Baidu, the only other large, publicly traded Chinese online company that is structured similarly to Alibaba (as a Variable Interest Entity) is used for comparison and its pricing ratios are applied to Alibaba's metrics to arrive at value.
    Baidu Multiples Applied to Alibaba; Enterprise values adjusted for cash, cross holdings and debt
    On second thoughts, given how low these values are, relative to the rumored IPO numbers, it is entirely possible that bankers will avoid talking about Baidu as much as they can, since it will not fit their pricing story. 
    Pricing: Alibaba is not a publicly traded company yet, but there is no shortage of estimates of how much the company will be valued at after its IPO. The rumored IPO estimates of equity value (http://www.bloomberg.com/news/2014-02-05/alibaba-s-average-valuation-rises-to-153-billion-after-earnings.html) range from $150 to $200 billion.

    The Bottom line
    At this stage, we have three paths we can follow to estimate the value per share in Yahoo, which entitles you to a full share in the parent, 35% of the equity of Yahoo! Japan and 22.1% of the equity in Alibaba. In each case, I have netted out the taxes that Yahoo will have coming due on the 208 million shares of Alibaba that it will have to sell. Pulling together the numbers for all the valuation/pricing of the individual companies, here is where we stand:
    1. All intrinsic value: Using the intrinsic value estimates that we have for the three companies in the mix, we can estimate an intrinsic value per share for Yahoo:


    The taxes were computed based on the capital gains, the difference between the assessed equity value for Alibaba and the book value (from Yahoo's 10K) for these shares. Using intrinsic value estimates for all three companies, the value per share is $41.19, making it under valued by 18%, relative to the prevailing price per share ($33.76).
    2. All relative value: Using the relative value estimates that we have for Yahoo, Yahoo Japan and Alibaba, we derive a relative value per share for Yahoo:


    On a relative value basis, the value per share is $39.19, making it under valued by 14% at its current price.
    3. Pricing break-even: There is a third twist that can be used to value Yahoo's equity. You can use the market pricing of Yahoo Japan and Alibaba to back out the value that the market is attaching to the parent company's operating assets. Since Alibaba is not public yet, this will require use of the estimated IPO value numbers (I will use $150 billion for the base case), but once Alibaba becomes a public company, the pricing will be the market value.

    Using the expected IPO value of equity of $150 billion, the conclusion you arrive at is that the market must be attaching a negative value to the parent company's operating assets. To the extent that this may just reflect the possibility that we are misplacing the Alibaba IPO, I estimated the value of Yahoo operating assets as a function of the value of Alibaba equity after the IPO.
    Imputed value versus Intrinsic value
    The results here are consistent with both the intrinsic and relative value assessments. Unless the Alibaba post-IPO equity value is less than $104 billion, it looks like Yahoo is mispriced, relative to how its holdings are being priced. 

    What next?
    While I remain concerned about the overall valuation of companies in the sector, Yahoo seems mispriced on every basis, intrinsic, relative and market pricing. I am aware that there are risks (as with any investment) and there are three concerns that I have:
    1. Cross holding complexity: Yahoo is a case study in why valuation becomes difficult in the presence of cross holdings. In particular, the accounting for cross holdings, though it has its own internal logic, creates inconsistencies across financial statements that both confuse and trip up investors. In the case of Yahoo, the cross holdings in Yahoo Japan and Alibaba are recorded using the equity approach. The net result of the accounting is that the operating numbers for Yahoo (revenues, EBITDA and operating income) reflect nothing from these holdings whereas the net income and book value of equity do reflect the cross holdings . So what? For those investors who are dependent upon enterprise value multiples (EV/EBITDA or EV/Sales), applying either of these multiples to Yahoo numbers, adding cash and subtracting debt, i.e., following conventional practice, will yield a value of equity far lower than the market capitalization of the company because you are effectively attaching no value to its cross holdings. It is true that you may be able to use net income as your base, since it includes the income from the cross holdings, and apply a PE ratio to it, but that PE ratio will have to reflect the composite expectations across three companies (Yahoo, Yahoo Japan and Alibaba) on growth and risk.
    2. The tax bite may get larger: I have assumed the minimum tax bite in my valuations, since it really makes no sense for Yahoo to liquidate its cross holdings now, unless it is forced to, as it is in the case of the 9% of Alibaba that it has to sell. It does not need the cash, its investors should get the pass-through value and it certainly does not want to pay the tax bill early. There are two scenarios, though, where this assumption may break down. First, if the market prices for Yahoo Japan and Alibaba skyrocket and Yahoo's price does not, the gap that we highlighted in the last section may get bigger. In fact, if it gets big enough, Yahoo may be forced to monetize the gap, i.e., sell its holdings in Yahoo Japan and Alibaba, pay the taxes, and still have money left over for its stockholders. The second relates to Yahoo's relationship with Alibaba. It is possible that Alibaba may be uncomfortable with Yahoo's continued large stock ownership and find a way, legal or extralegal, to get Yahoo to sell. 
    3. The "do something quickly" discount: There is a bias both among analysts and financial journalists towards CEO action over inaction, towards quick action over more deliberate choices and towards growth over retrenchment. Leading into the Alibaba IPO, there has been a drumbeat of articles like this one, this one and this one that are full of advice for Ms. Mayer about what she should do with the cash windfall that Yahoo will have after the IPO. Most of these articles suggest ways in which Ms. Mayer can use the cash to return Yahoo to its glory days. I think that Yahoo has lost the fight to Google and should concede gracefully. Rather than throw good money after bad, my suggestion is that Yahoo do the following: (a) concede that growth in its core business will be too expensive to go after, cut back on growth investments and run itself as a mature business (essentially what I have assumed in the intrinsic valuation), (b) work on making the performance and the pricing of its cross holdings more transparent to investors and (c) return the excess cash to investors. The upside of doing this will be that the gap between price and break up value may shrink, benefiting stockholders. The downside is that Ms. Mayer loses a chance (albeit one with low odds) to go down in history as the CEO who brought Yahoo back from the dead.
    The cross holdings and the confusion they breed among investors it both an ally and a hindrance, an ally because it is one reason why the stock (in my view) is mispriced and a hindrance because it may take a while for the mispricing to become evident. Alibaba's IPO may seem an obvious catalyst but market corrections don't always follow the logical path. The tax issue is a nagging problem, but the company seems cognizant of the tax overhang and negotiated with Alibaba to reduce the number of shares that it would have to sell after the IPO. Finally, Ms. Mayer seems to be saying all the right things, talking about how how she plans to be a "good steward of capital", but talk is cheap and the pressure to go for bigger and better will be difficult to resist. On balance, none of these risks is enough of a deal breaker for me. Not only is there a gap between price and value with Yahoo but there is one between price (that the market is attaching to Yahoo) and price (that the market is attaching to Yahoo! Japan and Alibaba) and as a newly minted Yahoo stockholder, I am hoping that one or the other of these gaps will close.

    Yahoo! Equity Valuation: Master spreadsheet (is linked to individual company valuations below)



    Alibaba: A China Story with a profitable ending?

    Let me begin with a couple of confessions. The first is that I am not a China expert and what I do not know about the country vastly outweighs what I do. The second is that I start with strong negative biases about the Chinese governance system, political and corporate, that color my assessment of Chinese companies and investments. Having said that, I cannot resist trying my hand at valuing what may be the most valuable IPO in history in Alibaba, but as you review my valuation, keep both my ignorance and biases in mind. 

    Alibaba: Setting the table
    Since I had no exposure to Alibaba and its operations, I started my exploration of the company by visiting their flagship site, TaoBao, a chaotic and colorful hub where both individuals and businesses can offer their goods, used or new, for sale, at fixed or negotiable prices. Though modeled on eBay, Taobao is different on two counts. The first is that it is far more tilted towards small and midsized retailers offering new products for sale than to individuals selling used items. The second is that Alibaba, unlike eBay, does not charge a transaction fee, but instead makes its revenues primarily from advertising.

    In 2010, Alibaba opened a new front in its business with TMall, a site for a selective list of larger retailers, playing an expanded role in the process for a larger slice of the transaction pie. On this site, retailers pay a deposit to Alibaba to reimburse buyers who receive counterfeit goods, a technical service fee to cover the fixed costs of carrying the store and a sales commission determined by transactions value. Alibaba also developed Alipay, a third-party online payment platform, akin to Paypal, that has grown in the last few years to dominate the Chinese online payment market. As we value Alibaba for its IPO, though, it should be noted that investors will not be getting a share of Alipay, because it has been separated from the company and will be operated as an independent entity. (Note: As Blake notes in the first comment, there is a clause in the prospectus that specifies that Alibaba will be entitled to 37.5% of the proceeds if Alipay is taken public or sold, with a floor of $2 billion and a cap of $ 6 billion in that value).

    Alibaba has been phenomenally successful both in terms of both helping online retailing find its legs in Cina and becoming extremely profitable while doing so. In 2013, the company generated almost $4 billion in operating profit on revenues of approximately $ 8 billion and its rapid evolution from small start up to profitable behemoth are traced in the graph below:


    Not only have revenues accelerated over the last three years (the growth story), but the company's profitability has surged even more. If timing is everything in going public, you can see that Alibaba has chosen a good time.

    Alibaba: Four Steps to Valuation Nirvana
    There are four steps to understanding how Alibaba has got to where it is today, where it can expect to go in the future and the risks along the way.
    1. Enter a growth market early and mold it to your strengths: In 1999, when Alibaba was founded, online retailing in China was in its infancy. While the largest US online players (Amazon, eBay etc.) either ignored or mishandled the market, Alibaba not only adapted to Chinese conditions but played a key role in the evolution and growth of the Chinese e-commerce market, as China has become the second largest online market in the world, as shown in this comparative graph from this McKinsey's report on the market:

    One key difference between the Chinese e-tailing market and US online retail is that the former has historically been much more dependent on online marketplaces (as opposed to retailer-based online sites)  largely because of Alibaba's influence.
    Future: As Chinese consumers get increasingly comfortable buying online, the expectations are that the Chinese online market will continue to grow at high rates. In its prospectus, Alibaba estimates a compounded growth rate of 27% a year in Chinese online commerce between 2014 and 2018, and that number is in line with estimates made by other services. If these forecasts hold up, the online retail market in China will become the world's largest in the next few years.
    Fears: Though there are few who seem to question the China story today, the history of growth in emerging markets is that there are always unpleasant and unexpected surprises on the pathway to prosperity. Investing in Alibaba is an investment in continued growth in China, and any economic or political troubles that operate as speed bumps on that growth will affect Alibaba disproportionately, since it generates almost all of its profits in China and is dependent on growing consumer spending.

    2. Differentiate and dominate: The story of how Alibaba beat eBay and Amazon is grist for strategic story tellers, but at its core, there are three reasons why Alibaba won (and eBay lost). The first is economic. By charging no transactions fees initially and depending entirely on modest advertising charges, Alibaba made itself a bargain to retailers, relative to competitors. The second is that Alibaba molded its offerings to Chinese culture and consumer behavior. The Economist’s characterization of TaoBao as an online bazaar is apt, since the site is colorful, chaotic and set up for online haggling between buyers and sellers. Third, the site is also attuned to the fact that the Chinese retail market is splintered, with thousands of small and mid-sized retailers who lack visibility, credibility and payment processing skills online and TaoBao offers all of those. The visibility comes from the traffic on the site, the credibility from Alibaba’s system of independent verification, paid for by sellers, and payment processing from Alipay,  In 2013, about 75% of all online retail business in China was routed through one of Alibaba’s sites. To provide a measure of the sheer volume of transactions on TaoBao and TMall, it is estimated that $5.75 billion merchandise was sold on Chinese online retail sites just on "Singles Day" on November 11, 2013, more than two and half times what US online retailers sold on Cyber Monday, and much of the merchandise was sold on the Alibaba sites. To get a measure of Alibaba's market share online, take a look at the breakdown of the biggest players in the B2C (retailers selling to customers), C2C (customers/small retailers selling to other customers), mobile markets and mobile payments in China:

    In every segment, Alibaba is not just the leader but an overwhelming one.
    Future: The domination of Alibaba creates a network effect, since retailers have to go where the customers are now, and as a consequence, they have to be on an Alibaba site to be noticed. That, in turn, make it easier for Alibaba to attract more customers, as the overall market grows, keeping the cost of customer acquisition low for the company.
    Fears: The dark side of having as large a market share as Alibaba does is that almost all of your future growth will have to come from the overall market growing. The size of the Chinese market is also drawing in competitors who are willing to spend significant amounts of money to chip away at Alibaba’s market share, with Jingdong (360Buy) and Tencent offering faster delivery and better after-sale service.

    3. Don't be greedy: While most online retail transactions in China go through Alibaba sites, the slice that Alibaba keeps for itself is very small. In TaoBao, in particular, its revenues are just advertising charges paid by retailers to list on the site, a very small portion of the total transaction value. In TMall, Alibaba does get a larger slice of the transaction revenues because it charges a transaction fee, but it is still only 0.5 and 1.5% of revenues. While this small share may seem like a negative, it has proved to be one of Alibaba's competitive advantages, since it has made it difficult for competitors to undercut it and offer better deals to customers and retailers.
    Future: The question of how Alibaba's slice of overall transaction revenues will change over time, we have to make judgments on the relative growth of TMall and TaoBao. If the former grows faster than the latter, the slice of revenues that Alibaba keeps will increase over time. I was disappointed that Alibaba was not more transparent about the evolving shares of its two market places in its prospectus, choosing to lump them together as China commerce.
    Fear: The market, especially in B2C, is getting more competitive, as international players like Amazon and EBay are coming back to the market, chastened by past failures, but perhaps having learned from their mistakes and deep pockets.

    4. Avoid pretense: Alibaba seems to generate these revenues with little effort (and marketing costs) and since the company does not aspire to be a technological innovator, its R&D and development costs are negligible. These factors result in the company’s most impressive statistic: in 2013 it had a pre-tax operating margin of almost 50% and a net profit margin of close to 40%, high even by any standards. 
    Future: Alibaba's high margins are a result of the network effect (that we referenced earlier) created by its immense market share and its limited ambitions (where it has been willing to settle for a small portion of revenues). While there is nothing to indicate that either will change significantly in the near future, there are signs that the company is getting more ambitious, planning large investments in social media companies and logistics infrastructure. 
    FearAlibaba will have to start working harder (and spending more) to get consumers to continue to use its sites and to keep advertisers on its site. For instance, Alibaba has announced plans to spend billions in building a logistics network to allow for same-day delivery. These investments, while necessary to preserve Alibaba’s success, will reduce both margins in the future and cash flows in the near term.

    Alibaba: What next?
    Alibaba is exceptionally profitable and will probably remain so for the near future. To value Alibaba, though, I had to make judgments on the following parameters:
    1. Revenue growth: The expected revenue growth at Alibaba will be a composite effect of three of the four dimensions described in the last section.

    In my judgment, Alibaba's revenues will grow at a compounded rate of 27% a year for the next five years, the same rate as the overall online retail market in China, with losses in market share being offset by a more diverse business model allowing it to keep a larger slice of transaction revenues. While that is a steep climb down from last year's growth, note that it is a compounded growth rate and that I am probably understating revenue growth in the first year or two but overstating it in the fourth and fifth year. Starting in year 6, that revenue growth will start sliding down towards a mature stage growth of 2.63%. With my estimates of growth, Alibaba's revenues in 2024 will be approximately $47.6 billion. To provide perspective, that estimate is 40% lower than Amazon's revenues of $78.1 billion in 2013, about 25% below from Google's revenues of $62.3 billion in 2013 and more than five times Facebook revenues of $8.9 billion in 2013.

    2. Operating margin: The stratospheric margin enjoyed by Alibaba currently (of approximately 50%, pre-tax) makes it extremely unlikely that the margin will increase over time and more than like that it will decrease. In fact, while the numbers don't reflect this yet, the news stories about recent investments that the company  has had to make in logistics and technology suggest that it is not a question of whether the margin will decline over time but by how much. While the margins at TaoBao will remain high, the competitive nature of the B2C market will put downward pressure on operating margins at TMall. I will be assuming that the operating margin will decline over time down to 40% in 2024. To provide perspective again, Facebook reported an operating margin of 35.6% in 2013 and Google's pretax operating margin in 2013 was 23.4%. I would justify Alibaba's higher operating margin by noting that Alibaba spends far less than either Facebook or Google on R&D or technology. I also assumed that the tax holidays and credits that have kept Alibaba's effective tax rate at close to 10% will start to fade over time, and that the tax rate will move towards the Chinese statutory rate of 25% over time.

    3. Investment: If Alibaba plans to ramp up revenues, as I have forecast, it will be called upon to make investments in logistics, technology or social media companies. While it is difficult to be specific about what form these investments will take, the company currently generates $1.93 in revenues for every dollar in capital invested (based on 2013 revenues and capital invested). I assume that for every $2 in incremental revenues in the future, Alibaba will have to invest a dollar in incremental capital. That will still make them more efficient than the typical US company in this space, where the ratio of sales to invested capital is closer to 1.40.

    4. Cost of capital: Alibaba's business is a mix of advertising and merchandising (the transaction fees that it charges in TMall). Using a mix of 70% advertising and 30% online retailing as my mix, I estimated a cost of capital, in US dollar terms, of 8.84% for the company, at least for the next five years. As the company matures and growth eases, this cost of capital will decline to 8% by 2024.

    5. Cross holdings: Alibaba has made investments in other companies in recent years, primarily because they offer technologies or products that will help Alibaba in its operations. These investments are recorded in the balance sheet at $2,093 million and the five biggest are listed below:
    Since two of these companies, Weibo and AutoNavi, are publicly traded, I estimated the market value of these holdings and replaced the equity value on the balance sheet with the market values instead. The net effect was small, yielding a corrected value for the cross holdings of $2,087 million. Finally, the liquidity clause in the Alipay agreement entitles Alibaba to 37.5% of the proceeds from any liquidity event associated with Alipay (an IPO or a sale), with a cap of $ 6 billion and a floor of $2 billion on Alibaba's share. Alipay's earnings just from Alibaba in 2013 was $305 million and it likely that it will keep growing over time, suggesting that the value from a liquidity event is likely to yield a payoff to Alibaba that will be closer to $ 6 billion than $2 billion, in case of a liquidity event. That $6 billion, though, has to be adjusted for the likelihood that the entangled nature of Alipay (with Alibaba) will make it difficult to sell the company or take it public as well as the time value of money. Conservatively, I am adding an additional $ 3 billion to Alibaba's value to reflect both of these factors.

    The valuation: The value that I obtain for the equity is approximately $130 billion, before IPO proceeds are considered, and in excess of $145 billion with the IPO proceeds built in. The valuation picture, summarizing my inputs, is below and you can download the spreadsheet with the valuation, if you so desire. (You can also download the prospectus by clicking here.)


    The value of the operating assets in Alibaba, based on my assumptions, is $127.48 billion. Adding cash ($7,876 million),  the value of cross holdings in other companies ($2,087 million) and Alipay ($3,000 million), netting out debt ($6,670 million) and the value of equity options granted to employees ($3,190 million) results in a value for equity of $130.59 billion. Finally, since this is an initial public offering that will raise money that is going to be kept in the firm (according to the prospectus), I added an estimated $15 billion (the rumored IPO target) to arrive at an overall equity value of $145.59 billion. Again, working with the 2368.67 million shares outstanding, including restricted stock units granted to employees, that works out to a value per share of $61.46/share.

    Caveats
    Rather than give you the usual caveats, which would be that my estimates are likely to be wrong and that you should make your own valuation judgments, there are four specific concerns I would draw your attention to.
    1. Status quo, not disruption: When you invest in young growth companies in big markets, you usually are hoping for disruption, since you need the game to be shaken up for these companies to displace larger, more established players. With Alibaba, though, that is not the case. This is a company that has in large part built the status quo for online retailing in China and benefits hugely from more of the same. Your biggest fear if you are an Alibaba stockholder is of a seismic change in either technology or Chinese consumer buying habits that will undercut Alibaba's network advantages.
    2. Corporate governance: Corporate governance at young technology companies is weak and it is toothless at Chinese companies. So, it goes without saying that if you buy shares in Alibaba, you should do so with the expectation that if you do not like the way the company is run, you will have no recourse other than sell your shares and move on. Since that is a conclusion that you would reach if you bought Facebook or Google shares, as well, Alibaba is not that unusual, at least in this sector.
    3. Legal Jeopardy: The shares that will be offered in the Alibaba IPO are not shares in the operating company but in a legal entity that is incorporated in the Cayman Islands. That legal entity, structured as a variable interest entity (VIE), owns the operating company in China. The reason for this complex holding structure is that the Chinese government has restrictions on foreign ownership in a wide range of businesses, including retailing, and this structure allows companies to evade those restrictions. The Chinese government is undoubtedly aware of the evasion and looks the other way, at least for the moment, though it does reserve the right to change its mind and challenge the legality of the structure. I am still a novice to the nuances of investing in a VIE, but there are others who know far more than I do and have posted on the dangers. While Alibaba seems to have structured it's VIE with more protections than most, I am still uncomfortable with the notion that my investment value is left to the tender mercies of Chinese regulators and law.
    4. The Silent Partner: While much of Alibaba's success can be traced to good management and a favorable market climate, it is also true that almost every successful Chinese company owes part of its success to friends in high places,. While I am not suggesting that the company is guilty of corruption or underhanded practices, it is also true that the Chinese government has tilted the competitive balance in Alibaba's favor in subtle and not-so-subtle ways especially against foreign competitors. The downside of being a beneficiary of official favors is that Alibaba will be asked to reciprocate at some time or worse still, it (and by extension, its stockholders) may fall out of favor. 
    What next?
    As I have noted in my previous pre-IPO musings on Facebook and Twitter, the IPO process is a pricing game, not a valuation one. Thus, it matters little what you or I or even the company think Alibaba's value is today. It matters more what investors, institutional and individual, are willing to pay for Alibaba in this market. In spite of the recent swoon in technology stocks, Alibaba brings together in one package many of those buzzwords that I referenced in an earlier post: it is a company with strategic aspirations, significant growth potential and expansion options in China, creating a perfect storm for sky-high pricing.



    Numbers and Narrative: Modeling, Story Telling and Investing

    When I put together the outline for my very first valuation class in 1986, I was warned by a senior faculty member not to go down that path. I was told that there was really not enough theory in valuation to warrant a class and that I would end up teaching a glorified accounting class. I chose to ignore that advice and I have not regretted it since, for two reasons. The first is that I love teaching a subject where there is little theory, the questions are entirely about practice, you draw on a unique blend of skills and tools to accomplish your tasks and the market acts as your task master.  The second is that I have learned almost everything I know about valuation and more importantly, how much I don't know, in the process of teaching this class. This post is about one of the recurring themes in my class which is the interplay between narratives and numbers that makes for a good valuation.

    The Numbers Game
    When most people think about valuation, they generally visualize dense financial statements and elaborate excel spreadsheets, and those coming into my valuation class are no exception. They expect me to immerse them in accounting rules and the building of models and are either deeply disappointed, if their background is in accounting or banking, or relieved, if it is not, to find out that the only thing I know about accounting rules is that there lots of them and that I am not an Excel Jedi Master. Don't get me wrong! I do draw on accounting statements for my information and use Excel incessantly, but here is how I see their place in valuation:
    1. Accounting statements provide me with the raw material for my valuation, nothing more and nothing less. Like all raw material, I have to decide what I will use and what I will discard, and I discard far more than I use. As the end user of the raw material, I get to determine what makes sense for me and what does not and not GAAP, IFRS or the accounting profession. As for fair value accounting, I am sympathetic with the motives (which is to make accounting more relevant) but unimpressed with the results. To me, fair value accounting estimates are like microwave frozen dinners, quick and convenient, but you will never mistake them for the real thing.
    2. Excel (or Numbers) is a versatile and powerful multi-purpose tool, but like all tools, it can be misused or over used. My knowledge of Excel is limited to those parts of it that help me complete my valuation and I frankly have no interest in expending time and resources mastering the parts that I can get done with simpler tools or none at all.
    So, why do so many appraisers and analysts emphasize their mastery (at least in their minds) of the numbers side of valuation? The answer, I think, lies in the trifecta of illusions that go with numbers-based models.
    1. The illusion of precision: For better or worse, we seem to feel better about uncertain outcomes, if we can attach numbers (expected values, risk adjusted discount rates) to them. That, by itself,  is healthy but what is unhealthy is the belief that quantifying risk somehow makes it dissipate. 
    2. The illusion of objectivity: I believe that all valuations are biased, with the only questions being how much bias and in what direction. That is because we bring in our preconceptions and beliefs about companies into our valuations and we sometimes add to the bias because we have other agendas at play. Here again, analysts point to numbers as their defense against the bias charge, with the implicit argument that numbers don't lie, when the most effective way to shade the truth is with a selective use of numbers.
    3. The illusion of control: I believe that "numbers people" often use numbers to intimidate "non-numbers people" into mute acceptance. The intimidation factor is dialed up by adding more detail  (500 line items, anyone?) and buzz words (free cash flow, a few greek alphabets and a host of acronyms) to your valuations.
    In my view, there are at least three significant dangers, when numbers are used without any narrative (or story line) in constructing valuations. First, valuations become plug-and-point exercises, tools to advance sales pitches or confirm pre-conceived values. Second, if a valuation is built around line items and individual inputs, there is a strong possibility that you may be creating a business that can exist only in spreadsheet nirvana, where revenues double every year, margins expand without challenge and growth comes without significant reinvestment. Finally, discussions and debates about inputs become shallow exercises in quibbling about the "right" values to use, with no logical tie breaker.

    The Narrative as Valuation
    If one extreme of the numbers/narrative spectrum is inhabited by those who are slaves to the numbers, at the other extreme are those who not only don't trust numbers but don't use them. Instead, they rely entirely on narrative to justify investments and valuations. Their motivations for doing so are simple.
    1. Story telling is a powerful attention getter/keeper: Research in both psychology and business point to an undeniable fact. Human beings respond better to stories than to abstractions or numbers, and remember them for longer. After all, the Harvard Business School has taken story telling almost to an art form with its cases, tightly wound narratives that are supposed to convey larger lessons.
    2. Unrestrained creativity: "Creative" people through the ages have always fought back against any restraints on their creativity, especially those imposed by those that they view as less imaginative than they are. 
    3. The Creative Superiority Complex: Just as numbers people intimidate with mounds of numbers, good narrators can browbeat "bean counters" with superior story telling, especially if they can back their stories up with personal experience. 
    Narrative-driven investing is not uncommon, especially with younger firms and start-ups, and I have been taken to task for even trying to value these companies using number-driven models. Paraphrasing some of the comments on my valuations of Twitter and Uber, the argument seems to be that while cash flow based valuations may work on Wall Street and with mature companies, they are not useful in analyzing the type of companies that venture capitalists look at. While it is true that rigid cash flow based models will not work with companies where promise and potential are what is driving value, staying with just narrative exposes you to two significant risks. The first is that, without constraints, creativity can carry you to the outer realms of reason and into fantasy. While that may be an admirable quality in a painter or a writer, it is a dangerous one for an investor. The second is that, when running a business as a manager or monitoring it as an investor, you need measures of whether you are on the right path, no matter where your business is in its life cycle. When narrative alone drives valuation and investing, there are no yard sticks to use to see whether you are on track, and if not, what you need to do to get back on the right path. 

    Numbers plus Narrative
    If numbers without narrative is just modeling and narrative without numbers is story telling, the solution, as I see it, is both obvious and difficult to put into practice. In a good valuation, the numbers are bound together by a coherent narrative and story telling is kept grounded with numbers. Implementing this solution does require work and I would suggest a five-step process, though I am not rigid about the sequencing.

    Step 1: Develop a narrative for the business that you are valuing or considering investing in: Every business has a story line and the place to start a valuation is with that narrative. While managers and founders get to present their narrative first, and some of them are more persuasive and credible than others, you and I have to develop our own narratives, sometimes in sync with and sometimes at odds with the management story line. As an example, in my valuation of Uber, my narrative was this: Uber is an innovative car service company, with the untested potential to expand into other logistics businesses. It will expand the car service business (by attracting new users), while gaining a significant (though not dominant) market share and preserving its profitability.  The counter narrative that some of you presented is the following (and I am paraphrasing): Uber is a logistics company that will find a way to expand its profitable car service business model into the moving, car rental and electric car businesses.

    Step 2: Test the narrative against history, experience and common sense: This is the stage at which you put your narrative through a reality test and examine whether it withstands multiple tests. The first is the test of history, where you look at the past to see if there have been companies that have lived the narrative that you are claiming for your company and what they share in common.  The second is the test of experience, where you draw on investments based upon similar narratives that you have made in the past and remember or recognize road bumps and barriers that you ran into in practice. The third is the test of common sense, where you draw on first principles in economics and mathematics, to evaluate your narrative's weakest links. With Uber, here is how I justified my narrative. Uber will be able to gain (10%) is that the car service (taxi and limo) business is a splintered, regulated and inefficient business that is ripe for disruption. The reason I did not assume a dominant market share for Uber (40% or 50%) is because I don't see as large a networking effect in the car service business, where the service is both physical and localized, as there are in online technology businesses (search, merchandising or advertising). At the same time, I am assuming that Uber will be able to preserve its profitability in the face of competition and overcome regulatory hurdles.

    Step 3: Convert key parts of the narrative into drivers of value: Ultimately, even the most gripping narratives have to show up in the numbers. While this may seem like an insurmountable obstacle to those without a valuation background, it can be simplified by looking at the big picture. Here is my attempt to connect different narratives with key value drivers:
    Narratives and Value Drivers
    Step 4: Connect the drivers of value to a valuation: I use discounted cash flow models (DCF) to connect the drivers of value to value, because I am comfortable with the mechanics of these models. It is a tool that not everyone is comfortable with and you may find a different and perhaps better way to connect value drivers to value. In fact, the classic VC valuation takes a short cut by using three drivers of value: an expected earnings (or revenue) in a future period, an exit multiple (based on what others seem to be willing to pay today for similar companies) that converts that number into a future value and a target return to discount that value back to the present (and adjust for risk). To those of you who have never done valuation before, trust me when I say that valuation at its core is simple and that anyone should be able o do it. If you don't believe me, you are welcome to try my online valuation class on iTunes U. It comes with a money back guarantee.

    Step 5: Keep the feedback loop open: My kids and spouse are quick to remind me that the three words that I find most difficult to say are "I was wrong" and I am sure that I am not alone in my reluctance. The biggest enemy that we (whether numbers or narrative driven) face is hubris, where we get locked into our initial points of views and view changing our minds as a sign of weakness. While it does not come easily to me, I do try to stay open to the possibility that as events unfold, my narrative will change or even shift, sometimes dramatically. With Uber, if the next few months bring evidence of tangible success of the business model in other logistics markets, I will change my story, expand the potential market and with it, the value. If, in contrast, the company gets bogged down in regulatory and legal fights in its existing car service markets or a competing service improves its offering dramatically, I will have to dial down my optimism, reduce both market share and profit margins and change value. In either case, I will view these changes as part of investing rather than as a failure in my initial valuation.

    In my experience, it is easiest to play to your strengths (which, for me, are on the numbers side), but you will gain the most when you work on your weaknesses (which, for me, are on the narrative side). Consequently, I learn more from listening to those who think differently from me and disagree with me, even if they do not always do so constructively, than I do from those who agree with me. On my Uber valuation, the comments that I found most useful in fine tuning my valuation were those that I heard from those in the venture capital and technology space. After telling me that I had no idea what I was talking about and that "DCF won't work for these companies", they then proceeded to give me ideas that I incorporated into my DCF valuation. Here, for instance, are my attempts to quantify four of the most common narratives I heard about Uber, and the consequences for value.

    Narrative
    Total Market
    Market Share
    Uber Cut
    Cost of capital
    Failure Probability
    Value for Uber
    Car service company, facing significant competitive and regulatory hurdles, forced to make trade off of lower profitability for market share.
    $100 billion
    10%
    10%
    12%
    10%
    Car service company with potential to expand into other logistics markets, significant market share, sustained profitability (Mine)
    $100 billion
    10%
    20%
    12% ->8%
    10%
    $5.9 billion + $2-3 billion for disruption option
    Car service company with dominant market share (from networking effects) and sustained profitability (New York Times)
    $100 billion
    50%
    20%
    12% ->8%
    0%
    Logistics company with expansion of car service business model into other logistics businesses, while preserving profitability.
    $600 billion
    5%
    20%
    12% ->8%
    0%

    There are two points I hope to make with this exercise. First, even the most imaginative and far-reaching narratives can and should be converted into numbers. So, let's retire the argument that some companies cannot be valued. Second, big differences in valuation almost always result from differing narratives about companies, not disagreements about the "small stuff".

    Finally, since this is a discussion of how best to marry narrative to numbers, I cannot pass the opportunity to plug Shark Tank, one of my favorite shows, where narrative (from those pitching their businesses) meets numbers (from the venture capitalists/investors who challenge the business models while bidding on them), generating both drama and humor. 

    Implications
    If you view value as narrative overlaid with numbers, there are implications for both the founders/managers of businesses and the investors in these firms. To attract capital, managers need to develop coherent narratives about the firms that they run, convey these narratives to investors/markets effectively, and act consistently. To manage that capital well, they need to  identify value drivers, set yard sticks that measure how the narrative is unfolding and change in response to unforeseen events, both positive and negative.

    For investors, the lessons are just as profound. They need to find companies that have compelling narratives, convert these narratives into value and make sure that they are not paying too much.  They need to spread their bets across several good narratives and be open to changes in narratives and numbers. It is true that having a great narrative and the numbers to back them up is not a guarantee of investment success. The best laid plans of mice and men can go to waste, but to not plan at all will guarantee that waste.

    Attachments:
    Uber: A Challenged Car Service company 
    Uber: A Successful Car Service company 
    Uber: A Car Service company with networking effects
    Uber: A Logistics company



    Bubble, Bubble, Toil and Trouble: The Costs and Benefits of Market Timing

    If you believe that the stock market is in a bubble, you have lots of company. You have long-time market watchers, the New York Times and even a Nobel Prize winner in your camp. But what exactly is a bubble? How can you tell if you are in one?  And if you do believe you are in a bubble, what is your best course of action? Not only are these questions difficult to answer, but the answers can vary across markets, investors and time. 

    The Bubble Machine
    Every market has a bubble machine, though it is less active in some periods than others, and that machine creates an ecosystem of metrics and experts, as well as warnings about bubbles about to burst, corrections to come and actions to take to protect yourself against the consequences. In periods like the current one, when the bubble machine is in over drive and you are confronted by "bubblers" with varying credibilities, motives and methods, you may find it useful to first categorize them into the following groups.
    1. Doomsday Bubblers have been warning us that the stock market is in a bubble for as long as you have known them, and either want you to keep your entire portfolio in cash or in gold (or bitcoins). They remind me of this character from Winnie the Pooh and their theme seems to be that stocks are always over valued.
    2. Knee Jerk Bubblers go into hibernation in bear markets but become active as stocks start to rise and become increasingly agitated, the more they go up. They are the Bobblehead dolls of the bubble universe, convinced that if stocks have gone up a lot or for a long period, they are poised for a correction.
    3. Armchair Psychiatrist Bubblers use subtle or not-so-subtle psychological clues from their surroundings to make judgments about bubbles forming and bursting. Freudian in their thinking, they are convinced that any mention of stocks by shoeshine boys, cab drivers or mothers-in-law is a sure sign of a bubble.
    4. Conspiratorial Bubblers believe that bubbles are created by small group of evil people who plan to profit from them, with the Illuminati, hedge funds, Goldman Sachs and the Federal Reserve as prime suspects. Paranoid and ever-watchful, they are convinced that stocks are manipulated by larger and more powerful forces and that we are all helpless in the face of this darkness.
    5. Righteous Bubblers draw on a puritanical streak to argue that if investors are having too much fun (because stocks are going up), they have to be punished with a market crash. As the Flagellants in the bubble world, they whip themselves into a frenzy, especially during market booms.
    6. Rational Bubblers uses market metrics that are both intuitive and widely used, note their divergence from historical norms and argue for a correction back to the average. Viewing themselves as smarter than the rest of us and also as the voices of reason, they view their metrics as infallible and mean reversion in markets as immutable.
    There are three things to keep in mind about bubblers. The first is that bubblers will receive disproportionate attention in the media, for the same reasons that a reality show about a dysfunctional family will have higher ratings than one about a more normal family. The second is that even the most misguided bubblers will be right at some point in time, just as a broken clock is right twice every day. The third is that being right is often the worst thing that can happen to bubblers, because it seems to feed into the conviction that they are always right and leads to increasingly bizarre predictions. It is no coincidence that every market correction in history has created its gurus (who called that correction right) and those gurus have almost always found a way to discredit themselves ahead of the next one.


    Defining a Bubble
    What is a bubble? The lazy definition is that any time you see a large market correction, it is the result of a bubble bursting, but that is neither a useful definition, nor is it true. To me, a bubble reflects a market disconnect from fundamentals, where prices go up steeply, with no help from the fundamentals. The best way of illustrating this is to go back to an intrinsic value model, where the value of stocks can be written as a function of three fundamentals: the base year cash flows that investors are receiving, the expected growth in these cash flows and the risk in the cash flows:


    If cash flows increase, growth rates surge, risk free rates drop or macroeconomic risk subsides, stocks should go up, and sometimes steeply, and there is no bubble.  At the other extreme, if stock prices go up as cash flows decrease, growth rates become more negative and risk free rates and equity risk increase, you have a bubble. It is far more likely, though, that you will be faced with a more ambiguous combination, where shifts in one or more fundamentals (higher growth, higher cash flows, a lower risk free rate or lower macroeconomic risk) may explain the increase in stock prices and you will have to make judgments on whether the increase is larger than warranted. 

    Detecting a Bubble
    The benefits of being able to detect a bubble, when you are in in its midst rather than after it bursts, is that you may be able to protect yourself from its consequences. But are there any mechanisms that detect bubbles? And if they exist, how well do they work?

    a. PE and variants
    The most widely used metric for detecting bubbles is the price earnings (PE) ratio, with variants thereof that claim to improve its predictive power. Thus, while the conventional PE ratio is estimated by dividing the current price (or index level) by earnings in the last year or twelve months, you could consider at least three modifications. The first is to clean up earnings removing what you view as extraordinary or non-operating items to come up with a better measure of operating earnings. In 2002, in the aftermath of accounting scandals, S&P started computing core earnings for US companies which can differ from reported earnings significantly. The second is to average earnings over a longer period (say five to ten years) to remove the year-to-year volatility in earnings. The third is to adjust the earnings from prior periods for inflation to get a inflation-consistent or real PE ratio. In fact, Robert Shiller has a time series of PE ratios for US stocks stretching back to 1871, that uses normalized, inflation-adjusted earnings.

    In the graph below, I report on the time trends between 1969 and 2013 in four variants of the PE ratios, a PE using trailing 12 month earnings (PE), a PE based upon the average earnings over the previous ten years (Normalized PE), a PE based upon my estimates of inflation-adjusted average earnings over the prior ten years (My CAPE) and the Shiller PE. 

    Normalized PE used average earnings over last 10 years & My CAPE uses my inflation adjusted normalized earnings. Shiller PE is as reported in his datasets
    While the Shiller PE has become the primary weapon wielded by those who believe that we are in a bubble, perhaps because of the pedigree of its creator,  the reality is that all four measures of PE move together much of the time, with a correlation of close to 90%. (If you are wondering why my time series starts in 1969, I use the S&P 500 and earnings on the index and I was unable to get reliable numbers for the latter prior to 1960. Since I need ten years of earnings to get my normalized values, my first estimates are therefore in 1969.)

    To examine whether any of these PE measures do a good job of predicting future stock returns and thus market crashes, I computed the correlation of each PE measure with annual returns on the S&P 500 over one-year, two-year and three-year periods following the computation.
    T statistics in italics below each correlation; numbers greater than 2.42 indicate significance at 2% level
    First, the negative correlation values indicate that higher PE ratios today are predictive of lower stock returns in the future. Second, that correlation is weak with one-year forward returns (notice that none of the t statistics are significant), become stronger with two-year returns and strongest with three-year returns. Third, there is little in this table to indicate that normalizing or inflation adjusting the PE ratio does much in terms of improving its use in prediction, since the conventional PE ratio has the highest correlation with returns over time periods

    Defenders of the PE or one its variants will undoubtedly argue that you don't make money on correlations and that the use of PE is in detecting when stocks are over or under price. For instance, one rule of thumb suggests that a Shiller PE above 15 would indicate an over valued market, but that rule would have kept you out of US equities since 1988. To create a rule that is more reflecting of the 1969-2013 time period, I computed the 25th percentile, the median and the 75th percentile of each of the PE ratio measures for this period.
    PE measures: 1969-2013
    I then broke my sample down into four quartile classes with each PE ratio, from lowest to highest, and computed the annual stock market returns in the years following:
    One-year and Two-year stock returns
    The predictive power improves for PE ratios with this test, since returns in the years following high PE ratios are consistently lower than returns following low PE ratios. Normalizing the earnings does help, but more in detecting when stocks are cheap than when they are expensive. Finally, the inflation adjustment does nothing to improve predictive returns.

    Note, though, that this test is biased by the fact that the quartiles were created using data from the period on which the test is run. Thus, the conclusion that you can draw from this table is that if you had known, in 1969, what the distribution of PE ratios for the S&P 500 would look like for the next 45 years (which would suggest amazing foresight on your part), you could have made money by buying when PE ratios were in the bottom quartile of the distribution and selling in the top quartile.

    b. EP Ratios and Interest Rates
    One of the biggest perils of using the level of PE ratios as an indicator of stock market pricing, as we have in the last section, is that it ignores the level of interest rates. If  interest rates are lower, PE ratios should be higher and ignoring that relationship will lead us to conclude far too frequently (and erroneously) that stocks are over priced in low-interest rate environments. The link between PE ratios and interest rates is best illustrated by looking at how the EP ratio (the inverse of the PE ratio) moves with the T.Bond rate over time. In the figure below, I graph the movements of all four variants of EP ratios as the T.Bond rates changes between 1969 and 2013:

    It is clear that EP ratios are high when interest rates are high and low when interest rates are low. In fact, not controlling for the level of interest rates when comparing PE ratios for a market over time is an exercise in futility.

    This insight is not new and is the basis for the Fed Model, which looks at the spread between the EP ratio and the T.Bond rate. The premise of the model is that stocks are cheap when the EP ratio exceeds T.Bond rates and expensive when it is lower. To evaluate the predictive power of this spread, I classified the years between 1969 and 2013 into four quartiles, based upon the level of the spread, and computed the returns in the years after (one and two-year horizons):


    The results are murkier, but for the most part, stock returns are higher when the EP ratio exceeds the T.Bond rate.

    c. Intrinsic Value
    Both PE ratios and EP ratio spreads (like the Fed Model) can be faulted for looking at only part of the value picture. A fuller analysis would require us to look at all of the drivers of value, and that can be done in an intrinsic value model. In the picture below, I attempt to do so on June 14, 2014:

    Intrinsic valuation of S&P 500: June 2014
    It is true that this intrinsic value is a function of my assumptions, including the growth rate and the implied equity risk premium. You are welcome to download the spreadsheet and try your own variations.


    If your concern is that I have used too low an equity risk premium, you can solve, as I do at the start of each month, for an implied equity risk premium (by looking for that equity risk premium that will give you the current index level) and then comparing that value to historical values for that input:


    The current implied ERP of 4.99% is well above the historic average and median and it clearly is much higher than the 2.05% that prevailed at the end of 1999.

    Are we in a bubble?
    In the table below,  I summarize where the market stands today on each of the metrics that I discussed in the last section:

    If you focus on PE ratios, it is true the current levels in the market put it in the danger zone, given past history. However, bringing the level of interest rates into the measure (in the EP spreads) reverses the diagnosis, since stocks look under valued on these measures. Finally, expanding the assessment to look at growth and risk as well in the intrinsic value and ERP measures reinforces suggests that stocks are fairly valued. 

    While there are some who are adamant in their belief that the market is in a bubble, I remain unconvinced, especially given the level of rates today. To those who argue that earnings could drop, growth could turn negative, interest rates could go up or that there could be another global crisis lurking around the corner, has there ever been a point in time in stock market history where these concerns have not existed? And even if they do exist, the reason we demand an equity risk premium in the first place is for the uncertainty that we feel about macroeconomic variables driving value.


    Bubble Belief to Bubble Action: The Trade Off
    While I believe that the risk that we are in a bubble is over stated by PE ratio comparisons, you may come to a very different conclusion. Even if you do, though, should you act on that belief? The answer is not clear cut, since there are two ways you can respond to a bubble. The first, which I will term the passive defense, is to reduce the amount of your portfolio allocated to equity to a lower number than you would normally hold (given your age, liquidity needs and risk aversion). The second which I term the active defense is to try to profit off the market correction by selling short (or buying puts). The trade off is then between the cost and the benefit of acting:
    • The cost of acting: If you decide to act on a bubble, there is a cost. With the passive defense,  the money that you take out of equities has to be invested somewhere safe (earning a risk free rate, or something close to it) and if the correction does not happen, you will lose the return premium you would have earned by investing stocks. With an active defense, the cost of being wrong about the correction is even greater since your losses will increase in direct proportion with how well stocks continue to do. (Note that using derivatives to protect yourself against market corrections or for speculation will deliver variants of these defenses.)
    • The benefit of acting: If you are right about the bubble and a correction occurs, there is a payoff to acting. With the passive defense, you protect your investment (or at least that portion that you shift out of equities) from the drop. With the active defense, you profit from the drop, with the magnitude of your profits increasing with the size of the correction.
    The trade off then becomes a function of three variables: how certain you feel about the existence of a  bubble, how big a correction you see occurring as a result of the bubble bursting and how soon you see the correction coming.

    To illustrate the trade off, consider a simple (perhaps simplistic) scenario, where you are fully invested in equities and believe that there is 20% probability of a  market correction (which you expect to be 40%) occurring in 2 years. In addition, let's assume that the expected return on stocks in a normal year (no bubble) is 7.51% annually and that the expected annual return if a bubble exists will be 9% annually, until the bubble bursts. In the table below, I have listed the payoffs to doing nothing (staying 100% in equities) as well as a passive defense (where you sell all your equity and go invest in a  risk free asset earning .5%) and an active defense (where you sell short on equities and invest the proceeds in a risk free asset):
    Future value of portfolio in 2 years (when correction occurs)
    If you remain invested in equities (do nothing), even allowing for the market correction of 40% at the end of year 2, your expected value is $1.0672 at the end of the period.  With a passive defense, you earn the risk free rate of 0.5% a year, for two years, and the end value for your portfolio is just slightly in excess of $1.01. With an active defense, where you sell short and invest int he risk free rate, your portfolio will increase to $1.3072, if a correction occurs, but the expected value of your portfolio is only $0.9528, which is $0.1144 less than your do-nothing strategy.

    If you feel absolute conviction about the existence of a bubble and see a large correction coming immediately or very soon, it clearly pays to act on bubbles and to do so with an active defense. However, that trade off tilts towards inaction as uncertainty about the existence of the bubble increases, its expected magnitude decreases and the longer you will have to wait for the correction to occur. I know that I am pushing my luck here but I tried to assess the trade off in a spreadsheet, where based upon your inputs on these variables, I estimate the net benefit of acting on a bubble for the passive act of moving all of your equity investment into a risk free alternative:
    Payoff to Passive Defense against Bubble (Correction of 40% in 2 years)
    The net payoff to acting on a bubble generates positive returns only if your conviction that a bubble exists is high (with a 20% probability, it almost never pays to act) and even with strong convictions, only if the market correction is expected to be large and occur quickly.

    On a personal note, I have never found a metric or metrics that  allow me to have the combination of conviction that a bubble exists, that the correction will be large enough and/or that the correction will happen within a reasonable time frame, to be a market timer. Hence, I don't try! You may have a better metric than I do and if it yields more conclusive results than mine, you should be a market timer.

    Bubblenomics: My perspective
    It is extremely dangerous to disagree with a Nobel prize winner, and even more so, to disagree with two in the same post, but I am going to risk it in this closing section:
    1. There will always be bubbles: Disagreeing with Gene Fama, I believe that bubbles are part and parcel of financial markets, because investors are human.  More data and computerized trading will not make bubbles a thing of the past because data is just as often an instrument for our behavioral foibles as it is an antidote to them and computer algorithms are created by human programmers.
    2. But bubbles  are not as common as we think they are: Parting ways with Robert Shiller, I would propose that bubbles occur infrequently and that they are not always irrational. Most market corrections are rational adjustments to real world shifts and not bubbles bursting and even the most egregious bubbles have rational cores.
    3. Bubbles are more clearly visible in the rear view mirror: While bubbles always look obvious in hindsight, it is far less obvious when you are in the midst of a bubble. 
    4. Bubbles are not all bad: Bubbles do create damage but they do create change, often for the better. I do know that the much maligned dot-com bubble changed the way we live and do business. In fact,  I agree with David Landes, an economic historian, when he asserts that  "in this world, the optimists have it, not because they are always right, but because they are positive. Even when wrong, they are positive, and that is the way of achievement, correction, improvement, and success. Educated, eyes-open optimism pays; pessimism can only offer the empty consolation of being right." In market terms, I would rather have a market that is dominated by irrationally exuberant investors than one where prices are set by actuaries. Thus, while I would not invest in Tesla, Twitter or Uber at their existing prices, I am grateful that companies like these exist.
    5. Doing nothing is often the best response to a bubble: The most rational response to a bubble is to often not change the way you invest. If you believe, as I do, that it is difficult to diagnose when you are in a bubble and if you are in one, to figure when and how it will dissipate, the most sensible response to the fear of a bubble is to not change your asset allocation or investment philosophy. Conversely, if you feel certain about both the existence of a bubble and how it will burst, you may want to see if your certitude is warranted given your metric.






    Investment Advice from the Federal Reserve: Unusual, unwise and unseemly!

    On July 15, Janet Yellen made news with her semiannual policy testimony to Congress, with her views on interest rates, bubbles and the debt market. After making clear her intentions to continue with quantitative easing (QE) and keep rates low, she also provided her thoughts on whether the Fed’s policies were creating a market bubble. While she said that valuations were not in bubble-territory for stocks overall, the Fed report that was released in conjunction with her testimony suggested that “valuation metrics in some sectors appear substantially stretched– particularly those for smaller firms in the social media and biotechnology industries”. While the Fed (or any central bank) does sometimes make generic (and opaque) statements about overall market valuations, it is unusual for it to be this specific about individual sector valuations. In my view, it not only over stepped its bounds but strayed far from its expertise, which is not valuation.

    Is social media over valued?
    Those who have been readers of this blog know that I am fascinated with both the valuation and pricing of social media stocks. On Facebook, I thought the stock was priced too high at the initial offering, friended it after the market overreacted to early negative earnings reports and unfriended it after a price run up (and perhaps too early). On Twitter, I have been consistently skeptical about the reach of the company's business model, arguing that their advertising model restricted them to being a lesser player (even if successful) in the overall online advertising market. 

    My “conservative” valuations of Twitter and Facebook should make clear that I am not a social media company cheerleader, but I was perplexed by the Fed’s contention that the valuation metrics it was looking at suggested that social media and biotech stocks were over valued. What are the metrics that are being used to make the judgment? Clearly, they cannot be the conventional pricing ratios that investors use, such as PE ratios or an EBITDA multiples, since neither is particularly effective at assessing companies in a young sector. Perhaps, it is some version of a revenue multiple (EV to Sales or Price to Sales), but there again looking at what multiple of current revenues a company trades at, when those revenues can double or triple over the next two years is not indicative of valuation. As I see it, the only metric that consistently explains differences in market prices across social media companies is the number of users at each of these companies, and I used this relationship to explain why Facebook would pay $19 billion for Whatsapp. It is possible that the Fed has come up with a creative way of explaining what the “right” value per social media user should be, but creativity in valuation has never been (and will never be) the Fed’s strong suit.

    There is a case to be made that social media company are collectively being over valued and that case does not rest on valuation metrics or multiples. It stems from a common phenomenon in young sectors, where investors in individual companies price their companies on overall market potential but either misassess or ignore the fact that the overall market is not big enough to support all of them (and new entrants). This is the point I was trying to make in my post on micro and macro mistakes, where I used the pricing of social media and young tech companies that are in the online advertising space to back out implied future revenues and argued that if the market is right on each individual company, the collective market share of these companies would be well in excess of the total online advertising market a  decade from now. Note that even if you buy into this argument, you may still invest in an individual social media company (Facebook, Twitter or Linkedin), since the winners in this sector can yield superlative returns, even if the sector goes through a correction. The analogy would be to investing in Amazon during the dot-com boom and holding through the carnage of the dot-come bust; an investor who bought Amazon at is absolute peak in late 1999 and held through 2014 would have quadrupled her money and generated a compounded annual return of over 11% a year. With biotechnology companies, making judgments about overall valuation is even more fraught with danger because the pricing of these companies is a probabilistic exercise (dependent upon the drugs that are working their way through the FDA pipeline and their blockbuster potential) and comparing pricing across time is close to useless.

    In short, the Fed’s solicitude for investors in these high growth sectors is touching but investors in social media and biotechnology companies are grown ups, playing at a grown up game, i.e., trying to pick the winners in a sector that they may believe is over valued. They may be suffering from all of the behavioral quirks that get in the way of investment success, including over confidence and a herd mentality, but it is their choice to make. 

    The Fed as Market Guru and Sector Prognosticator
    Some of the fundamental parameters (interest rates, the term structure, economy growth) that drive both asset allocation and security selection are affected by Fed policy, with changes creating winners and losers among investors. If you view investing as a sport, the Fed’s role is closer to that of an umpire or a referee than it is to being a player. Thus, statements about specific sectors, such as those made in the most recent Fed reports on social media and biotechnology, come dangerously close to game interference. In fact, if you buy into the Fed’s contentions that the overall market is not over valued, but that social media and biotechnology are, is there not an implicit message that there must be some other sectors that are under valued? If investors believe the Fed, should they be selling their social media and biotech holdings and buying stocks in other sectors? 

    Even if you accept that the Fed should be doling out investment advice, I think that it is on particularly shaky ground at this junction in history, where there are many who believe that it has kept interest rates at “abnormally” low levels for the last five years (with QE1, QE2, QE3..). I have disagreed with those who attribute monumental powers to the Fed in an earlier post where I compared the Fed Chair to the Wizard of Oz, and argued that rates have been low for the last five years more because of the fundamentals, i.e., anemic growth and low inflation, than because of Fed policy. The crux of this argument is captured in the graph below, where I compare the actual ten-year bond rate to a fundamental interest rate, computed as the sum of real growth in GDP and expected inflation:
    Ten-year T.Bond rate versus Fundamental Interest rat (GDP Growth + Inflation)
    As you can see, the Fed’s role over the past five decades has been more as a tweaker of interest rates than as a setter of rates, but it is undeniable that the Fed can affect rates at the margin. In particular, the Fed’s quantitative tightening (in 1980 and 1981) and easing (in both the 2002-06 and 2010-13 timing periods) have had an effect on interest rates. In the figure below, I try to capture the Fed effect by looking at the difference between nominal 10-year T.Bond rates and the fundamental interest rate:
    The Fed Effect = T.Bond rate - Fundamental (Negative = Fed Easing, Positive = Fed Tightening)
    Note that negative values are loosely indicative of a "easy money" and a positive values with a "tight money Fed" and you can make the argument that the Fed's actions have kept rates lower than they should be, at least for the last three years.

    If you accept the notion that the Fed controls interest rates (that many investors believe and Fed policy makers promote) or even my lesser argument that the Fed has used its powers to keep rates below where they should be for the last few years, the consequences for valuation are immediate. Those lower rates will push up the valuations of all assets, but the lower rates will have a higher value impact on cash flows way into the future than they do on near-term cash flows, making the over valuation larger at higher growth companies. Consequently, a reasonable argument can be made that the Fed has been an active participant in, and perhaps even the generator of, any bubbles, real or perceived, in the market. In my post on market bubbles, I did agree with Ms. Yellen on her overall market judgment (that traditional metrics are sending mixed messages on overall market valuation) and used the ERP for the market, as she did, to back my point. In particular, I noted that the implied equity risk premium for the market at about 5% was high by historical standards (rather than low, which would be a indicator of overvalued stocks). However, breaking the ERP down into an expected stock market return and a risk free rate does point to an overall disquieting trend:
    The Fed's role in Equity Risk Premium Expansion
    Note that all of the expansion in ERP in the last five years has come from the risk free rate coming down and not the return on stocks going up. In fact, the expected return on stocks of 8% at the end of 2013 is a little lower than it was pre-crash in 2007 and if the risk free rate reverts to pre-2008 levels (say 4%), the ERP would be in the danger zone. Put differently, if there is a market bubble, this one is not because stock market investors are behaving with abandon but because the Fed has kept rates too low and the over valuation will be greatest in those sectors with the highest growth. 

    Given this history, a Fed (Chair, Governor or Staff report) complaining about frothy valuations and exuberant investors is akin to a bar-owner, who has been serving free beer all day, complaining about all the drunks on the premises. If the Fed truly believes that it has the power to keep interest rates low and that there is a market bubble, the solution is within its reach. Stop the quantitative easing, let interest rates find their natural level and the bubbles (if they exist) will take care of themselves.  

    The Fed as Economic Custodian
    There have been a few commentators who have argued it is in fact the Fed's job to not only keep its eye on market and sector valuations and actively manage bubbles. I disagree for two reasons.
    1. The Fed does not have a great history as a bubble detector. I am sure that I will be reminded of Alan Greenspan’s comment on irrational exuberance in markets, but few remember that the comment was not made in 1999 or 2000, at the peak of the boom but in 1996. Investors who listened to Greenspan and got out of the market then would have been net losers even a year after the crash. 
    2. Even if the Fed is in the business of bubble detection, let me pose the same question that I did in my earlier post on bubbles: what’s so bad about a bubble? The bursting of the dot-com bubble created losses for those who invested in the stocks, but looking back at the 20 years since these companies entered the market, not only have dot-com companies created substantial value (for themselves and the economy) but have changed our day-to-day lives.  It is true that the 2008 market crash created much larger economic costs and damage, but it was less because it was a bubble bursting and more because it was the bubble was centered in the financial services sector. Banks, investment banks and other financial service companies are creatures of the Fed and it is the one sector where the Fed does have both better information than the rest of the market (on the assets and risk in banks), and a clear economic interest in monitoring pricing and behavior. Even within this sector, though, I think that the Fed should be less concerned about pricing bubbles and more concerned with banking behavior. The Fed and banking regulators already have the capacity to monitor and restrict the investment (through risk constraints), financing (through regulatory capital needs) and dividend policies of banks (with veto power over dividend and buyback decisions) and I think that they should continue to do so. As for the rest of the market, is should be neither the Fed’s role nor its responsibility to keep investors from mispricing securities and facing losses, if they do.
    The Fed as Nanny
    The argument of whether the Federal Reserve should allow interest rates to rise in the face of a bubble is an age-old one that gets refought every generation. Benjamin Strong, the governor of the New York Federal Reserve from 1914 to 1928, is said to have argued against letting interest rates rise in his time, using the analogy of investors as children and saying that raising interest rates to puncture a  bubble would be like punishing all the kids because a few are misbehaving. That quote may be dated but I think it captures the mindset of many of today's Fed policy makers, with investors being viewed as children and the Fed acting as a super nanny, keeping its unruly and undisciplined charges from misbehaving.  It is time for the Fed to stop playing Mary Poppins and started treating investors as grown-ups, capable of making mistakes and living with the consequences, and for investors to stop looking to the Fed for guidance and counsel.



    Possible, Plausible and Probable: Big markets and Networking effects

    I do not know Bill Gurley personally, but I do know of him, and I was surprised, sitting in Vienna airport waiting for a connection home on Friday morning, to get an email from him. In the email, he graciously gave me a heads-up that he was planning to post a counter to my Uber valuation and that it would not pull punches. A little while later, I started getting messages from those who had read the post, with some seeking my response and some seeming to view this as the first volley in some valuation battle. I read the post a few minutes later and the first person I wrote to after I read it was Bill Gurley and I told him that I absolutely loved his post, even though it was at complete odds with my assessment of the company, for two reasons.
    1. Like anyone else, I like being right, but I am far more interested in understanding Uber's valuation, and the post provided the vantage point of someone who not only is invested in the company but knows far more about it than I do.  Rather than berating me for not getting "it" (technology,  the new economy, progress) or abusing valuation as a tool from the middle ages, the post focused on specifics about Uber and the basis for its high value. 
    2. In this earlier post of mine, I argued that good investing/valuation is the bridge between numbers and narrative and that neither the numbers nor the narrative people have an automatic right to the high ground. Bill Gurley's post brought home that message by laying out a detailed and well-thought-through narrative, backed up by numbers. 
    Mr. Gurley's narrative lends itself well to a more grounded discussion of Uber as a company and I am grateful to him for providing it. As a teacher, I am constantly on the lookout for "teachable moments", even if they come at my expense, and I plan to use his post in my classes.

    Dueling Narratives
    In my post on Uber's value (and in the Forbes and 538 versions of it), I laid out my narrative for Uber.  I viewed Uber as a car service company that would disrupt the existing taxi market (which I estimated to be $100 billion), expanding its growth (by attracting new users) and gaining a significant market share (10%). The Gurley Uber narrative is a more expansive one, where he sees Uber's potential market as much larger (drawing in users who have traditionally not used taxis and car services)  and much stronger networking effects for Uber, leading to a higher market share. In many ways, this is exactly the discussion I was hoping to have when I first posted on Uber, since it allows us to see how these narratives play out in the  numbers. In the table below, I contrast the narratives and the resulting values:

    You can download the valuations by clicking here. (Uber (Gurley) and Uber (Damodaran)).

    Given that the values delivered by the narratives are so different, the question, if you are an investor, boils down to which one has a higher probability of being closer to reality. If you had to pick one right now, I think Mr. Gurley's has the advantage over mine for at least three reasons. The first is that  as a board member and insider, he knows far more about Uber's workings than I do. Not only are his starting numbers (on revenues, operating income and other details) far more precise than mine but he has access to how Uber is performing in its test markets (with the new users that he lists). The second is that as an investor in Uber, he has skin in the game, and more at stake than I do and should therefore be given more credence. The third is that he not only has experience investing in young companies, but has been right on many of his investments.

    Does that mean that I am abandoning my narrative and the valuation that goes with it? No, or at least not yet, and there are three reasons why. First, it is difficult, if not impossible, for someone on the inside not to believe the best about the company that he directs, the managers he listens to and the products that it offers. Second, an investor in a company, especially one without an easy exit route (at least at the moment), is more attached to his or her narrative than someone who has little to lose (other than pride) from abandoning or altering narratives. Third, as Kahnemann notes in his book on investor psychology, experience is not a very good teacher in investing and markets. As human beings, we often extract the wrong lessons from past successes, don't learn enough from our failures and sometimes delude ourselves into remembering things that never happened. I am not suggesting that Bill Gurley is guilty of any of these sins, but I am, by nature, a cautious convert and I will wait to buy into his narrative, compelling though it may be.

    The Acid Test: Probable, Plausible and Possible
    As I noted at the start of this post, I liked Bill Gurley's post because it offers a coherent narrative that leads to a higher value. The narrative has two key building blocks and I think that there is much to be gained by taking a closer look at them. The first is that Uber is pursuing a much larger market than just taxi service and that it may very well redefine the nature of car ownership. The second is that Uber will have networking effects that will allow it to capture a dominant market share of this larger market, well above the 10% that I estimated in my original value.  In the sections below, I hope to stress test these assumptions, more as a friendly observer than antagonist.

    Market Breakthrough
    Companies like Amazon, Google and Netflix owe their success and immense market values to their capacities to redefine markets (retail, advertising and entertainment respectively) and it is true that in these and other cases, investors and analysts have under estimated these capacities and have paid a price for doing so. Unfortunately, it is also true that there have just been many cases where managers and investors have over estimated the capacity to expand markets and lost money in the process.  The Gurley narrative for Uber makes a good case that the convenience and economics of Uber will expand the car service market initially to include light users and non-users (suburban users, rental car users, aged parents and young children), but it does have three key barriers it has to overcome:
    1. Reason to switch: Uber has to provide users with good reasons to switch from their existing services to Uber. For taxi services, the benefits from using Uber are documented well in the Gurley narrative. Uber is more convenient (an app click away), more dependable, often safer (because of the payment system) and sometimes cheaper than taxi service. However, the trade off gets murkier as you look past taxi services. Since mass transit will continue to be cheaper than Uber, it is comfort and convenience that will be the reasons for switching. With car rentals, Uber may be cheaper and more convenient in some senses (you don't have to worry about picking up a rental car, parking it or worrying about it breaking down) and less convenient in others (especially if you have multiple short trips to make). With suburban car service (the aged parents, the dating couple and school bound kids), the problem that Uber may face is that a car is usually more than just a transportation device. Any parent who has driven his or her kids to school will attest that in addition to being a driver, he or she has to play the roles of personal assistant, private investigator, therapist and mind reader. As for date nights, whether Uber succeeds will be largely a function of how much the car itself is an integral part of the date, especially with younger couples.
    2. Overcome inertia: Even when a new way of doing things offers significant benefits, it is difficult to overcome the unwillingness of human beings to change the way they act, with that inertia increasing with how set they are in their ways. It should come as little surprise that Uber has been most successful with young people, not yet set in their ways, and that it has been slower to make inroads with older users. That inertia will be an even stronger force to overcome, as you move beyond the car service market. The articles that point to young people owning fewer cars are indicative of larger changes in society, but I am not sure that they can be taken as an indication of a sea change in car ownership behavior. After all, there have been almost as many articles on how many young people are moving back in with their parents, and both phenomena may be the results of a more difficult economic environment for young people, who come out of college with massive student loans and few job prospects.
    3. Fight off the status quo: The empire, hobbled and inefficient though it may be, will fight back, since there are significant economic interests at stake. As both Uber and Lyft have discovered, taxi service providers can use regulations and other restrictions to impede the new entrants into their businesses. Those fights will get more intense as car rental and car ownership businesses get targeted.
    In summary then, the difference in market size in the narratives boils down to a simple calculus of what is probable, what is plausible and what is possible, a distinction that to me is at the center of value:

    Not everything that is possible is plausible, and not all plausible opportunities make the transition to the probable.  As I see it, the divergence between the my narrative and Bill Gurley's are captured in where we draw the lines between the probable and the plausible and the value that we attach to the possible. At the risk of mischaracterizing Mr. Gurley's thoughts, I have tried to contrast these differences:


    Here again, Bill Gurley has two advantages to work with. The first is that as an investor and insider, he has access to information on Uber's experiences and experiments in its frontier markets (mass transit and suburban users), that may have led him to shift these markets from the plausible to the probable. The second is that as a board director and advisor to management, he is in a position to influence Uber's potential in these markets. For all we know, the Uber Momcar and the Uber Datecar have been already conceived, market tested and are ready to go.

    I think Bill Gurley and I agree on the car ownership market  more than we disagree. I see it as a possibility right now and attach an option value of about $2-3 billion to it, partly because it is in the more distant future and partly because Uber's business model in this market is unformed. From Bill Gurley's description of the market, I think he sees it as a possibility as well, though I think he attaches a larger value to it than I do. The reason for the higher value is that it is a conditional possibility, with the likelihood of it happening increasing with the success that Uber has in the car service market. 

    Network Benefits
    The second part of the Gurley Uber narrative rests on the company having network benefits that allow it to capture a dominant market share. As Mr. Gurley notes, a networking effect shows up any time you, as a user of a product or service, benefit from other people using the same product and service. If the networking effect is strong enough, it can lead to a dominant market share for the company that creates it and potentially to a  ‘winner take all’ scenario. The arguments presented in his post for the networking effects, i.e., pick up times, coverage density and utilization, all seem to me to be point more to a local networking effect rather than a global networking one. In other words, I can see why the largest car service provider in New York may be able to leverage these advantages to get a dominant market share in New York, but these advantages will not be of much use in Miami. There are global networking advantages listed, such as stored data that can be accessed by users in a new city and partnerships with credit car, smartphone and car companies, but they seem much weaker.

    In fact, if the local networking advantages dominate, this market could very quickly devolve into a city-by-city trench warfare among the different players, with different winners in different markets. Thus, it is possible that Uber becomes the dominant car service company in San Francisco, Lyft in Chicago and a yet-to-be-created company has the largest market share in London.  For the Gurley Uber narrative to hold, the global networking advantages have to become front and center and here again, it is possible that I am unaware of a management initiative designed to do exactly this. 

    The Verdict Awaits

    I know that this may be hard to believe but I have less of an interest in making the case that Uber is over priced than I am in understanding what it is that drives its value. I have learned a great deal about why Bill Gurley is so excited about the company but I am inherently cautious, not because I don’t find his arguments to be plausible, but because I have seen how often the plausible does not make the transition to the probable and how frequently the probable fails to show up in the actuals. That quality may make me a bad venture capitalist but I am sure that there are plenty of good ones out there to take up the slack.




    Reacting to Earnings Reports: Let's get real!

    In my last two posts, I considered how earnings reports can generate narrative shifts or changes, thus affecting value, and pricing effects, when companies trail or beat investors’ estimates on metrics (earnings per share, revenues, user numbers etc.). In this one, I intend to apply the lessons in those posts to three companies that I have been working with over the last couple of years: Apple, Facebook and Twitter. In particular, I would like to look at the most recent earnings report for each company, the news each report contained, the distractions in each one and the effect on stock prices. I would also like to look at the information in past earnings reports for each company, over the entire (limited) histories for Facebook and Twitter’s, and the last two years of reports for Apple, with the intent of incorporating what I have learned into updating my narrative for each company.

    Apple Earnings Reports: The Meh Chronicles

    I looked at Apple in detail a few months ago, chronicling my estimates of value for the company and stock price movements starting in 2011 and going through April 2014. The graph below reproduces my findings (with prices and values per share adjusted for the recent seven to one stock split), with an update through August 2014:
    Apple: Price versus Value (My Estimates)
    Note that while stock prices have ranged from $45 to close to $100 over this period, my value estimates have had a much tighter range, reflecting my largely unchanged story line for the company, over the period. Starting in 2011, my narrative for Apple has been that it is a mature company, with limited growth potential (revenue growth rates< 5%) and sustained profitability, albeit with downward pressure on margins, as its core businesses becomes more competitive. I allowed for only a small probability that the company would introduce another disruptive product to follow up its trifecta from the prior decade (the iPod, the iPhone and the iPad), partly because of its large market cap and partly because I thought it had used up its disruption karma over recent years. 

    Looking at the earnings reports from the company over the last nine quarters, it is remarkable how little that narrative has changed. In the first two sets of columns, I report on Apple’s revenues and earnings per share and contrast the actual numbers with the consensus estimate for these numbers in each quarter. For much of the time period, Apple has matched or beaten revenue and earnings estimates, albeit by small amounts, but the market has been unimpressed, with stock prices down on six of the nine post-report days and seven of the nine post-report weeks. 
    Apple: Earnings Reports from July 2012 to July 2014
    Note that after controlling for the quarterly variations, revenues have been flat or have had only mild growth and operating margins have been on a mild downward trend.  With Apple, the other focus in the earnings reports has been on how iPhone and iPad sales are doing and the table below reports on the unit sales that Apple reported each quarter, with the growth rates over the same quarter’s sales in the prior year. In the last two columns, I report Apple’s global market share in the smartphone and tablet markets, by quarter. 

    Apple: Unit Sales for iPhone & iPad, with global market share
    While the market fixation with Apple’s iPhone and iPad sales may be disconcerting to some, it makes sense for two reasons. First, it reflects the fact that Apple derives most of its revenues from smartphones/tablets and that the growth in unit sales and change in market share therefore becomes a proxy for future revenue growth. Second, Apple’s earnings are being sustained by its impressive profit margins in the smartphone and table businesses and looking at how well it is doing in these markets becomes a stand-in for how sustainable the company’s margins (and earnings) will be in the future. Each quarter, there are rumors of another Apple disruption in the works, but each time the promises of an iWatch or an iTV don’t pan out, investor expectations that Apple will pull another rabbit out of its hat have eased. 

    The most recent earnings report seems to reflect this period of stability, temporary though it may be, for Apple, where investor expectations have moderated and the company is being measured for what it really is: an extraordinarily profitable company, with the most valuable franchise in the world. It seems to have stabilized its position in the smart phone world, is seeing its tablet market shrink and its personal computer business is being treated as a rump business. In effect, analysts are treating it as a mature company that is being powered by the iPhone money machine, where margins are declining only gradually. Since that is the narrative that I have using all along in my valuations, I see little change in my assessment of intrinsic value for Apple. Allowing for the stock split, the value per share that I assess for the company, with the information in the new earnings report incorporated into my estimates, is $96.55, almost unchanged from my estimate of $96.43 in April 2014. With the new iPhone 6 launch just a few months away, I am sure that the distractions will start anew, and I think it is prudent for me as an investor to map out an exit plan, if the stock price rises to $100 or higher. If it does not, I will happily continue to hold Apple, collect my dividends, and hope for a disruption down the road.

    Facebook: Bigger than Google?
    I valued Facebook just before its IPO in this post, and argued that the stock was being over priced at $38 for the offering. The tepid response to the offering price made me look right, but for all the wrong reasons. The botched IPO was not because the stock was over priced or because the market attached a lower value to the stock but largely due to the hubris of Facebook’s investment bankers who seemed to not only think that the stock would sell itself but actively worked against setting a narrative for the company. My initial valuation, though it will look conservative in hindsight, was based upon the belief that Facebook would be as successful as Google in its growth in the online advertising business, while maintaining its sky-high profit margins. 

    Looking at Facebook’s earnings reports since its IPO, there have been nine reports and the market reaction has shifted significantly over the period.
    Facebook: Earnings Reports & Price Reaction
    I think that the botched public offering colored the market response to the very first earnings report, with the stock down almost 25%. In fact, I revalued Facebook after this report, when the stock price plunged below $20, and wrote this post, arguing that there was nothing in the report that changed the narrative and that the company looked under valued to me. I was lucky enough to catch it at its low point, since the company turned the corner with the market by the next quarter and the stock price more than doubled over the following year. I revisited the valuation after the August 2013 earnings report, and chose not to change my narrative, leaving me with the conclusion that the stock was fully priced at $45 and that it was prudent to sell.  Looking at the earnings numbers over the nine quarters, it is clear that has Facebook has mastered the analyst expectations game, delivering better-than-expected numbers for both revenues and earnings per share for each of the last seven quarters. 

    With Facebook, the market has also paid attention to the size and growth of its user base as well as the company’s success at growing its mobile revenues. In the table below, I list these numbers as well as Facebook’s invested capital each quarter (computed by adding the book values of debt and equity and netting out cash) and a measure of capital efficiency (sales as a proportion of invested capital):
    Facebook: User Numbers, Revenue Breakdown & Invested Capital
    This table captures the heart of the Facebook success story: a continued growth rate in a user base that is already immense, a dramatic surge in both online users and advertising and improving capital efficiency (note the increasing sales to capital ratio).  The most recent earnings report provided more of the same: continued user growth, increased revenues from mobile advertising and improved profitability, both relative to revenues and invested capital. Looking at the last report, I have to conclude that I was wrong about Facebook’s narrative remaining unchanged, for the following reasons: 
    1. While my initial reaction to Facebook’s success on the mobile front was that it was what it needed to do to sustain its narrative as a successful online advertising company, the rate at which it has grown in the mobile market has been staggering. In fact, I think that there is now a very real possibility that Facebook will supplant Google as the online advertising king and continue to maintain its profitability. That is a narrative shift, which will translate into a larger market share of the online advertising market, higher revenue growth and perhaps more sustainable operating margins (than I had forecast). 
    2. The inexorable growth in the user base, astonishing given how large the base already is, has also been surprising. That remains Facebook’s biggest asset and a platform that they can try to use to enter new markets and sell new products/services. Facebook has also shown a willingness to spend large amounts of money on acquiring the pieces that it needs to keep increasing its user base and build on it. The downside of this strategy is that growth has been costly (though the costs are hidden for the moment in the financials), but the upside is that is putting in place the pieces it needs to monetize its user base. While the revenue breakdown does not reflect this business expansion yet, I think that Facebook is better positioned for a narrative change now than it was a year or two ago. 
    My updated valuation for Facebook reflects these adjustments. Incorporating a higher revenue target ($90 billion, rather than $60 billion) and more sustained margins (40% instead of 35%) , I estimate a value per share of $63 today. For those of you who have been taking me to task for selling at $45 in September 2013, I commend you for your foresight in holding on to the stock, but I am at peace with decision for two reasons. First, given what I knew in September 2013, I did what I had to do, given my investment philosophy, and second guessing it now is an exercise in futility. Second, if the biggest regret I have in my investing life is that I sold a stock to make a 150% return rather than holding on to it to make a 300% return, I would consider myself to be truly blessed. I may be compounding my mistake here, but at $72, I don't see it as a bargain, and I am in no hurry to buy the stock now. For those of you who are Facebook stockholders, though, this may be one of those companies where the value could chase the price for years, as the company finds way to turn the possible into the plausible and the plausible into the possible, and I wish you only positive returns.

    Twitter:  The Early Returns
    In the weeks leading up to the Twitter IPO, I wrestled with valuing the company. In the valuation that I did in the week before the IPO, the narrative I offered was of a company that would become a significant but not a dominant player in the online advertising business. I argued Twitter’s strength (the 140 character limit on messages) would also be its weakness, and that businesses would be loath to make Twitter their primary advertising platform. My targeted revenues in ten years were still substantial, and in conjunction with a healthy profit margin of 25%, yielded a value per share of $18, well below the offering price of $26 and even further below the opening day price of $46. 

    In the months since, Twitter has had three earnings reports, and the accounting results are summarized below, with analyst expectations and the stock price reaction to each report. 
    Twitter: Earnings Reports and Price Reactions
    Twitter’s first two earnings reports were received badly by the market, though the company beat revenue forecasts on both, partly because the company continues to lose money. The most recent earnings report received a rapturous response immediately after it came out, though some of the rapture seems to have eased in the days after.  Even more so than Facebook, the market has focused on secondary numbers at Twitter, with particular attention being paid to the growth in the user base. In the table below, I list these other numbers: 
    Twitter: The Other Numbers
    The negative reaction to the second earnings report was partly due to the low growth (relative to expectations) that Twitter reported in the number of users and the positive reaction to the last report seems to be traceable to Twitter beating analyst expectations for user growth in the most recent quarter.  Looking at both the accounting and user numbers, what is striking about Twitter is how little the company has changed over the period that it has been in the market. The proportion of revenues it receives from advertising has remained around 90%, its revenues from international sales have increased only marginally and its mobile advertising has stayed at a high percentage of revenues (which is not surprising given that its compact format travels well to mobile devices). Its use of invested capital has not become more efficient and while you may argue that this is early in the game, contrast Twitter's evolution with Facebook's over the first few quarters.

    There is nothing that I see (and I may be missing some key component) in these reports that would lead me to reassess my initial narrative, i.e., that Twitter will be a successful, but not dominant online advertising company, and the last earnings report only reinforced that view. There was some good news in the report, especially on the revenue front, but there was some game playing that was needless, in my view. First, as this article points out, the user numbers includes those who are not Twitter users in the conventional sense but are exposed to tweets in the context of news stories. Since these indirect users will not get to see (and therefor click on) the sponsored tweets that are the company’s advertising mainstay, I think that including them with total users is a little misleading, though the company may not have intended to be deceptive. Second, and this is not a problem specific to only Twitter, is the claim that the company actually made money, if you do not count stock-based compensation as an expense. As I argued in this post, this is nonsense, but I blame the analysts and investors who buy into this fiction just as much as I do the companies that feed them the fiction. In fact, as I listened in on the Twitter earnings call, I was left with the uneasy feeling that this was an earnings report produced for equity research analysts, by an equity research analyst, in terms of the numbers it emphasized. It may be pure coincidence that Twitter acquired a new CFO between its last report and this one, and that in addition to being a banker who led their public offering, he was an equity research analyst in a prior incarnation, but I don't think so. 

    Incorporating everything that I have learned from these reports into my valuation, I see little movement in my intrinsic value. Even allowing for a much more efficient use of capital in the future, my estimate of value per share is $22.53. It is still early in Twitter’s corporate life and like Facebook, and I did see this news story about Twitter perhaps entering the online retailing world, and while it may be just as much a sign of desperation as hope, it is true that young company narratives can change quickly. There is a lot more about Twitter (and its business model) that I do not know than I do, and I would like to see Twitter come through on their promise of better metrics of user engagement with their business model. 
    • I am curious about how many users actually click on the sponsored tweets. I don't like to extrapolate from personal experience but I not only have never clicked on one (or even been tempted to do so) but I find myself irritated to see tweets in my timeline from businesses trying to sell me their products and services. For Twitter's sake, I hope that I am an outlier.  
    • I am also curious about how much it is costing Twitter to get new business (how much does it cost to add an advertiser) and what their pricing system for ads is. After all, surging revenues don't have much value, if your costs to deliver those revenues surge even more.
    As someone who uses Twitter a lot more than Facebook, I would like to see the company succeed, but as an investor, I remain a skeptic.

    The Bottom Line 
    I could go on with other companies but I think I will outlive my welcome. With just these three companies, I hope that I have been able to bring home two salient points about earnings reports. The first is that while it is always the most recent earnings report that people tend to focus on, there is value in looking at a time series of reports, since there are patterns that may emerge from that series. The second is that the patterns you observe should feed back into your narrative and valuations, reinforcing your existing views in some cases, changing them in small ways in other cases and shifting them dramatically in still others. The earnings report trail is leading me to different destinations: with Apple, to an exit point, with Facebook, to a shifting of perception on what the company is worth (though not to the point of being a buyer at its current price) and with Twitter, to no real change in my perception that while the company has promise but is over priced.





    Reacting to Earnings Reports: Pricing Metrics and Market Reactions

    In my last post, I looked at how earnings reports and other news stories about a company contain information that can lead you to reassess your narrative and consequently the value that you attach to that company. If you are an investor or analyst who is familiar with how markets react to earnings reports, you can legitimately argue that I am making this process more complicated than it has to be and that what you see at the time of the earnings report is a market reaction to how well or badly companies deliver on a specific pricing metric, relative to expectations. You are right and in this post, I will look at why investors often focus on these simple (and sometimes simplistic) metrics, how these metrics can change as a function of where a company is in its life cycle and  the dangers of focusing on metrics rather than value.

    The Allure of Price Metrics
    As you watch investors react, sometime violently, to a company reporting earnings per share that are a few cents below or above expectations, you may wonder why so much attention is being paid to a single metric and so little to the rest of the news in the earnings report. While I think the practice is dangerous, it can be explained with the following:
    1. It is easier to focus on a single number or metric than it is to develop a narrative and a valuation for a company. Consequently, investors and many analysts prefer to spend almost all of their time in coming up with estimates for that number, on the assumption that if they are right about those estimates, neither narratives nor valuations matter.
    2. In several earlier posts, including these on Apple and Twitter, I have drawn a distinction between value and price and argued that while investors care about the former, traders are much interested in the latter. If you are a trader, it makes complete sense to not only find the metric that other traders are using to judge companies (even if that metric is a weak measure of value and subject to manipulation) but to make estimating that metric the center of your investment strategy.
    It is for this reason that I call this the "earnings game", where analysts and investors form expectations about a metric (earnings per share, revenues, number of users/subscribers), companies try to deliver actual numbers that beat these expectations and markets then react to the reports. I describe the process in detail in this post, with the aggregate evidence on both the market reaction to earnings reports as well as the post-report price adjustment process.

    Pricing Metrics and the Corporate Life Cycle
    While it is true that the predominant metric used to judge a company is earnings per share, investors sometimes use other metrics, rewarding Twitter for increasing its user base more than expected, pushing up Facebook's stock price for its success in mobile advertising and leaving Apple's stock price unchanged on the news that it sold more iPhones than expected, but fewer iPads. Given that investors choose one or two metrics on which they judge company performance, how do they decide which metric to use for a company? Using the narrative adjustment categorization that I introduced in my last post can provide some perspective:
    • For firms where the prime concern that investors have is about narrative breaks, the pricing metric reflects that concern. Thus, with young start-ups, investors may focus on cash in hand or access to capital, as proxies for survival risk. For distressed companies, the pricing metric may be linked to the company's capacity to service debt, interest coverage ratios or debt payments coming due.
    • For firms that have well established narratives, i.e., firms that have established business models in clearly defined markets, the focus will be on narrative shifts, and small ones at that. Given that the market size is stable and market shares are sticky, you can see why investors pay attention to earnings per share and react to surprises on that score. 
    • For firms where the narrative is still taking form, investor will shift away from earnings not only to top-line numbers (like revenues) but to other measures that are related to narrative change. With social media companies, for instance, that explains why investors pay attention to the number of users or measures of user intensity, on the assumption that companies can exploit larger values for either to enter new markets. 
    Thus, the pricing metrics (and multiples) that investors focus on will vary across the life cycle of a company and this is the point that I hope to bring through in the picture below:
    Life Cycle, Pricing Metrics & Multiples
    Thus, early in the process, it is not irrational to focus on market potential or users, but as a company matures, the attention will inevitably turn to profitability and cash flows. Using real-world examples to illustrate this shift, a company like Yo, priced recently at $10 million by investors, even though it really has no product or service to speak of at the moment, is being priced entirely on market potential (all those people with smart phones whose notification center is accessible to apps like Yo). Moving further up the life cycle, consider Snapchat, a company that has a product with tens of millions of users but has not figured out a way to monetize them, it is the number of users and the frequency of their use that drives its pricing (with Alibaba willing to pay $10 billion for them). With Twitter, Linkedin and Yelp, investors seem to be making a transition, where revenues are clearly part of the equation, even though the number of users is still a key number. With Google and Apple, companies with established business models, revenue growth is a consideration but earnings clearly dominate.   

    The Dangers of Pricing Metrics
    While it is easy to see why investors focus on one or two metrics, when measuring company performance, the dangers of using these short cuts are manifold:
    1. Missing the rest of the story: The value of a business is driven by many determinants, including its capacity to generate profits (and cash flows) from existing assets, the expected growth rate in these earnings & the efficiency with which this growth is delivered and the risk in future cash flows. No single metric will ever capture all of these factors, and in using any metric (number of users, revenues, earnings), you are in effect assuming that everything else that drives value remains unchanged. To illustrate, a company that reports higher earnings per share but does so because it has entered riskier businesses, may see its stock price jump on the earnings report, even though its value has dropped.
    2. Tunnel vision: It is natural to develop tunnel vision, when your focus narrows. Investors and analysts who spend all of their time and resources refining their estimates of one or two metrics, whether they be revenues or number of users, will soon care just about those numbers and ignore the rest of the data (and story). 
    3. Game Playing: Once companies recognize that investors are focused on one or two metrics, it is natural for them to play the game as well. Thus, if analysts are unduly focused on earnings per share, companies will play accounting games to make their earnings per share look better than they should. I argued that the market's focus on the number of users at social media companies best explained why Facebook would pay $19 billion for Whatsapp
    4. Transition Phases: As the life cycle picture illustrated, investor focus does change as a company moves through the life cycle. It is therefore a given that at some point in time, as social media companies evolve and grow, investors will stop looking at the user base and focus first on user engagement with business models (revenues) and then on the profitability of these models (earnings). However, these transitions are unpredictable, and when they do occur, companies that think that they are playing by market rules (delivering more users than markets expected) may be shocked to discover that the rules have changed (and that they are being punished for losing money). 
    The Bottom Line
    To play the earnings report game, if you are a trader, you have to be able to both pinpoint the metric that markets will react to (which may not always be the metric that analysts following the company are focusing on) and be better at estimating how the company will do on that metric than other investors. If you can play that game well, it is a lucrative one but it is also risky, since seismic shifts can occur from quarter to quarter. That is why it may behoove traders to understand the narrative/value process described in my last post, even if they choose not to invest based upon that process.

    Links
    1. Earnings Surprises, Price Reaction and Value
    2. Winning (losing) by losing (winning): The Power of Expectations
    3. Reacting to Earnings Reports: Narrative Adjustments to Value
    4. Reacting to Earnings Reports: Pricing Metrics and Market Reaction
    5. Reacting to Earnings Reports: Let's get real!



    Reacting to Earnings Reports: Narrative Adjustments and Value Effects

    Reality shows seem to have taken over much of television, but I am not a fan for two reasons. The first is that I don't enjoy watching people who are either so psychologically damaged that they like living their lives in a fishbowl or are so economically desperate that they do not have a choice. The second is that while I recognize the draw of these shows comes from their unscripted nature, I prefer getting my reality jolts from two other forums. The first is live sports, where the allure is that no matter how scripted a sport is, there are those moments of magic, where anything can happen. The second is financial markets, which delight in bringing investors and especially market experts to their knees by behaving in unpredictable ways. Just as ratings week is when television shows are made or ended, earnings season is when the markets deliver their biggest surprises. Building on a theme I introduced about narrative and numbers in an earlier post, I would argue that earnings reports are the vehicles that we should use to confirm, reject or modify narratives (and thus value).

    Narrative Adjustments: The Real World Intrudes
    In my post on narrative and numbers, I argued that valuation acts as a bridge between the story tellers and number-crunchers and that in a good valuation, every number should be part of a story and that the story has to be checked for viability against history, common sense and data. I also argued that big differences in value can be attributed to differences in narratives rather than differences in numerical assumptions.

    So, let’s say that you have taken this message to heart, constructed a defensible narrative and converted that narrative into a valuation. That narrative, and the valuation that is built on it, cannot be etched in stone, since the real world will deliver surprises, positive as well as negative, that should lead you to revisit your narrative. While some of these narrative-changers can come from macro economic developments and occasional news stories about the company, earnings reports remain the primary mechanism for delivering news about companies. While much of the focus in these earnings reports remains on the bottom line, often defined as earnings per share, and investors react to whether that number comes in above or below expectations, it is also true that these reports can contain news that should lead you to revisit your narrative and change your valuation. I would broadly classify these narrative effects into three categories:
    1. Narrative breaks/ends: The most dire scenario is news that leads you to conclude that your existing narrative for the firm is no longer operative, rendering your original valuation moot. Narrative breaks are almost always bad news and can be caused by legal events (e.g., the Supreme Court decision that brought Aereo's disruptive efforts to a halt), economic events (e.g., the Argentine government default and its effect on the valuation of any Argentine company), government actions (the nationalization of a company or the removal of protection from competition) or credit events (a company's failure to make a debt payment, resulting in bankruptcy). 
    2. Narrative shifts: In most cases, earnings reports don’t deliver large surprises about a company’s business model or direction, and this is especially the case for mature companies. Instead, you get is information that lead you reassess your narrative and extend that reassessment into new estimates for the company’s future revenues, earnings and cash flows, shifting value. This is the exercise, for instance, that I chronicled in a post about Apple's earnings report on April 23, 2013, where I deconstructed the information in that report and looked at its impact on key inputs into Apple's valuation. Note that narrative shifts, especially if they are consistently positive or negative can lead to major changes in company value over time. This has been the case for a company like Google, which in spite of all its innovations and new services, derives almost all of its revenues still from online advertising but has done it so well that it has managed to expand both the size of the overall online advertising market and its share of it over the last decade.
    3. Narrative changes (expansion/contraction): In some cases, earnings reports deliver news that may be peripheral in terms of the impact it has on operating numbers (revenues, earnings) but are significant because they signal that the company’s business model is changing in ways that you had not anticipated in your original narrative. No company has epitomized this process better than Amazon, a company that I have valued multiple times since 1998. In my very first valuation of Amazon, I valued it as a book retailer, but in subsequent valuations, I have seen it evolve first into a specialty retailer, then become a general retailer, and in recent years, make forays into the media, entertainment and cloud storage businesses. I am sure that there are people more prescient than me who saw all of this coming in 2000, but I sure did not, though notwithstanding that vision failure, I still found Amazon to be cheap (and a good investment) at least four times in the last decade.
    Narrative Shifts versus Narrative Changes: Shades of Gray
    This distinction between narrative breaks, shifts and changes is a good one to think about when you look at earnings reports, but it is not alway easy to make. In fact, it is entirely possible that you and I could look at the same earnings report and come to very different conclusions about its impact on narrative for three reasons:
    1. Your classification (break, shift or change) will depend upon your initial narrative: The more expansive your initial narrative, the more likely it is that you will see narrative shifts, rather than radical changes. Let me take Uber as an example, and use the contrast of my narrative with Bill Gurley's  to illustrate this point. Uber is still private but any information that I receive about Uber’s success in suburban markets will be a narrative change for me, since my base valuation is built on the presumption that Uber will be successsful as a urban car service company. For Bill Gurley, whose base narrative already incorporates expectations of sucess in suburban markets, this news will be more of a narrative shift than a change.
    2. The lines between the categories can become fuzzy: Even for a given narrative, information in an earnings report or news story can fall in gray areas and be tough to categorize. For instance, Facebook’s better than expected performance in the mobile advertising market in its last few quarters may be viewed by some as just a narrative shift (giving them a larger market share of the online advertising business) and by others as a narrative change (with the mobile users giving them a platform that they can use to enter other online businesses), with very different implications for Facebook's value.
    3. Narrative adjustments can vary across time, for the same company: As a company reports earnings over many periods, you can see narrative shifts in some periods and narrative changes in others, good news in some and bad news in others. Staying with Amazon, a company that I used as my example of a successful narrative changer, the market reaction to the last two earnings reports has been brutal, as markets seem less  focused on revenue growth (which continues to be extraordinary) and more on profit margins (which have been abysmal). A narrative shift may be occurring, where investors are reassessing Amazon’s potential profitability in steady state and concluding that it will make less money than they thought it would.
    Narrative Adjustments: Reactive and Proactive Valuation Responses
    How do we deal with these narrative adjustments in conventional valuation? Very badly, I am afraid. If your valuation is a rigid discounted cash flow valuation, your response to narratives breaking, shifting or changing is denial. In that static world, the narrative remains constant, your valuation inputs stay the same, intrinsic value never changes and it is the market that is viewed as being at fault for its volatility. Even those who claim to use more dynamic processes for valuation often stay within the traditional framework, trying to increase discount rates to reflect potential narrative breaks and growth rates to capture narrative changes.  Finally, even the best among us tend to be more reactive than proactive, adjusting value for narrative adjustments that have already occurred, but not making any attempt for the potential for adjustments in the future.

    By definition, since you cannot anticipate the unexpected, you have to draw on the full arsenal of valuation tools to both react to narrative adjustments as they happen and to proactively incorporate the possibility of future adjustments into value.  While the reactive effects of narrative adjustments on value are straight forward, incorporating expectations of future narrative adjustments into current value is much more difficult to do and the table below lists some of the tools that we have available:
    1. When valuing companies where the possibility of a narrative break is high, either because they are young, start-ups or debt-ridden, distressed companies, you have to bring in the likelihood of the narrative ending, explicitly as a probability. (See my papers on valuing young companies and declining, distressed companies for estimation tools that you can use to make this judgment)
    2. For narrative shifts, where the effects play out as better-than or worse-than expected revenue growth and profit margin numbers, the tool that works best is a simulation, where you use probability distributions for the inputs into your valuation rather than just your base case numbers and estimate a distribution of values. (See my paper on probabilistic approaches in valuation)
    3. For narrative changes, which, by definition, are unanticipated and unexpected, you have to treat them as real options and value them as such. (See my paper on the promise and peril of real options)
    In the table below, I summarize this discussion of narrative adjustments, how they affect value when they do occur and how you can proactively bring them into your valuations:


    The Bottom Line
    Earnings reports remain a company's key delivery mechanism for news about both its operations and plans of the future, but they are filled with distractions. Paraphrasing Nate Silver, it is important that we separate the signal from the noise and use these reports to revisit our narratives and valuations. If you are an avid market watcher, you may feel that I am over analyzing the earnings process and that the market reaction to an earnings report has little to do with narrative shifts or long term value, and more to do with meeting investor expectations on key numbers (earnings per share, revenues, number of users etc.). I don't disagree with you and in my companion post, I will focus on the metrics that investors use to judge earnings reports, why these metrics might vary across companies and over time and the potential danger of letting these metrics determine investment decisions. 



    The insanity of the US tax code: Bad Laws and Predictable Consequences

    If taking the same action, over and over, expecting different consequences, is the definition of insanity, it aptly describes the US tax code, where legislators write tax laws designed to elicit bad behavior, moan about the consequences and then write even worse tax laws. In the last few weeks, AbbVie’s acquisition of Shire seems to have brought the complaints about perverse tax law and badly behaved corporations to a boil. In particular, the news headlines have been centered on AbbVie’s plan to move its corporate headquarters to the UK from the US after the acquisition, part of an emerging trend among US companies towards tax inversions, designed to generate tax benefits. The New York Times thinks it borders on the criminal, Paul Krugman accuses corporations of being "tax dodgers", Senator Carl Levin has written legislation to stop the practice and even Jon Stewart has joined in the fun.  

    The US Tax Code = Invitation to Move

    To understand the “inversion” story, you have start with the US tax code. The US requires domestic corporations, i.e., companies incorporated in the US, to pay the domestic marginal tax rate on their global income. It is one of eight OECD countries that continues to use a global tax system, while the remaining twenty six OECD countries have shifted to a territorial tax system, where corporations  pay the domestic tax rate on income that they generate domestically and the local tax rates on income generated in foreign locales. (See the list of countries using each tax system at this link).

    The US tax law does allow for a timing lag, since the differential tax (between the US tax rate and the tax rate on the foreign income) does not have to be paid until that foreign income is repatriated back to the US. To illustrate, assume that you have a US company that generates $50 million of its income in the US (with a tax rate of 40%) and $50 million of its income in China (where the tax rate is 25%). The company will pay a total of $32.5 million in taxes when it generates that income, 40% of the $50 million of US income and 25% of the $50 million of Chinese income, If the company now returns the $50 million in Chinese income to its US domicile, it will have to pay the differential tax of $7.5 million, reflecting the differential tax rate of 15% (US tax rate - Chinese tax rate). What happens if the company chooses to leave the cash in its Chinese subsidiary? That cash of $50 million cannot be used for investments in the United States or to pay dividends/buybacks to stockholders. In effect, it is “trapped”, but it can be used for investments anywhere else in the world. The longer the company continues to hold back cash in foreign locales, the larger the trapped cash balance becomes and after a decade of not repatriating cash, it can amount to hundreds of millions or even billions of dollars.

    Now, assume that this company relocates its headquarters to Singapore, a country with a territorial tax system. After the relocation, the taxes it pays on its US income remain unchanged at $20 million but there are two tax benefits that follow:
    1. The trapped cash that the company has is no longer trapped and the differential tax due to the US dissipates into thin air. The larger the current trapped cash balance, the greater this immediate benefit will be. 
    2. The second tax benefit is that the company’s future income in China is no longer subject to a differential tax and is thus released from that obligation. The tax benefits from relocation will therefore be greater for companies that expect their foreign operations to grow at a higher rate than their domestic (US) business.
    Given how large these potential benefits can be for many US companies, relocation becomes an attractive option and inversion is one way of accomplishing this objective, though a 2004 law does put restrictions on its use. With inversion, the company will acquire a Singapore-based company of sufficient size (to meet the law's requirements) and relocate the headquarters of the combined company after the merger in Singapore. 

    Changing Times. Static Code
    Since the US tax code has always taxed global income, you may wonder why this trapped cash phenomenon is suddenly in the news. Is it because no one noticed the problem three decades ago or because US companies have become bigger tax avoiders? I think that the answer is that the US tax code has not changed much but the world has changed in two significant ways:
    1. US companies are more global: As the rest of the world's economies have grown, the US economy has become a smaller part of the global economic order and US companies are increasingly dependent on their foreign operations. In 2012, almost 50% of the revenues of S&P 500 companies came from foreign locales, with the number varying widely across sectors (with utilities getting almost no revenues from outside the US and technology companies getting about 58%). In fact, this document has an exhaustive breakdown of this phenomena. It is also worth noting that in 2012, the companies in the S&P 500 paid $146 billion to the US government and $139 billion to foreign governments as taxes, which should dispense with the canard that the foreign income of US companies is somehow untaxed.
    2. The US corporate tax rate has become high, relative to the rest of the world: In the early 1980s, the US corporate tax rate was 46% but that tax rate would have put the US in the middle of the global pack in that period. The US federal marginal tax rate on corporations dropped to 35% in 1993,  and has stayed at that level since. With state and local taxes added on, the marginal tax rate on US corporate income is now close to 40%. The rest of the world seems to have shifted to lower corporate tax rates, giving the US the higher marginal corporate tax rate in the world in 2014, as can be seen in the global tax map below (KPMG maintains an excellent public database of marginal tax rates, by country):


    The combination of the globalization of US companies and a high US marginal tax rate has had predictable consequences. Companies that generate a big portion of their revenues from outside the United States are choosing to leave the income they generate overseas. Last year, the cumulative trapped cash at US companies was conservatively estimated at more than $1.5 trillion, and growing. Apple alone had more than $100 billion in cash in its overseas locales and a large portion of AbbVie’s current cash balance of $10 billion is probably trapped its foreign subsidiaries. AbbVie can use this trapped cash outside the US, to invest in non-US assets or but non-US companies, but the decision to move its headquarters to the UK frees it up to invest the money wherever it wants (including in the US). The UK follows a territorial-based tax system, where you pay taxes based on where you generate income and not where you are headquartered. Thus, the question again becomes not why AbbVie is buying a UK-based company and moving its headquarters to London, but why it took them so long.

    Do US companies pay their fair share of taxes?
    Any question about whether someone else is paying their fair share of taxes is fraught with complications, since the rule in this debate is that every tax payer (and even a few who don't pay taxes) seems to believe that he (she) pays more than his (her) fair share of taxes and that the rest of the world is shirking. We have all heard the anecdotal evidence about individual companies that don't pay their fair share of taxes and I am sure that some companies fit the billing of tax scofflaws. To answer the question of whether US companies collectively are tax avoiders, relative to corporations elsewhere in the world, I computed the effective tax rates for all publicly traded companies listed globally and estimated the average effective tax rates by sector and by region. The effective tax rate is computed by dividing the accrual taxes in the income statement by the accrual taxable income reported in that same statement. In the table below, I compare three measures of the average effective tax rate across global companies: the simple average effective tax rate across all companies (including money losers), the weighted (by taxable income) average effective tax rate across all companies that have a  positive taxable income and an aggregate tax rate (obtained by dividing the total taxes paid by the total taxable income).
    Effective Tax Rate: 2013
    There is something in this graph for almost every side of this debate. On all three measures of the effective tax rate, Japanese companies pay the most in taxes, even though Japan has a territorial tax system where foreign income is not taxed at the Japanese marginal tax rate (of approximately 38%), backing those who believe that the US will gain from moving to a territorial tax system. When you look at the weighted (by income) average effective tax rate across money making companies, US companies actually pay a higher percentage of their taxable income than much of the rest of the world and almost as much as European companies, bolstering those who contend that US companies pay roughly the same amount in taxes as companies in the rest of the world and are not tax shirkers. However, those who contend that US companies pay too little in taxes will undoubtedly point to aggregate effective tax rate, which is lower in the US than in the rest of the world.

    My measure of how effective a tax system is the difference between marginal and effective tax rates. I computed this statistic, using the marginal tax rate at the start of 2013 and the effective tax rate for that year, for every country for which I was able to obtain both a marginal and an effective tax rate, and ranked them based upon the difference. The list below includes my ranking of the ten most ineffective tax regimes in the world, with a comparison to some developed markets and four emerging markets (Brazil, India, China and Russia).
    Marginal & Effective Tax Rates: 2013
    The US has the ninth most ineffective tax system in the world, collecting 13.34% less in taxes than its marginal tax rate. Lest you are comforted by the fact that there are 8 countries in the world that have even more ineffective tax systems, it should be give you pause to see Greece, Venezuela, Nigeria and Kazakhastan on that list. While I am not a fan of first-world versus third-world categorizations, I think it is fair to say that the US is a first-world economy with a third-world tax system, a point that is made starkly when you contrast it with other developed markets or the largest emerging markets. (You can get the entire list of countries by clicking here.)

    I don't think that you will get any disagreement from either side (right or left, Republican or Democrat, liberal or conservative) that the US tax code today is ineffective, though the solutions they offer are starkly different. The combination of a global taxation system, high marginal tax rates and debt-friendly clauses in the US tax code create predictable and perverse consequences. With the current tax law, US companies will continue to move more of their business and earnings overseas and keep the cash there, reinvest too little in the US, borrow too much (often to pay dividends or buy back stock to US investors) and hold on to too much cash.   

    The Solution
    At this point, if you are a US taxpayer, you are probably boiling with rage, ready to pick up your pitchforks and to attack unpatriotic companies. Vent as much you want, if it makes you feel better, but you have to decide whether you want a tax code that makes you feel good or one that actually works. Some of the solutions suggested to the US tax problem may work well as political selling points but will only worsen the perverse effects. 

    Punitive Solutions
    Once you label corporations as tax dodgers, crooks or reprobates, you are signaling that you favor a punitive solution. After all, why would you try to negotiate with such entities? Before we look at some of remedies (mostly legal) that are being suggested for both trapped cash and tax inversions, it is worth retracing the three steps in the process that lead to these remedies, with the flaws in logic I see in each step.
    1. The first step is an appeal to patriotism, where corporations are asked "what they will do for their country of incorporation, rather than what that country will do for them". In fact, the taxation of global income at the US tax rate is not restricted to US corporations. It applies to all US citizens who work abroad, requiring them to pay not only the taxes due in the country in which they work in but the additional tax that they would owe the US, if that country has a lower individual income tax rate than the US does. Thus, long-term expatriates working in low-tax locales are given a choice of whether they want to continue to be US citizens (and pay the extra tax) or give up their citizenship. In effect, their patriotism is put to the test and while many people pass that test (even if it means paying extra taxes), more and more chose to give up their US citizenships each year.  There are some who think that US corporations can be put to the same patriotism test, I don't think that the argument make sense. Since a publicly traded company is owned by its stockholders, should we determine patriotic standing based upon the nationality of the stockholders who hold its stock? Thus, should a US company where Chinese own 51% of the outstanding shares try to maximize taxes paid to the Chinese government? Even if you don’t buy the “stockholders as owners” argument, what if more than 50% of your employees now work in a different country? Is it your patriotic duty to maximize taxes paid to that country?
    2. Shame corporations into paying their "fair" share of taxes: An extension of the patriotism argument is to push the theme that it is shameful for taxpayers not to maximize taxes paid to the government. You may view this as a sign of my moral decay or ethical shortcomings, but I don't believe that taxpayers (individual or business) should be required to maximize taxes paid to the government. That does not preclude individual taxpayers who want to maximize taxes from doing so, but you cannot demand that other taxpayers (individuals or corporations) do more than pay what they legally owe in taxes. 
    3. Force immediate tax payments (and ban inversions): The punitive solutions almost always revolve around legislation. You could change the US tax code to force all multinationals to pay the US marginal tax rate on their global income, when the income is earned, not when it is repatriated and the trapped cash problem will go away, we are told. Really? I will argue that  passing this law will create two consequences. The first is that if you think that US companies moving their headquarters outside the US is a problem now, it will become a deluge, if you pass this law. The second is that even those multinationals that choose to stay US-based will spin off their foreign subsidiaries as stand-alone companies. I guess you can try to pass more laws to prevent both these developments, but legislation that goes against common sense (and economic self interest) is doomed to fail.
    There are two other weapons that the punitive solutions crowd plan to use to keep companies in line. The first is to bar companies that move their headquarters outside the US from ever doing business with the US government. Thus, AbbVie’s drugs can be removed from the list of Medicare/Medicaid allowed medications, which would cost the company money, but would also leave a whole group of patients in both programs without their preferred medicine. And if enough US pharmaceutical companies follow AbbVie out the US, then what company’s drugs will be left on the medication list? The second is to penalize stockholders in companies that move outside the US by charging them a higher tax rate on their dividends/capital gains. I am not even sure how this would work, but I am sure that an aide to some legislator will come up with a "can't miss' scheme.

    Implicit in the punitive solutions is the belief that the benefits that companies get from being incorporated in the United States are so large that most of them will not consider moving elsewhere. But what exactly are these benefits? The first is the legal and institutional protection that operating in the United States offers companies: a well-functioning, efficient legal system that enforces laws and contracts is critical to running businesses. The second is the political climate in the US has historically been viewed as more favorable for private enterprise, in general, and corporations, in particular. Both may have been compelling considerations three decades ago, but the US advantage has shrunk on both counts. European countries, other than France, have become more receptive to businesses and Asian and Latin American countries, not counting the obvious exceptions, are fixing their worst excesses. In fact, there is reason to believe that just as the rest of the world is getting friendlier towards corporations, the US is moving in the opposite direction.

    Temporary Solution
    There is a temporary solution to the problem that will alleviate the immediate pressure on companies to invert and that is to offer a tax holiday, where companies will be allowed to bring their trapped cash home, without paying taxes due or only a small portion thereof. It will be marketed as a one-time deal, and will be coupled with feel-good clauses, requiring companies to use the cash to fund more investments and create more jobs in the United States. Not only will these investments and jobs never come to fruition, but the incentive to let cash build up in overseas locales will only increase after such actions. After all, one-time tax holidays that seem to happen once every decade are really not really one-time, are they?

    Long term Solution
    If we do not want companies trapping cash in overseas locales or trying to move from the United States, there are two solutions. One is to lower the marginal tax rate for US corporate income to a level closer to those that you observe in the rest of the world, since it reduces the cost of repatriating foreign income to the United States. On that count, the Obama administration's proposal to lower the marginal corporate tax rate to 28% is a sensible one. I believe, though, that this has to be coupled with a shift to a territorial tax system, in recognition of the reality that corporations are now multinational in every sense (investors, employees, operations) and have to be treated as such. In conjunction, I think the tax code should be stripped of most or all of the "goodies" that legislators have added to it over time.

    Will these changes create costs, especially in the near-term? Of course. There will be companies that will pay more in taxes than they do right now and tax lawyers and transfer pricing specialists will have to find something else to do. Paul Krugman will probably have a conniption, Senator Carl Levin's legislative masterpiece will not see the light of day and Jon Stewart will have to find other comedic material. To be honest, I would not be unhappy with any of these developments.

    A pessimistic end note
    Writing bad tax law is easy, but changing it is really difficult. It is generally true that even the most sensible (and obvious) fixes to the tax law can be used against those who vote for it. Populists of all stripes (right and left) will tar you as a corporate stooge or worse, if you do vote to lower corporate tax rates or change from a global tax to a territorial tax system. Not only am I pessimistic about Congress making sensible changes to tax laws, but I fear that any changes that get made will only make the long term problems worse. That, in turn, will set off a new round of outrage and more misguided tax law changes and the cycle will continue.

    Attachments:
    Marginal tax rates, Effective tax rates and Tax Regime Efficiency: By Country



    The Walking Dead: Blackberry, Yahoo and the Zombie Apocalypse!

    I will start with a confession. I have distinctly lowbrow tastes when it comes to literature, movies and entertainment. I would much rather read a novel about a unhinged serial killer than one written by the latest Nobel Literature Prizewinner, watch The Avengers than an art film and be at Yankee stadium than the Museum of Modern Art. That may reflect the limits of my intellect and the shortcomings of my cultural education, but I know what I like, am set in my ways and no cultural gatekeeper is going to tell me otherwise. Given my plebeian tastes, it should come as no surprise that last summer, I joined my fifteen-year old son in binge-watching the first three seasons of The Walking Dead, a television show with not much of a stray line, lots of gore and few redeeming social qualities.  For those of you who have never watched the show, here is a taste:


    You may be wondering why I am talking about television shows on a blog dedicated to markets, but the Walking Dead was what came to my mind in the last couple of weeks, as I watched Blackberry and Yahoo, two companies that I have posted about before, make the news. 

    Blackberry announced that they were introducing a new phone, priced at $599, and aimed at getting them back into the smartphone market. Yahoo was initially not in the news, but Alibaba, a company that Yahoo owns 22.1% of, was definitely the center of attention at its initial public offering on September 19. While Alibaba opened to rapturous response, its stock price jumping 38% on the offering date, Yahoo’s stock price strangely dropped by 5%, the day after. By the end of last week,  Yahoo had been targeted by an activist investor, taken to task for not managing its Alibaba tax liability and pushed to merge with AOL. Since I have owned Yahoo for the last few months, I have a personal financial interest in trying to make sense of the dissonant behavior and I am afraid that  the Walking Dead is the best I can come up with as an explanation.

    The Life Cycle and beyond
    A few months ago, I posted on the life cycle that businesses go through and argued that companies are born, grow, mature and decline and that it is often both expensive and pointless to fight the cycle.


    The life cycle view of the corporate world may be simplistic, but it is surprisingly powerful in analyzing the evolution of corporate governance and different investment philosophies. Thus, there are some who argue that while an autocratic CEO can be a hindrance in a mature or declining company, he or she can be an asset early in the life cycle, and that success goes to those who are strong on narrative, early in the life cycle, but that the numbers people dominate later.

    In a series of posts, I looked at the challenges of managing and investing in companies across the life cycle, including a few in the most depressing phase, which is during decline.  I also conceded that there are examples of rebirth and reincarnation, where companies find a way back from decline (IBM in 1992 and Apple in 1999). In most cases, though, companies in decline that try to spend their way back to maturity have little to show in terms of earnings and growth for the billions of dollars spent on investments, acquisitions and R&D.

    The Walking Dead Company
    In drawing a parallel between human beings and corporations on the life cycle, I think I missed a key difference. Human beings die, no matter how heroic the medical attempts to keep them alive may be. Corporations on the other hand can survive well after their business models have expired, the Walking Dead of the business world, and can create damage to those vested in and closest to them. Here are the characteristics of these zombie companies:
    1. Broken Business Model: The company's business model is dead, with the causes varying from  company to company: management ineptitude, superb competition, macroeconomic shocks or just plain bad luck. Whatever the reasons, there is little hope of a turnaround and even less of a comeback. The manifestations are there for all to see: sharply shrinking revenues, declining margins and repeated failures at new business ventures/products/investments.
    2. Management in Denial: The managers of the company, though, act as if they can turn the ship around, throwing good money after bad, introducing new products and services and claiming to have found the fountain of youth. In some cases, the company may change managers at frequent intervals during the death spiral, but they all share in the denial.
    3. Enabling Ecosystem: The managers are aided and enabled by consultants (who collect fees from selling their rejuvenating tonics), bankers (who make money off desperation ploys) and journalists (either out of ignorance or because there is nothing better to write about than a company thrashing around for a solution). 
    4. Resources to waste: While almost all declining companies share the three characteristics listed above, the walking dead companies are set apart by the fact that they have access to the resources to continue on their path to nowhere and have to be kept alive for legal, regulatory or tax reasons. Those resources can take the form of cash on hand, lifelines from governments and/or capital markets that have taken leave of their senses.
    The challenges that you face as an investor in a walking dead company is that you cannot assess its value, based upon the assumption that the managers in the company will take rational actions: make good investments, finance them with the right mix of debt and equity and return unneeded cash to stockholders. To get realistic assessments of value, you have to assume that managers will sometimes take perverse actions, investing in low-probability, high-possible-payoff investments (think lottery tickets), financing them with odd mixes of debt and equity (if you are on the road to nowhere, you don't particularly care about who you take down with you) and holding back cash from stockholders. Incorporating these actions into your valuation will yield lower values for these companies, with the extent of the discount depending upon the separation of management from ownership (it is easier to be destructive with other people's money),  the capacity of managers to destroy value (which will depend on the cash/capital that they have access to and will increase with the size of the company) and the checks put on managers (by covenants, restrictions and activist investors). At the limit, managers without any checks, given enough time, on their destructive impulses can destroy all of a company's value, if not immediately, at least over time. For value investors, these companies are often value traps, looking cheap on almost every value investing measure but never delivering the promised returns, as managers undercut their plans at every step. 

    Blackberry’s future: Staring into the Abyss
    In fact, I argued in a post in December 2011 that Blackberry (then called Research in Motion) needed to act its age, accept that it would never be a serious mass-market competitor in the smart phone market and settle for being a niche player. That post, which occurred when Blackberry had a market capitalization of $7.3 billion, argued that Blackberry should give up on introducing new tablets or phones and revert to a single model (which I termed the Blackberry Boring) catering to paranoid corporates (who do not want their employees accessing Facebook or playing games on smart phones). I also suggested that Blackberry settle on a five-year liquidation plan to return cash to stockholders.

    I was accused of being morbid and overly pessimistic, but here we are three years later, with Blackberry’s market cap at $5.3 billion. In the three years since my last post, the company has spent $4.3 billion in R&D,  while its annual revenues have dropped from $18.4 billion in 2011-12 to $4.1 billion in the last twelve months and its operating income of $1.85 billion in 2011-12 has become an operating loss of -2.7 billion in the trailing twelve months. Blackberry’s new model may be a technological marvel, but the smart phone market has moved on, where a phone is only as powerful as the ecosystem of apps and other accessories available for it is. If it was true three years ago that Blackberry could not compete against Apple and Google in the operating system world, it is even truer today, when either of these mammoth companies can use petty cash to buy Blackberry. (Apple’s cash balance is $163 billion, Google’s cash balance is $63 billion and Blackberry’s enterprise value is $4.1 billion). Perhaps, I am missing something here, but I really don't see any light in the smartphone tunnel for Blackberry and even if I do, it is the headlight of an oncoming locomotive.

    The options for Blackberry, in my view, are even fewer than they were three years ago. At this stage, I am not sure that even the niche market option is viable any more. I see only two ways to encash whatever value is left in the company. The first is to hope that a strategic buyer (which to me is a synonym for someone who will pay far more than justified by the cash flows) with deep pockets will see some value in the Blackberry technology and buy the company.  The second is a more radical idea. In a world where social media companies like Facebook, Twitter and Linkedin command immense value, with each user generating about $100 in incremental market cap, Blackberry should consider relabeling itself as a social media company, create a Blackberry Club, where those with Blackberry thumbs can stay connected. Outlandish, I know, but why not?

    Do you Yahoo? 
    On May 10, 2014, I posted on Yahoo! and valued itscomponent parts: its operations in the US (Yahoo US), its 35% holding of Yahoo Japan and its 22.1% holding of Alibaba. I first valued it on an intrinsic basis at $41.19:
    Note that these numbers reflect my estimates of intrinsic value, which generated $146 billion for Alibaba's equity.  I then revalued it on a relative basis at $39.19, but this valuation reflected a pricing of Alibaba at $118 billion.
    I closed by arguing that the stock seemed under priced at $ 34 and that I would use it as my proxy bet on Alibaba.  The stock initially stalled but as the Alibaba IPO became imminent, Yahoo’s stock price rose to $42.09 at close of trading on Thursday, the day before the IPO:


    Alibaba went public on Friday, September 19, and its market capitalization jumped to $230 billion.  I updated my valuations and prices of Yahoo, Yahoo Japan and Alibaba in the table below:
    Updated using trailing 12-month values
    Note that both the intrinsic and relative values of Yahoo have increased over the period, almost entirely due to an increase in Alibaba's intrinsic value.  It is true that Yahoo did have to sell 124 million shares (actually good news, since that amounted to only 5.1% of Alibaba shares, when initial estimates suggested that the would have to sell about 9%)  worth of Alibaba stock on the IPO date at the IPO price of $68, giving it a net cash balance of about $ 8 billion on Monday, after allowing for a tax liability of $3.3 billion on the Alibaba stock sale. Updating the intrinsic value picture to reflect this, here is what I get:


    Allowing for both the higher cash balance and the re-estimated intrinsic values for the three businesses, my estimate of intrinsic value of $46.44 per share for Yahoo is higher than the current price of $40.66. If you don't trust my intrinsic value estimates, here is a simpler and far more powerful picture of where Yahoo stands today. Using today's market prices for Yahoo's holdings in Alibaba and Yahoo! Japan and adding the net cash balance that Yahoo has, net of taxes due on the shares sold on the IPO date, the value per share is $52.14.  At its current price, the market is attaching a value of -$12.22 billion (-$11.48/share) for the operating assets in Yahoo US.


    It is tough to imagine that this is a market oversight, since the market values of Yahoo Japan and Alibaba are easily checked and the cash balance is not really subject to debate. I am more inclined to view this as a Walking Dead discount, reflecting investor concerns, merited on not, that  Yahoo's management might do something senseless with the cash, and incorporating the reality that liquidation is not a viable or a sensible option today. Why? Liquidating Yahoo's holdings today will require cashing out of the Yahoo Japan and Alibaba holdings today, resulting in a total tax bill of $16.3 billion and a value for the equity per share of $34.18.

    What now? 
    As an investor in Yahoo, the question I face is whether the discount that the market is applying to Yahoo is reasonable. While I believe that Marissa Mayer can do serious damage to me as investor, by embarking on ambitious expansion plans with the cash, I also believe that she will be checked by activist investors along the way.  I will continue to hold Yahoo, at least at its current price, and hope for the best. That, to me, would require that Ms. Mayer recognize that Yahoo is really a shell company with two very valuable holdings and very little in actual or potential operating value. Perhaps, she would consider returning all cash to stockholders, reducing the workforce in the company to one person and giving that person a dual-display terminal and let him/her just watch the market value of Alibaba on one and Yahoo Japan on the other. That is my best case scenario and it is unfortunate, but true, that my value per share will move inversely with Ms. Mayer's ambitions.

    Attachments
    Master Spreadsheet for Yahoo (with holdings)
    Intrinsic value of Yahoo US
    Intrinsic value of Yahoo Japan
    Intrinsic value of Alibaba





    Stock Buybacks: They are big, they are back and they scare some people!

    This has been a big year for stock buybacks, continuing a return to a trend that started more than two decades ago and was broken only briefly by the crisis in 2008. Focusing just on the S&P 500 companies, buybacks in the 2013 amounted to $475.6 billion, not quite as substantial as the best buyback year in history (2007, with $589.1 billion), but still significantly up since 2009. As stock prices rise and anxiety about bubbles and real economic growth also come to the surface, it is not surprising that some of those looking at rising prices are trying to make a connection, rightly or wrongly, to the buyout numbers. As a general rule, even insightful stories about buybacks tend to focus on one cause or effect of the buyback phenomenon but miss the big picture. In particular, there have two news stories about buybacks, one in the Economist and one in the Wall Street Journal. Since I talked to both journalists as they wrote these stories, and I am quoted in one of them, I should disclose that I like both writers and think they did their research, but their particular perspectives (that stock buybacks can be value destructive in the Economist and that they affect liquidity in the WSJ) may be blurring the big picture of buybacks. In fact, I think that the Economist overplayed their hand by calling buybacks “corporate cocaine”, a loaded header that treats buybacks as a destructive addiction (for which the cure, as with any other addiction, is abstinence). This post is not aimed at the vast majority of investors who sensibly view buybacks as good or bad on a company-by-company basis but at the shameless boosters of buybacks, who treat it as a magic bullet, at one extreme, and the equally clueless Cassandra chorus, who view it as the market equivalent of the Ebola virus, signaling the end of Western civilization as we know it, at the other.

    Laying the Groundwork: Trends and History
    For much of the last century, companies were not allowed to buy back stock, except in exceptional circumstances. In the United States, companies have been allowed to buy back stock for most of their existence, but the pace of buybacks did not really start picking up until the early 1980s, which some attribute to a SEC rule (10b-18) passed in 1982, providing safe harbor (protection from certain lawsuits) for companies doing repurchases. The legal rules governing buybacks in the US today are captured nicely in this Harvard Law School summary. In the graph below, I show aggregate stock buybacks and dividends at US companies going back to 1980.
    Dividends & Buybacks at all US firms (Source: Compustat)
    This graph backs up the oft-told story of the shift to buybacks occurring at US companies. While dividends represented the preponderance of cash returned to investors in the early 1980s, the move towards buybacks is clear in the 1990s, and the aggregate amount in buybacks has exceeded the aggregate dividends paid over the last ten years. In 2007, the aggregate amount in buybacks was 32% higher than the dividends paid in that year. The market crisis of 2008 did result in a sharp pullback in buybacks in 2009, and while dividends also fell, they did not fall by as much. While some analysts considered this the end of the buyback era, companies clearly are showing them otherwise, as they return with a vengeance to buy backs.

    As some of those who have commented on my use of the total cash yield (where I add buybacks to dividends) in my equity risk premium posts have noted (with a special thank you to Michael Green of Ice Farm Capital, who has been gently persistent on this issue), the jump in cash returned may be exaggerated in this graph, because we are not netting out stock issues made by US companies in each year. This is a reasonable point, and I have brought in the stock issuances each year, to compute a net cash return each year (dividends + buybacks - stock issues) to contrast with the gross cash return (dividends + buybacks).
    Gross cash (Dividends+Buybacks) and Net Cash (Dividends+Buybacks-Stock Issues) as % of Market Cap
    Note that I have converted all these numbers into yields, by dividing them by the aggregate market capitalization at the end of each year. Both the gross cash yield (5.53%) and net cash yield (3.89%) peaked in 2007, and the lowest values for these numbers were in 1999 and 2000, when the gross cash yield was 2.17% (1999) and the net cash yield was 0.67% (2000). At the end of 2013, the gross cash yield stood at 4.49% and the net cash yield at 3.16%, both slightly higher than the aggregate values of  4.24% for the gross yield and 2.46% for the net yield over the 1980-2013 time periods; the simple averages yield 4.65% for the gross yield and 2.60% for the net yield over the entire time period.

    Since the aggregate values gloss over details, it is also worth noting who does the buybacks. It goes without saying that the largest buybacks (in dollar terms) are at the largest market cap companies, and the following is a list of the top fifteen companies buying back stock in 2013:
    Companies buying back the most stock in 2013 (in millions)
    Not only is more money being returned in the form of buybacks, but the practice of buybacks has also now spread far and wide across the corporate spectrum, with small and large companies, as well as across different sectors, partaking in the phenomenon:
    Dividends and Buybacks in 2013: Data from S&P Capital IQ
    Other than utilities, the shift to dividends is clear in every other sector, with technology companies leading with almost 76% of cash returned taking the form of buybacks. 

    Keep it simple: Buybacks are a return of cash to stockholders
    To understand buybacks, it is best to start simple. Publicly traded companies that generate excess cash often want to return that cash to stockholders and stockholders want them to do that. There are only two ways you can return cash to stockholders. One is to pay dividends, either regularly every period (quarter, semiannual or year) or as special dividends. The other is to buy back stock. From the company’s perspective, the aggregate effect is exactly the same, as cash leaves the company and goes to stockholders. There are four differences, though, between the two modes of returning cash. 
    1. Dividends are sticky, buybacks are not: With regular dividends, there is a tradition of maintaining or increasing dividends, a phenomenon referred to as sticky dividends. Thus, if you initiate or increase dividends, you are expected to continue to pay those dividends over time or face a market backlash. Stock buybacks don’t carry this legacy and companies can go from buying back billions of dollars worth of stock in one year to not buying back stock the next, without facing the same market reaction.
    2. Buybacks affect share count, dividends do not: When a company pays dividends, the share count is unaffected, but when it buys back shares, the share count decreases by the number of shares bought back. Consequently, share buybacks do alter the ownership structure of the firm, leaving those who do not sell their shares back with a larger share in a smaller company.
    3. Dividends return cash to all stockholders, buybacks only to the self-selected: When companies pay dividends, all stockholders get paid those dividends, whether they need or want the cash. Thus, it is a return of cash that all stockholders partake in, in proportion to their stockholding. In a stock buyback, only those stockholders who tender their shares back to the company get cash and the remaining stockholders get a larger proportional stake in the remaining firm. As we will see in the next section, this creates the possibility of wealth transfers from one group to the other, depending on the price paid on the buyback.
    4. Dividends and buybacks create different tax consequences: The tax laws may treat dividends and capital gains differently at the investor level. Since dividends are paid out to all stockholders, it will be treated as income in the year in which it is paid out and taxed accordingly; for instance, the US tax code treated it as ordinary income for much of the last century and it has been taxed at a dividend tax rate since 2003. A stock buyback has more subtle tax effects, since investors who tender their shares back in the buyback generally have to pay capital gains taxes on the transaction, but only if the buyback price exceeds the price they paid to acquire the shares. If the remaining shares go up in price, stockholders who do not tender their shares can defer their capital gains taxes until they do sell the shares.
    Buybacks: The Value Effect
    Buybacks can have no effect, a positive effect or negative effect on equity value per share, depending on where the cash from the buyback is coming from and how it affects the firm’s investment decisions. To illustrate the effects, let’s start with a simple financial balance sheet (not an accounting one), where we estimate the intrinsic values of operating assets and equity and illustrate the effects of a stock buyback on the balance sheet.

    Note that the buyback can be funded entirely with cash, partly with cash and partly with new debt or even entirely with debt. (I am going to leave out the perverse but not uncommon scenario of a company that funds a buyback with a new stock issue, since the only party that is enriched by that transaction is the investment banker who manages both the issuance and the buyback). The value of the operating assets can change, if the net debt ratio of the company changes after the buyback (thus affecting the cost of capital) or if the buyback reduces the amount that the company was planning to invest in its operating assets (thus changing the cash flows, growth and risk in these assets).  This framework is a useful vehicle to look at the conditions under which buybacks have no effect on value, a positive one and a negative one.

    The indifferent: For buybacks to have no effect on value, they should have no effect on the value of the operating assets. That must effectively mean that the buyback is entirely funded with cash off the balance sheet or that even if funded with debt, there is no net value effect (tax benefits cancel out with default cost) and that the buyback has no effect on how much the company invests back into its operating assets. As an example, consider the $13.2 billion in stock buybacks at Exxon Mobil in 2013. The company funded the buybacks entirely with cash surpluses and it not only had more than enough cash to cover reinvestment needs but continues to generate billions of dollars in excess cash (over and above its reinvestment needs).

    The good: There are three pathways through with which a buyback can have a positive effect on value:
    1. Discounted cash holdings: There are some companies with significant cash balances, where investors do not trust the management of the company with their cash (given the track record of the company). Consequently, they discount the cash in the hands of the company, on the assumption that they will do something stupid, and this stupidity discount can be substantial. This is one of the few scenarios where a stock buyback, funded with cash, is an unalloyed plus for stockholders, since it eliminates the cash discount on the cash paid out to stockholders.  
    2. Financial leverage effect: A firm that finances a buyback with debt, increasing its debt ratio, may end up with a lower cost of capital, if the tax benefits of debt are larger than the expected bankruptcy costs of that debt. That will occur only if the firm has debt capacity to begin with, but that lower cost of capital adds to the value of the operating assets, though it can be argued that it is less value enhancement and more of a value transfer (from taxpayers to stockholders). 
    3. Poor investment choices: There is also the scenario where a firm that has been actively investing in a bad business or businesses (earning less than the cost of capital) redirects the cash towards buybacks. Here, less investment is value increasing and I will let you be the judge on how many firms on the top fifteen list in 2013 fall into that scenario. (I can think of quite a few...)
    The bad: There are two ways in which a buyback can have a negative effect on value. The first is if the firm is correctly or over levered and chooses to finance the buyback with even more debt, since that would push the cost of capital higher after the buyback (as the expected bankruptcy costs overwhelm the tax benefits of debt). The second is if the firm takes cash that would have been directed to superior investment opportunities (where the return on capital > cost of capital) and uses it to buy back stock; this requires that the company also face a capital constraint, imposed either internally (because the company does not like to raise new financing) or externally (because the company is prevented from raising new financing). 

    Buybacks: The Pricing Effect
    If buybacks have no effect on value, can they still affect stock prices? Sure, and there are three possible factors that may cause the effect. The first is if there is a market mistake at play, where the stock is priced above or below its intrinsic value and the buyback occurs at a price that is not equal to the value. The second is that markets extrapolate from corporate actions and may view the buyback as a signal about what managers of the company think about its fair value. The third is that a buyback, especially if large and/or on a lightly traded stock, can have liquidity effects, tilting the demand side of the pricing equation. All of the effects are captured in the picture below:


    1. Market mispricing: If the stock is mispriced before the buyback, the buyback can create a value transfer between those who tender their shares back in the buyback and those who remain as stockholders, with the direction of the transfer depending on whether the shares were over or under valued to begin with. If the price is less than the value, i.e., the stock is under priced, a buyback at the prevailing price will benefit the remaining shareholders, by letting them capture the difference but at the expense of the stockholders who chose to sell their shares back at the “low price”. In fact, it is likely that the market will view the announcement of the buyback as a signal that the stock is under valued and push the price impact in what is commonly categorized as a signaling effect. If the price is greater than the value, i.e., the stock is over priced, a buyback will benefit those who sell their shares back, again at the expense of those who hold on to their shares. In either case, there is no value creation but only a value transfer, from one group of stockholders in the company to another. Lest you feel qualms of sympathy for the losing group in either scenario, remember that most stockholders get a choice (to tender or hold on to the shares) and if they make the wrong choice, they have to live with the consequences. 
    2. Signaling: For better or worse, markets read messages into actions and then translate them into price effects. Thus, when companies buy back stock, investors may consider this to be a signal that these companies view their stock to be under valued. If there is a signaling effect, you should expect to see the stock price jump on the announcement of the buyback and not the actual execution. The problem with this signaling story is that it attributes information and valuation skills to the management of the company that is buying back stock, that they do not possess. The evidence on whether companies time stock buybacks well, i.e., buy back their stock when it is cheap, is weak. While there is some evidence that companies that buy back their own stock outperform the market in the months after the buyback, there is also evidence that buybacks peak when markets are booming and lag in bear markets. 
    3. Liquidity effects: A stock buyback, especially if it is of a large percentage of the outstanding shares, does create a liquidity effect, with the buy orders from the company pushing up the stock price. For this to occur, though, the shares bought back have to be a high percentage of the shares traded (not the shares outstanding). If there is a liquidity effect, you should expect to see the stock price rise around the actual buyback (and not the announcement) but that price effect should fade in the weeks after. While the Wall Street Journal makes legitimate points about how buybacks can sometimes tilt the liquidity playing field, looking across companies that buy back stock and scaling the buyback to the daily trading volume on the stock, the median value of buybacks as a percent of annual trading volume was 0.79% and the 75th percentile across all firms is 2.17%. It is true that there are firms like IBM and Pfizer that rank among the biggest buyback firms, where buybacks are a significant percentage of annual trading volume and there will be a liquidity effect at these companies, albeit short lived:

    The Sum of the Effects
    In summary, buybacks can increase value, if they lower the cost of capital and create a tax benefit that exceeds expected bankruptcy costs, and can increase stock prices for non-tendering stockholders, if the stock is under valued. Buybacks can destroy value if they put a company’s survival at risk, by either eliminating a cash buffer or pushing debt to dangerously high levels. They can also result in wealth transfer to the stockholders who sell back over those who remain in the firm, if the buyback price exceeds the value per share. 

    What about the share count effect? This is the red herring of buyback analysis, a number that looks profoundly meaningful at first sight but is useless in assessing the effect of a buyback, on deeper analysis. Let’s start with the obvious. A stock buyback will always reduce share count. For those lazy enough to believe that dilution is the bogeyman, and that less shares is always better than more, buybacks are always good news. However, lower share count often does not signify higher value per share and it may not even signify higher earnings per share (or whatever per share metric you use). For those slightly less lazy, focused on earnings per share, the assessment of whether a buyback is good news boils down to estimating how much earnings per share goes up after it happens. In a world where PE ratios stay constant, come out of sector averages, or are just made up, this will translate into higher price per share. The problem is that a buyback alters the risk profile of a firm and should also change its PE ratio (usually to a lower number).

    To assess the effect of a buyback, you have to consider the full picture. You have to look at how it is financed (and the effect it has on debt ratio and cost of capital) and how the stock price relates to its fair value (under priced, correctly priced or over priced) to make a judgment on whether stockholders will benefit or be hurt by the stock buyback. I have a simple spreadsheet that tries to do this assessment that you are welcome to take for a spin.

    Back to the Market
    Now that we have the tools to assess how and why stock buybacks affect stockholders in the companies involved, let’s use them to look at whether the buyback “binge” in the market is good news, neutral news or bad news, at least in the aggregate.  The article in the Economist provides the perspective of those who believe that stock buybacks are the most destructive trend in corporate America. Looking at the value destruction pathways described in the last section, this group believes that the stock buybacks at US companies are increasing leverage to dangerously high levels and/or reducing investment in good projects. But are these contentions true? Let’s check the facts:

    1. The leverage story: The notion that US companies are dangerously over levered seems to be built on two arguments: the aggregate debt levels of businesses as reported in the US national accounts and on anecdotal evidence (Apple borrowed money to do buybacks, so every one must...). To examine this argument,  I have estimated debt levels at US companies from 1980 to 2013 in the graph below, both as a percentage of capital (book and market) and as a multiple of EBITDA.
    Debt as % of capital & multiple of EBITDA: All US companies (Source: Compustat)
    It is true that overall financial leverage, at least as measured relative to book value and EBITDA has increased over time (though it has remained relatively stable, as a percent of market value). While this increase can be partially explained by decreasing interest rates over the period, it is worth asking whether buybacks were the driving force in the increased leverage. To answer this question, I compared the debt ratios of companies that bought back stock in 2013 to those that did not and there is nothing in the data that suggests that companies that do buybacks are funding them disproportionately with debt or becoming dangerously over levered.
    Data from 2013: Debt burdens at buyback versus no-buyback companies
    Companies that buy back stock had debt ratios that were roughly similar to those that don't buy back stock and much less debt, scaled to cash flows (EBITDA), and these debt ratios/multiples were computed after the buybacks.

    2. The under investment story: The belief that US companies in sectors other than technology have been reinvesting less back into their businesses is widespread, but let’s check the facts again. In the table below, I look at capital expenditures at US firms collectively, as a percent of revenues and invested capital, from 1980 to 2013: 
    Capital Expenditures, Revenues and Invested Capital: US companies (Source - Compustat)
    The trend line (on everything other than cap ex as a percent of sales) does back the conventional wisdom, and since buybacks went up over the same period, the bad news bears seem to win this round, right? Well, not so fast! What if investment opportunities in the US, in sectors other than technology, are drying up, either because of global competition or due to industry maturation? If this is the case, not only should you expect exactly what you observe in the data (less reinvestment, more cash returned) but it is a good thing, not a bad one. Before you get too heated under the collar, there are three things to remember in this debate.
    1. The first is that there is little evidence that companies that buy back stock reduce their capital expenditures as a consequence. The table reports on the capital expenditures and net capital expenditures, as a percent of enterprise value and invested capital, at companies that buy back stock and contrasts them with those that do not, and finds that at least in 2013, companies that bought back stock had more capital expenditures, as a percent of invested capital and enterprise value. When you net depreciation from capital expenditures (net cap ex), the two groups reinvested similar amounts, as a percent of enterprise value), but the buyback group reinvested more as a percent of invested capital.
      Capital Expenditures & Net Capital Expenditures = Capital Expenditures - Depreciation; US firms in 2013
    2. The second is that the cash that is paid out in buybacks does not disappear from the economy. It is true that some of it is used on conspicuous consumption, but that is good for the for the economy in the short term, and a great deal of it is redirected elsewhere in the market. In other words, much of the cash paid out by Exxon Mobil, Cisco and 3M was reinvested back into Tesla, Facebook and Netflix, a testimonial to the creative destruction that characterizes a healthy, capitalist economy. 
    3. The third is the notion that more reinvestment by a company is always better than less is absurd (unless you are a politician), especially if that reinvestment is in bad businesses. In the table below, I have listed the ten companies that were the biggest buyers of their own stock over the last decade (using the Economist's ill advised heading for those who buy back stocks):

    As a stockholder in any of these companies, can you honestly tell me that you would rather have had these companies reinvest back in their own businesses? Put differently, how many of you wish that Microsoft had not bought back $100 billion worth of shares over the last decade and instead pumped that money into more Zunes and Surfaces? Or that Hewlett Packard instead of paying out $60 billion to stockholders had bought three more companies like Autonomy (and written them off soon after)? Or that Cisco had spent the $70 billion in buyback money on a hundred small acquisitions? If, as the Economist labels them, these companies are cannibals for buying back their own stock, investors in these companies wish they had more voracious appetites and eaten themselves faster.

    There are two other issues brought up by critics of stock buybacks. One is that there is firms may buy back stock ahead of positive information announcements, and those investors who tender their shares in the buy back will lose out to those who do not. The other is that there is a tie to management compensation, where managers who are compensated with options may find it in their best interests to buy back stock rather than pay dividends; the former pushes up stock prices while the latter lowers them. Note that doing a buyback ahead of material information releases is already illegal, and any firm that does it is already breaking the law. As for management compensation, I agree that there is a problem, but buybacks are again a symptom, not a cause of the problem. In my view, it is poor corporate governance practice on the part of boards of directors to grant huge option packages to managers and then vote for buybacks designed to make managers even better off. Again, fixing buybacks does nothing to solve the underlying problem.

    Wrapping up
    I think that both ends of the spectrum on buybacks are making too much of a simple cash-return phenomenon. To the boosters of buybacks as value creators, it is time for a reality check. Barring the one scenario where companies that buy back stock stop making value-destructive investments, almost every other positive story about buybacks is one about value transfers: from taxpayers to equity investors (when debt is used by an under levered firm to finance buybacks) and from one set of stockholders to another (when a company buys back under valued stock).

    To those who argue that buybacks are destroying the US economy, I would suggest that you are using them as a vehicle for real concerns you have about the evolution of the US economy. Thus, if you are worried about insider trading, executive compensation, tax-motivated transactions and or under investment by the manufacturing sector, your fears may be well placed, but buybacks did not cause of these problems, and banning or regulating buybacks fall squarely in the feel-good but do-bad economic policy realm.

    Is it possible that some companies that should not be buying back stock are doing so and potentially hurting investors? Of course! As someone who believes that corporate finance at many companies is governed by inertia (we buy back stock because that is what we have always done...) and me-too-ism (we buy back stock because every one else is doing it...), I agree that there are value destroying buybacks, but I also believe that collectively, buybacks make far more sense than dividends as a way of returning cash to equities. In the Economist article, I am quoted as saying that dividends are a throwback to the nineteenth century (not the twentieth), when stocks were offered as investment choices to investors who were more used to bonds and that fixed, regular dividends were designed to imitate coupons. Since equity is a residual claim, it is not only inconsistent to offer a fixed cash flow claim to its owners, but can lead (and has led) to unhealthy consequences for firms. In fact, I think firms are far more likely to become over levered and cut back on reinvestment, with regular dividends that they cannot afford to pay out, than with stock buybacks.

    Attachments:
    1. Stock buybacks, dividends, stock issuances - Aggregate for US companies (1980-2013)
    2. Debt ratios/multiples - Aggregate for US companies (1980-2013)
    3. Buyback effect calculator



    Alibaba's Governance by Politburo: Corporate Governance and Value

    In my last post on Alibaba, I valued the company at about $162 billion but also argued that investors considering investing in the company might hold back because of corporate governance concerns. I will start by making the case (and it is an easy one) that Alibaba is more corporate dictatorship than corporate democracy, but I would then like to use the company as a vehicle to talk about what constitutes good corporate governance and how best to incorporate its presence or absence into value. 

    The Alibaba Corporate Governance Model
    In theory, the stockholders in a publicly traded company are its owners and get to determine who runs the company and how it is run. In practice, we know that this is more myth than reality and that a variety of constraints, both internally  and externally imposed, exist on stockholder power. Even in  the most idyllic corporate democracies, incumbent managers start off with an advantage over stockholders in the power game, though activists can sometimes even the playing field. With a company like Alibaba, stockholder don't even have the fig leaves of choice that they do with most other publicly traded companies and there are three reasons why:
    1. Legal Structure: The corporate governance problem with Alibaba starts with its legal structure. As I have noted in my prior posts, if you buy shares in Alibaba, you are not getting a piece of Alibaba, the Chinese online merchandising profit-machine, but a portion of Alibaba, the Cayman-Islands shell entity that has a contractual arrangement to operate its Chinese counterpart. While the Chinese government has granted legal standing to that contractual agreement, at least for the moment, it reserves the right to change it's mind and if it does, Alibaba's  shareholders will be left with just the shell.
      Operating Structure for Alibaba
    2. Management Powers: While the board of directors in publicly traded companies often fail in their obligation to protect the interests of stockholders, stockholders at least get to elect board members and have a say (nominal thought it may be) in the management of the company. With its partnership set-up, Alibaba has stripped even this minimal power away from stockholders, and the board will be named by a group of partners, which includes Jack Ma and his hand-picked partners. This is decision by corporate politburo, not through corporate democracy, but to give the Hong Kong Stock Exchange credit, they refused to allow Alibaba a listing with this set-up, but the NASDAQ NYSE seemed to have no qualms. In fact, given the NASDAQ’s NYSE's track record of going after large market cap listings at any cost, is there is any entity (Atilla the Hun? The Evil Empire?), with sufficient market capitalization, that the NASDAQ NYSE would refuse to list? (In my initial version of this post, I had wrongly accused the NASDAQ for this listing sin and I apologize, since I am sure that the NASDAQ would never have been this craven).
    3. Country setting: China has been the growth story of the decade and there is much to admire in the country’s single minded focus at making itself a first world economy. However, it is not a market economy in any sense of the word and I do not believe that the management at a Chinese company, let alone one as large and high-profile as Alibaba, can survive, if it upsets the Beijing power structure. Thus, it not only does not surprise me to read stories like this one about ties with politics but it brings home the realization that what stockholders want for this company is irrelevant, if their wants are not consistent with what the Chinese government would like to see happen. 
    In effect, you have a corporate non-governance trifecta, a publicly traded entity with questionable legal standing, run by a strong willed CEO who can write his own rules, in a country that does not put much weight on ownership rights. To give Alibaba credit, they do not hide the fact that this is a company where stockholders are powerless, as evidenced by this section from the prospectus (Pages 57-60), where they are clear that they are not required to maintain the illusion of board independence and accountability that most public corporations are required to.

    What is corporate governance?
    Now that we have established that stockholders in Alibaba have no power, it is time to ask a broader question about what exactly constitutes good corporate governance. In the last three decades, academic research and shareholder services have followed a standard path to measuring corporate governance by looking at the corporate charter and the composition of the board of directors. Institutional Shareholder Services (ISS), which provides perhaps the most widely used measure of corporate governance, builds its quick score around four pillars: an audit pillar (looking at whether the company makes its financial filings in time), a board pillar (director composition, compensation and shareholder approval rates), a shareholder rights pillar (hostile takeover restrictions, ease of dilution) and a compensation pillar (whether it is aligned with performance, how much say stockholders have in setting it and how well it is disclosed). Through no fault of ISS, companies have learned the system and play it well, meeting the checklist criteria for good corporate governance while rendering the concept toothless.

    While I understand the need to use objective measures to arrive at corporate governance scores, my definition of corporate governance is both broader and more difficult to measure. It reflects the power of stockholders to change the management of a company, if they feel the urge to do so. In that sense, it is very similar to the power that voters have in a democracy, to change their government. Note that the right to change management (or a government) may not always be exercised, because stockholders (voters) are lazy and abstain, or be exercised wisely, insofar as stockholders (voters) may leave bad managers (governments) in place or replace good managers (governments). The key is that with they have the power to create change, if they choose to.

    Corporate governance and corporate performance

    Proponents of stronger corporate governance argue that it critical to corporate performance, but the evidence of the link between the two is not very strong. There are badly run companies with impeccable corporate governance in place and superbly performing businesses where there is absolutely no restraint on corporate managers. Google and Facebook are corporate fiefdoms, where founder/CEOs have unchallenged power to do almost anything that they want, but they are also companies that have delivered immense profits and value to their stockholders. 

    It is true that generalizing on the basis of anecdotal evidence is dangerous, but studies that look at the overall relationship between measures of strong corporate governance and value deliver the same fuzzy message that good corporate governance does not always translate into higher value or better performance. One of the most widely quoted studies in support of strong corporate governance is this one, which finds that companies with stronger stockholder rights have higher profits and trade at higher multiples than companies with weak governance. Other studies, though, note that the the correlation between corporate governance measures and stock performance is weak and that there is some evidence that subsets of firms with weak corporate governance deliver superior performance.

    As in the previous section, you can use an analogy from political governance to examine the link of governance with performance. Is a country better off run by a benevolent (and intelligent) ruler-for-life or by a sometimes chaotic, often messy democracy? As someone whose instincts tend towards the latter, I would love to tell you that the answer is obvious, but I have had my moments of frustration with self-serving, short-term legislation and populist politicians, when I have dreamed about the former.

    The Value of Corporate Governance
    At the start of each of my valuation classes/sessions, I start with what I call the It Proposition and here is how it goes, “If it does not affect the cash flows or the risk in an investment, it cannot affect value”. If you are wondering what “it” is, “it” can be any of those words that are used to justify adjusting value with premiums (control, synergy, brand name) or discounts (illiquidity). Since it would be hypocritical of me to abandon this proposition in the context of corporate governance, I would argue that any corporate governance effect on value has to show up in either the cash flows or the risk.

    Valuing Corporate Governance: The Static Framework

    To consider how best to incorporate good or bad corporate governance into the value of a company, consider the determinants of value. We make judgments about how well a company is managing its existing assets, how much value there will be in future growth and the risk in the business to arrive at an estimate in value. 


    These judgments, though, are based upon assumptions about who is running the company (the management) and what these incumbent managers do well or badly. Thus, if you are valuing a company where managers have had a history of delivering high growth efficiently but are conservative when it comes to the use of debt, you may assume continued high quality growth accompanied by predominantly equity funding in valuing the company. In contrast, if you are valuing a company that borrows too much and consistently over pays on acquisitions, you may assume that those destructive tendencies will continue in valuing the company. Let’s term these the status quo values. Now, consider revaluing these companies with a new management in place without the blind spots of the status quo managers and reassess investment, financing and dividend policies. This will require you to take a fresh look at the key inputs into value, and with the changes that you make in how the company is run, you can revalue the company. Let’s term this value the optimal value

    By definition, the optimal value cannot be lower than the status quo value, but it can be equal to it (in the unlikely event that your company is perfectly run by the existing management) and will generally be greater.  Now that you have the status quo value and the optimal value of a publicly traded company, you can write the expected value of the company as a probability weighted average of the two numbers:
    Expected value of company = Status Quo Value (Probability of Existing Management staying in place) + Optimal Value (1 – Probability of Existing Management staying in place)
    Note that the probability attached to the optimal value can be construed as the probability of management change and it gives us a platform for assessing the value of corporate governance. If corporate governance is weak or non-existent, the probability of changing management decreases and the expected value of a company will converge on the status quo value. That may not result in significant value loss, if you have a well managed company, but the discount for bad corporate governance can be significant for a poorly managed company. 

    Valuing Corporate Governance: The Dynamic Framework

    The static approach to valuing corporate governance tends to work better for mature companies that are set in their ways. It does not work as well for younger companies that are run by strong willed CEOs, but are also perceived as being run well (at least for the moment). In these companies, the status quo and the optimal values may converge, leading to the conclusion that corporate governance does not have an impact on value. Thus, if you were valuing Google or Facebook, companies with excellent track records and imperial CEOs, you may conclude that there is little consequence to having poor corporate governance.

    Taking a longer-term perspective, and borrowing again from the political governance framework, the advocates for strong corporate governance would argue that there is a cost to bad corporate governance even at companies that are well managed today, since you are buying a share of these companies in perpetuity. That cost will show up in the future, when managers make wrong choices (and even the best ones do) or take value destructive paths. Since they are not accountable to stockholders and boards tend to be rubber stamps, there is no mechanism for bringing them back on track and the costs in the long term can be immense to stockholders. Even with the longer term perspective, though, there are others who argue that the restraints put on top management in a strong corporate governance system will result in slower and sub-optimal decisions, perhaps costing investors value in future periods.

    In valuation, the question of how best to capture this long term risk is a difficult one to answer. It is almost impossible to do in conventional valuation, where you make you base your value on your expected values for growth, risk and cash flows. It is possible, however, to get a sense of how much  corporate governance matters, if you are willing to estimate a distribution for value, allowing for both good and bad decisions/outcomes. Returning to my Alibaba valuation, I reframed the inputs on revenue growth, operating margin, reinvestment and risk (cost of capital) as distributions (rather than point estimates) and estimated a distribution of value for the equity per share in the company:


    Notice that while the expected value ($66.45/share & $162.9 billion in equity) and median value ($65.15/share & $159.7 billion in equity) are close to my base case valuation ($65.98/share & $161.7 billion in equity), there are outcomes that diverge widely from these numbers. Based on my assumptions, Alibaba could be worth as little as $38.11/share ($93.7 billion), if revenue growth drops, margins sag and risk rises, or as much as $153.10/share ($ 374.4 billion ). While this is going to be true for any firm with uncertainty about the future, the distribution of value allows us to get perspective on the contrasting points of view about strong management. 
    1. The Benevolent Ruler school: Investors in this school see an upside to unrestrained managers, arguing that there will be opportunities that will open up for the company to increase its value that require the quick, decisive and consistent actions that a strong, informed CEO can make without having to worry about or being slowed down by stockholder reactions or board approval. In effect, investors in this school may actually add a premium to discounted cash flow value to reflect the CEO's power, because they believe that a stronger CEO makes it more likely that Alibaba's value will converge on a higher number.
    2. The Corporate Democracy school: Investors in this school believe that CEOs with absolute power will inevitably make mistakes, and lacking accountability to shareholders and an active board of directors, will continue down value-destructive paths. Not surprisingly, these investors will reduce their DCF value to reflect this probability.
    The determinants of the premium attached by the first school and the discount tacked on by the second school are surprisingly similar. They will both increase as the uncertainty in the value of the business increases, since they have the characteristics of an option: a call option that adds value for the benevolent ruler school and a put option that reduces value with the corporate democracy school. They will also increase with your time horizon as an investor, with longer time horizons associated with higher values for both the premium and discount. Thus, if you are investor with a ten-year time horizon, you care a lot more about the good and bad qualities of top management than if have a six-month time horizon. That, in turn, may explain why so few portfolio managers and investors seem to be even looking at the corporate governance question with Alibaba with any concern.

    The Bottom Line
    As a long term investor, I am torn. While I think that Alibaba's current management team has done an superb job in building up the company, my instincts as an investor and my memories of well-managed companies that have mutated into badly run ones (with the same CEO in place) make me hold back. To be honest, I don't like being asked for my money (as an investor) and then being told that I have no say in how its run. With Alibaba, the decision is easier for me, at least for the moment, because the company is, at best, fairly priced at its offering price. It will be a decision, though, that I will have to revisit, if the price drops and the value does not. In effect, I will have to decide the discount on value at which I am okay with being in Jack Ma's outhouse.

    Attachments
    1. Alibaba: A China Story with a Profitable Ending (My May 8th post on Alibaba)
    2. Alibaba's Coming out Party: Fairly Valued but is it fairly priced? (My September 8th post on Alibaba)
    3. The value of control (My paper on status quo and optimal values)
    4. My valuation of Alibaba 
    5. My simulation assumptions for Alibaba (You will need Crystal Ball or some variant to be able to run the simulation yourself)




    HP's Break Up : Value Enhancement, Pricing Game or Management Hype?

    In my post on corporate breakups, I looked at the value and price consequences of breakups. Since that post was triggered by the news stories about HP and eBay splitting themselves, I though it would make sense to put those companies under the microscope, to see if they are good, neutral or bad candidates for the breakup story. In this post, I will focus on Hewlett Packard, a company with a long and rich history as a technology company, that has been a case study on bad corporate governance, the dangers of overpaying for acquisitions and the perils of bad accounting for the last few years.

    HP: From a bad past to a better future?
    The last decade has not been a good one for Hewlett Packard. During the period, the company has not only seen its core businesses (computers, printers, business services) come under assault but it has also had self-inflicted wounds from corporate governance failures and terrible acquisitions. I posted on one of those failed acquisitions (Autonomy) a while back and you can read the post here.

    Meg Whitman, who made her reputation by building up EBay, joined the board of directors at HP in 2011 and became CEO in September 2011, with the promise that she would turn the company around. Ironically, she was instrumental in rejecting an earlier plan to break up the company, arguing that the company was “better together”.  In the last three years, Whitman has toiled with mixed results on both the profitability and the stock price front. HP’s revenues have declined in the last three years and its margins are under pressure:

    The net loss in 2012 reflected the write off of their ill-fated Autonomy acquisition. HP’s stock price has reflected this turmoil, dropping in 2011 and 2012, before making a recovery in the last year and a half:


    In early October, HP announced that it was planning to break itself up into two companies, one containing the computer and printer businesses and the other incorporating business services and its financial arm. The official announcement (or at least presentation) that HP made about the break up is here. In the presentation, HP provides the broad details of the two businesses:
    From HP Investor Presentation Deck
    Note that the combined operating income for the two businesses in the last twelve months ($11.4 billion) exceeds the operating income for HP as a consolidated company ($8.6 billion) by about $2.8 billion. The footnote suggests that this does not include corporate investments (I assume that this refers to unallocated corporate costs) and seems to leave the impression, intended or not, that these costs will disappear after the break up. 

    Valuing the Break up
    In my post on valuing the effect of a break up, I argued that there were two questions that needed to be answered. The first is an assessment of the effects of the break up on cash flows, growth and risk and the resulting effect on value. The second, and just as important, step is deciding on why the company needed to break up to accomplish these changes:
    a. The Value Effect
    In the table below, I do fairly simple (and simplistic) valuations of HP as a consolidated company and the broken up pieces:
    Note that the broken up businesses reflect the characteristics of the consolidated company with low growth and reinvestment, but the broken up units have a value that is $31.85 billion higher than the consolidated company. Magical, right? Before you get too excited about the value creation, almost all of the value addition here comes from the upfront assumption that the operating income of the pieces will be $2.8 billion higher than the consolidated company’s income. If you believe that HP has $2.8 billion in annual operating costs that are truly wasteful, the break up will add value, but only if the break up is a prerequisite for the cost cutting to happen.In this final part, that is the question that I explore by looking at what the value increase will be as a function of how much of the $2.8 billion will really be cut and how much is mirage that will manifest at the new HP pieces. To estimate the effect, I considered different estimates of the cost savings and the impact on value. Thus, if there are no cost savings, the value change goes to zero and as the cost savings increase as a percent of $2.8 billion, the value effect of the breakup also increases:
    Annual Cost Savings
    Value Change
    $0.00
    $0.00
    $500.00
    $601.00
    $1,000.00
    $7,386.00
    $1,500.00
    $14,170.00
    $2,000.00
    $20,936.00
    $2,500.00
    $27,738.00
    $3,000.00
    $34,522.00

    You can check for yourself, by downloading the spreadsheet that I used and tweaking or changing the numbers that you think I got wrong.

    b. The need for a break up
    Even if we take HP at its words and accept their argument that the break up will lead to significant cost cuts and lay offs, the question is why these cost cuts and layoffs cannot be carried out by the consolidated firm. Looking at the possible explanations, I don't see any of them holding up to scrutiny:
    1. Bad management: It is entirely possible that the existing management at HP was aware of its bloated cost structure and chose to do nothing (or very little) about it. The problem with this rationale is that the broken up units will be run by the same management (Meg Whitman and Dion Weisler) that run the consolidated company. 
    2. Culture: It is possible that Meg and Dion wanted to cut costs but that they were unable to do so because of the HP culture (which has historically focused on growth and innovation). While it is possible that the ghosts of Bill Hewlett and David Packard inhabit HP headquarters but the story would have more resonance if the new units had made a clean break with the HP culture. (At the minimum, would it not have made sense to give them names other than HP?)
    3. Regulatory considerations or other restrictions: As far as I can tell, there are no obvious restrictions on HP laying off employees or cutting costs. The only peripheral concern may be that HP has its corporate base in California, a state with more stringent restrictions on corporate actions than most others in the US. For this story to have any play, though, one or both of HP's units would have had to move its corporate base elsewhere.
    4. Financial leverage and taxes: While debt always seems like a gimme when it comes to value enhancement, the debt ratio of 19% that is borne by the consolidated HP is greater than the debt ratios of the two sectors that its units will inhabit. Hence, if there is significant borrowing capacity that will be unleashed by this break up, I don' see it. It is also possible that this break up is a cover for a tax inversion, where one or both of HP's units will move overseas, but I seriously doubt it.
    In summary, even if HP is right about the potential for cost cuts in the company, the break up seems to be an elaborate and unnecessary mechanism to make it happen. 

    Pricing the Break up
    As I noted in my earlier post, the motivation for a break up may have nothing to do with value and everything to do with price. By breaking up, a company may find itself priced more highly because investors reprice the parts to yield a higher aggregate value than the consolidated company. Revisiting the reasons for this repricing, I am hard pressed to find a good one:
    1. Market mistakes: It is possible that the market is under valuing HP but it is difficult to argue that this is because the market is significantly misplacing in one of the pieces. The reality is that neither part of HP (business services or computers/printers) has been doing well and that the market is building in the expectation of continuing revenue decline and margin compression. 
    2. Contaminated parts: Neither part of HP carries toxic attachments that may drag the company down. In fact, the most toxic parts of HP are the acquisitions that it has done in the last five years and breaking up into two businesses is not going to stop that predilection. 
    3. Simplicity story: Is HP much simpler to value as two businesses than as one? I don’t think so. The businesses are not vastly different in their risks and cost structures and on the face of it, there is little to be gained from having two independent units that you could not have gleaned from the consolidated enterprise.
    There is a cynical rationale for the break up, which is that it might be exploiting the laziness of equity research analysts, who like to use broad metrics (EBITDA) and the tunnel vision that they bring to their comparisons. Just to provide an illustration of the potential payoff, I looked at repricing HP's units, using the median revenue and EBIT multiples of the sectors that I thought they best fit in:


    Do I believe that HP's price will triple if they break up? Not for a moment, but I would not blame HP's management for trying to play this game, where they hold forth the most desirable operating metric for each unit (revenues, EBITDA, EBIT) and push analysts towards the sector that delivers the highest multiple of that operating metric. I don't think it will work because HP is being priced as a no-growth, declining-margin company now and breaking it up into two no-growth, declining-margin companies does not change the calculus. 

    Bottom line
    Your assessment of this break up boils down almost entirely to whether you think that there will be cost savings from the break up and how big and lasting those savings will be. I am skeptical. I think that the company is over estimating its capacity to cut costs, finesse capital structure and grow in the future and I am afraid that it is carrying bad (value destructive) habits with it into the new ventures. I am also unclear about why there has to be a breakup of the company for their cost savings to manifest themselves. I don't see a significant potential for a pricing correction from the break up, either, since there are no radical differences between the two units and very little clarity added by the break up. 

    Attachments:



    "If you build it (revenues), they (profits) will come": Amazon's Field of Dreams!

    I have a long standing fascination with Amazon from its inception as a dot-com poster child in the late 1990s to its current standing as online retailer to the world. I have always liked the company's willingness to challenge established rules on how business should be done and admired Jeff Bezos for being to willing to leap into places where others only tip toe. As an investor, though, I have found the company to be cheap at times in the last 15 years and expensive at others, and the most recent earnings report led me to revisit it, partly to examine whether the market's negative reaction to the most recent earnings report was appropriate and partly because I may learn something.

    A short history of Amazon
    For those are twenty five or younger, it is hard to imagine a world without online retailing, in general, and Amazon, in specific, but it was just over 20 years ago (in July 1994), that Amazon was founded by Jeff Bezos in his garage, continuing the long tradition of garage-founded companies in the United States. The company caught the dot-com wave of the late 1990s and was listed on the NASDAQ in 1997. Initially focused on book retailing, the company remained small in operating numbers, relative to other retail giants, and generated only $1.6 billion in revenues in 1999, while reporting an operating loss of almost $600 million. Its market capitalization, though, rocketed up (with the rest of the dot-com sector), hitting $ 35 billion in early 2000. In fact, it was one of the companies that I used as a prop for a book I had on valuing young, technology companies. At the risk of gravely embarrassing myself, this was my valuation of Amazon in January 2000, close to its peak:

    My valuation of Amazon in January 2000 (The Dark Side of Valuation)

    It is never flattering to the ego to compare actual to forecasted numbers, especially for young growth companies but it is a process that has never bothered me, because it comes with the territory. I compare my forecasted revenues & operating income for Amazon (from my January 2000 valuation) to the actual revenues & operating income for the company (from 2000 to 2013) in the table below.
    Comparison of my forecasts in 2000 to actual numbers

    I will cheerfully confess that I did not have the foresight to predict the behemoth that Amazon would become in retailing and the tentacles that it put into other businesses (including media and cloud data) but my forecasted revenues were higher than the actual numbers every year through 2010. Since 2010, though, the company has blown the lid of my revenue forecasts but that outperformance has come at a price. I may have been pessimistic in my assessments of Amazon's capacity to scale up its revenues, but I was also overly optimistic in assuming that it would find a pathway to strong profitability. After mounting a steady improvement in margins in the first half of the last decade, the company seems to have relapsed in the last few years. 


    A Field of Dreams company
    A couple of years ago, James Stewart wrote an article in the New York Times, using Amazon to draw a contrast between short-term markets and long-term managers. The discussion about whether markets are short term and if so, why, is one well worth having, but I took issue with Mr. Stewart on his use of Amazon as an example of short term markets. In fact, I would argue that markets have been extraordinarily forgiving of Amazon's long loss-making history and have given Mr. Bezos breaks that very few companies have received through time. If anything, they have been too "long term" in their thinking, not too "short term".

    In keeping with my obsession with popular culture, the movie that comes to mind whenever Amazon reports yet another earnings report, with strong revenue growth and decreasing profits, is the Field of Dreams, with this scene, in particular, playing out.


    As I see it, Jeff Bezos has built the ultimate field of dreams company (and I don't mean that in a dismissive way), where he has sold investors on the notion that if he builds revenues up, the profits will come. The losses at Amazon are thus a deliberate consequence of the way the company approaches business, selling products and services below cost and with lots of hype, with the intent of inserting itself in peoples' lives so completely that they will be unable to abandon it in the future. To provide a simple illustration of this process, consider one of Amazon's most successful services, Amazon Prime, to which I am a subscriber. At $99/year, it is a bargain, since the shipping costs I save vastly exceed the cost of the service. While that may reflect my family's profligate spending habits, there is some evidence in Amazon's own financials that the cost of providing this service significantly exceeds the revenues that they collect from it. In the figure below, I compare shipping revenues and costs reported by Amazon each year for the last few years.

    From Amazon financial filings

    Not only has Amazon lost billions on shipping each year, but its losses have become larger over time.  In fact, you can take many of Amazon's recent innovations (including the Kindle) and put them to the profitability test and will find them falling short. I am sure that Amazon's cheerleaders will argue that both the Prime and Kindle create synergistic benefits to Amazon, but that argument would have more resonance, if the company made money in the aggregate.

    Valuing Amazon
    At this stage, the value of Amazon rests on how much you trust the vision that Jeff Bezos has for the company and whether you believe in his capacity to fulfill that vision. In fact, the value of Amazon will be largely determined by your assumptions about revenue growth and operating margins. To provide perspective, let’s start by looking at where Amazon falls in the competitive spectrum by looking at the retail sector as a whole. In the table below, I list the ten largest retailers in the US and globally, in terms of revenues:
    Largest Retail Companies: Trailing 12 month data (on 10/29/14)
    Note that while Amazon makes the top ten lists in terms of revenues both in the US and globally, it lags in terms of profitability with paper-thin operating margins.  To get a measure of profitability in the retail sector, I estimated operating margins (converting leases to debt) for all retail firms and report the distribution in the graph below (for both the conventional pre-tax operating margin, which is operating income as a percent of sales, and a lease-adjusted operating income, where leases are converted to debt).


    Since many of the firms in this sample are small, with revenues of a billion or less, I looked at the pre-tax operating margin for firms in different revenue classes and the results are not surprising, with margins decreasing as revenues increase.
    Source: S&P Capital IQ, Trailing 12 month data (October 2014)
    The median pre-tax operating margin for a US retailer with at least $1 billion in sales is  7.67% and the 75th percentile is 11.99%, but the median operating margin for US retailers with more than $10 billion in sales drops to 5.14% and the 75th percentile is 10.17% (and the 25th percentile is only 2.85%). It is true that Amazon also draws revenues from its media and cloud computing businesses and that the margins are higher at least in the media business. Using a (revenue) weighted average of the operating margins across the businesses (with the weights based on Amazon's mix of media and retail) yields values of 4.35%, 7.38% and 12.84% for the 25th percentile, median and the 75th percentile.

    If you assume that Amazon will continue its steep revenue growth into the future (and is able to grow revenues to about $250 billion by 2024) and that its operating margin will converge on the weighted median operating margin for the retail and media sectors (7.38%), the value of equity that you obtain is about $81 billion (or $175/share). You can download the spreadsheet that contains the Amazon valuation. If you are bullish on Amazon, at its current stock price, you have to be either be expecting even higher revenues (than $250 billion) in 2024 than or much higher steady state margins (than 7.38%), with the best-case scenario being one where Amazon continues growing revenues significantly, driving its competitors into bankruptcy, and then uses its market power to charge higher prices and generate high profit margins. Thus, assuming a 12.84% operating margin (the weighted average of the 75th percentiles), in conjunction with the revenues forecast in the base case, would yield a value per share of $345/share, higher than the current stock price of $295.

    Rather than play scenario games, I chose to vary revenue growth and operating margins to see the combinations that deliver values (shaded in yellow) that exceed the current stock price ($295) in the table below:

    I draw three lessons from this table. The first is that there are pathways that Amazon can follow that deliver values greater than $292 but they are narrow and require a combination of high revenue growth and high operating margins, and some of these combinations may expose the company to anti-trust action down the road. The second is that the variable that makes the bigger difference is the operating margin, not revenue growth. In fact, if the margin stays at 2.5%, higher revenue growth causes value to decline as the cost of increasing revenues (acquisitions and reinvestment) exceed the benefits. The breakeven operating margin at which growth even starts to create value is about 4%. and if the operating margin stays at 7.5% or lower, you cannot get above the current stock price, even with Walmart-like revenues. The third is that the potential for explosive returns is low, given the current stock price. While there are combinations of revenue/margin that deliver values well above $295, they seem improbable, requiring Amazon to have revenues like Walmart and margins like Lululemon.

    Bottom line
    In a world of cookie-cutter CEOs, uninspired and uninspiring, eager to please analysts (rather than investors) and playing the me-too game (You can buy back stock, me too! You can do acquisitions, me-too!), Jeff Bezos offers a refreshing contrast. He has a vision for Amazon, has communicated it to markets with passion and has acted consistently with that vision, and has been rewarded by markets with a high market value for his company, even in the absence of profitability. However, the peril with charismatic CEOs is that the strength and single-mindedness that make them so successful can become weaknesses, if they start believing the hype. As a consumer, I am delighted that I get Amazon Prime for $99 a year, that the Kindle costs a lot less than an iPad and that I can (though I don’t plan to) pick up the Amazon Fire for nothing, but as an investor, this is not a winning game.  Mr. Bezos has delivered on half of his field of dreams vision by building up the revenues for Amazon, but the other (and more difficult) half of the vision requires that the “profits” arrive. Much as I would like to believe in miracles, it will take far more work to make Amazon profitable than it will to make Shoeless Joe Jackson show up in a cornfield in Iowa!

    Attachments
    1. Amazon 10K from 2013
    2. Amazon 10Q from September 2014
    3. Amazon Valuation (Late October 2014)
    4. Global retail companies (revenues & margins)
    5. Global media companies (revenues & margins)



    Go where it is darkest: When company, country, currency and commodity risk collide!

    You learn valuation (and find out how much you don't know) by valuing businesses and companies, not by talking, reading or ruminating about doing valuation. That said, it is natural to want to value companies with profit-making histories and a well-established business models in mature markets. You will have an easier time building valuation models and you will arrive at more precise estimates of value, but not only will you learn little about valuation in the process, it is also unlikely that you will find immense bargains, because the same qualities that made this company easy to value for you also make it easier to value for others, and more importantly, easier to price.

    I believe that your biggest payoff is in valuing companies where there is uncertainty about the future, because that is where people are most likely to abandon valuation first principles and go with the herd. So, if you are a long-term investor interested in finding bargains, my advice to you is to go where it is darkest, where micro and macro uncertainty swirl around every input and where every estimate seems like a stab in the dark. I will not claim that this is easy or comes naturally to anyone, but I have a few coping mechanisms that work for me, which I describe in this paper

    While I enjoy valuing companies with uncertain futures, there are cases where my serenity about valuation is disturbed by the coming together of multiple uncertainties, piling on and feeding of each other to create a maelstrom. In this post, I want to focus on two companies, one Brazilian (Vale) and one Russian (Lukoil), where bad corporate governance, a spike in country risk, currency weakness and plunging commodity prices have conspired to devastating effect on their stock prices. You could adopt the very dangerous contrarian strategy that Vale and Lukoil must be cheap simply because they have dropped so far, but I don't have the stomach for that. I do believe, though, that if I can find ways to grapple with this risk, there may be opportunity in the devastation.

    Background, history and market standing

    Vale is one of the largest mining companies in the world, with its largest holdings in iron ore, incorporated and headquartered in Brazil. Vale was founded in 1942 and was entirely owned by the Brazilian government until 1997, when it was privatized. In the last decade, as Brazilian country risk receded, Vale expanded its reach both in terms of reserves and markets well beyond Brazil, and its market capitalization and operating numbers (revenues, operating income) reflected that expansion. 
    In US dollars
    Notwithstanding this long-term trend line of growth, the last year has been an especially difficult period for Vale, as iron ore prices have dropped and Brazilian country risk has increased (leading into a presidential election that was concluded in October 2014). The graph shows Vale's stock price over the last 6 months (and contrasts it with another mining giant, BHP Billiton).


    While declining commodity prices have affected both companies adversely, note that Vale’s stock price has dropped more than twice as much as BHP’s stock price has. In fact, Vale has lost approximately $130 billion in market capitalization since 2010.

    Lukoil is a Russian oil company that has seen its profile, market capitalization and revenues rise as Russia's oil production has surged. While the company is not owned by the Russian government, it does have close ties to the Russian power structure and that connection, which has served it well during its lifetime, has become a liability in the aftermath of the Russian adventures in the Ukraine, compounded by the collapse of oil prices in the last few weeks: 
    In US dollars
    Though there are fundamental reasons for the stock price decline at both Vale and Lukoil, the fear factor is clearly also at play, because these companies are exposed to risk not only to commodity and country risk but there are also significant concerns about corporate (or is it political) governance at both companies as well as currency risk factors (as both the Brazilian Real and the Russian Ruble have slid over the last few months).

    Corporate governance risk
    In a post on Alibaba, I made the argument that corporate governance affects value by making it more difficult (if not impossible) to change management, and thus increasing the risk that a company that embarks on the wrong course may continue on that path unchecked. With both Vale and Lukoil, there are both explicit and implicit reasons to believe that investors in these companies will have little or no say in how the company is run. 

    The place to start analyzing corporate governance is the ownership structures of the company. With Vale, the first sign that corporate governance is weak is the fact that they have two classes of shares (and yes, I would make this argument about Google and Facebook as well). In the graph below, I break down the top stockholders in both classes.


    The common stockholders, who control the composition of the board of directors and the voting rights of the company, are held by Valepar, a shell entity controlled by inside investor groups. If you own Vale shares, as I do, it is very likely that you own the non-voting preferred shares and that you have no say in who sits on the board of directors and how the company is run. There is also a wild card in this equation in the form of a golden share that is owned by the Brazilian government, giving it veto power over major decisions and the line between corporate and political governance becomes a fuzzy one. While Vale is nominally an independent company, the Brazilian government reserves the right to intrude in its management, and that power can be used to good and bad effects. The positive is that it gives Vale a leg-up on competition in Brazil, giving it first dibs on Brazilian reserves of iron ore, and the negative is that the company can become a pawn in political games. Much of Vale's success in the last decade came from a willingness on the part of the Brazilian government to give it free rein to be run as a profit-making entity, but the machinations leading up to the last election (where the incumbent, Dilma Roussef, was viewed as more likely to interfere in the company's operations) have taken their toll. (The damage has been even greater at Vale's dysfunctional twin, Petrobras, Brazil's oil company). 

    Lukoil's ownership structure provides some clues to both why it has been successful and the potential corporate governance nightmares ahead. The good news is that Lukoil has only one class of shares outstanding, with equal voting rights, but the bad news is that it is not quite clear whether you will ever get to vote for meaningful change, making it akin to a Russian political election:
    Source: Bloomberg
    The lead stockholder is Vagit Alekperov, formerly Russian deputy minister for oil production. It is entirely possible that he accumulated substantial knowledge about the oil business, while in the ministry, and brought that knowledge and entrepreneurial zeal into play in founding Lukoil, but it is also likely that he used his connections with the power elite to get reserves at well below fair-market prices in building up the company which would make him obligated to maintaining good relations with the inner circles of Russian government. In September 2004, ConocoPhilips bought 7.6% of Lukoil's shares to create what it termed a strategic alliance, which it increased to close to 20%, before selling its stake in 2011 at an undisclosed price, partly to Lukoil and partly in the open market. It is a sad commentary on corporate governance in Russia, that Lukoil, in spite of its flaws, is a paragon of stockholder accountability, relative to most other Russian companies. Notwithstanding this relative standing, if you are considering buying shares in the company, it should be with the recognition that you will have no role in how the company is run (no matter what you read about corporate governance on the company's website). 

    Country risk
    While investing is always risky, it is riskier in some countries than others, partly because of where the countries are in terms of its life cycle (with growing emerging markets being more volatile than established mature markets), partly because of the overlay of political risk in the countries and partly because of the effectiveness or lack thereof of legal protection and enforcement of property rights. When valuing companies, you have to factor in where the company operates to measure its exposure to country risk and incorporate that risk into an expected return.

    As a commodity company, Vale does sell into a global market and as a producer of iron ore, it gets a significant portion of its revenues from China, which is the largest consumer of iron ore in the world. The country of incorporation in Brazil, and Vale is exposed disproportionately to Brazilian country risk not only because a significant proportion of its reserves are in Brazil, but also because the government has powers to intrude in the day-to-day running of the business. Not surprisingly, Vale has been affected  by changes in perceptions of Brazilian country risk. Using the sovereign CDS spread for Brazil as a proxy for country risk, and looking at the last decade, here is what we get. As Brazilian country risk has declined over much of the last decade, Vale benefited, but country risk is a double-edged sword. As Brazilian country risk has risen in the last few weeks, Vale has felt the pain in the market:

    It goes without saying that Lukoil, which has 90.7% of its reserves in Russia, is affected by Russian country risk. Here again, the last decade has been a good one for both Russia and for Lukoil, as lower country risk (measured with the CDS spread) for the former has gone with higher market capitalization for the latter. To investors who were expecting more of the same, this year must have been a shock, as Russian country risk surged in the aftermath of the events in the Ukraine.

    In both companies, country risk has clearly played a role in the drop in stock prices. With Vale, at least, it cannot explain the entire price drop, since Vale has dropped more than the Bovespa over the last few months and a lot more than the index over the last few years. With Lukoil, a greater portion of the blame can be attributed to country risk.

    Currency risk
    When valuing individual companies, it is generally good practice not to be a currency forecaster and to value the company based upon prevailing exchange rates (current and forward, from the market). It is also undeniable that currency movements in your favor will make a bad investment into a good one, just as currency movements against you can turn a good investment into a bad one. 

    With Vale, the stage was set in a decade where the Brazilian Real strengthened against the US dollar, even though inflation in Brazil was much higher than inflation in the US. As with country risk, the currency risk dragon has turned on investors and the last few weeks has seen a meltdown in the value of the Brazilian currency.
    Source: Bloomberg
    The story is similar for Lukoil. A decade of a strengthening ruble, in spite of fundamentals that would suggest otherwise, has been followed by the collapse in the last few months.
    Source: Bloomberg
    While the immediate effect of a currency decline is that your investment in these companies will be worth less in US dollar terms (simply because of the translation effect), it is debatable what the effect of a weakening currency will be on both companies over time. To the extent that their reserves are in Brazil (at least for iron ore, for Vale) and in Russia (for Lukoil), the costs are in the local currencies but their revenues are in global markets, denominated in US dollars. Thus, a weakening of the currency can improve profit margins and increase value.

    Commodity price risk
    Do commodity prices affect the value of commodity companies? Stupid question, right? Of course, they do, but the degree of impact can vary across companies. Higher commodity prices will generally push up revenues and to the extent that the cost of developing reserves stays stable, operating margins will increase. In some cases, though, and especially so with oil companies, the government can use a heavy hand (see political risk in the corporate governance section) and force the company to sell oil at subsidized prices to consumers in the country, effectively creating a subsidy cost for the company that will increase with oil prices. 

    Vale's fortunes have risen as the Chinese economy has grown, primarily because China has become the largest consumer of iron ore in the world. It is robust Chinese growth that lifted iron ore prices in the last decade to hit highs in 2011, but that engine has slowed and as it has, iron ore prices have dropped in the last two years: 

    This history shows why making a judgment about a normal price for iron ore is so difficult to do. If your historical perspective is restricted to just the last few years, the current price of iron ore (about $75/tonne) is low but extending that perspective to cover a longer time period (say 20-25 years) may suggest otherwise.

    Lukoil also benefited from the increase in oil prices in the last decade, driven partly by geopolitics and partly by the explosive surge in automobile sales in emerging markets. Here again, though, the last few months have seen a decline in oil prices to less than $80/barrel. 
    Source: Bloomberg
    As with iron ore, the question of whether oil prices have dropped below a normal price is largely a function of perspective, with the answer being yes, if you have 2 or 3-year perspective but not if you have a ten-year or longer perspective. 

    While it is easy to make the argument that commodity prices move in cycles and that what goes down has to go back up again, these cycles are unpredictable and can stretch over long time periods. Thus, you could have spent the entire 1980s waiting for oil prices to go back up, just as you would have waited the entire last decade for the drop back in prices.

    Valuing Vale 
    The value of Vale is a function of company, country, currency and commodity risks. To capture the effects, I valued Vale in US dollar terms and assumed that Vale was a mature company, growing at 2% a year in perpetuity. I varied the following inputs:
    1. Operating income: The operating income in the trailing 12 months, through November 2014, was $12.48 billion, well below the operating income in the last fiscal year ($17.6 billion) and the average operating income over the last five years ($17.1 billion).
    2. Return on capital: The return on capital in the last 12 months was 11.30%, higher than the cost of capital that I estimated of 8.59%, but lower than the return on capital in the most recent fiscal year (14.90%) and the average over the last five years (18.22%)
    To estimate the cost of capital, I built off the US 10-year treasury bond rate as the risk free rate and used an equity risk premium of 8.25%, reflecting a weighted average of the equity risk premiums across the countries where Vale has its reserves (60% are in Brazil). You can check out the spreadsheet yourself and change the numbers. I have summarized the valuation in the picture below.


    Note that I have attempted to incorporate the effect of commodity price declines and currency devaluation in the base-year operating income, choosing to value the company, using the depressed income from the last 12 months. The effects of corporate governance are captured in the investment and financing choices made by the firm (with reinvestment and ROIC measuring the investment policy and the debt mix in the cost of capital reflecting financing policy). Finally, the country risk is incorporated into the equity risk premium (where I used risk premium weighted by the geographic distribution of Vale’s reserves) and the default spread in the cost of debt. The value per share that I get with this combination of assumptions is $19.40, well above the share price of $8.53 on November 18, 2014.

    It is entirely possible that I am under estimating how much further iron ore prices can drop and the damage that the Brazilian government can (to Vale, the Brazilian real and to country risk). I tried varying the numbers to see the impact of changes in my inputs on the value per share:


    I am sure that I am missing something but at the stock price of $8.53 on November 18, 2014, it looks grossly under valued. Even in my worst case scenario, where operating income drops another 20% from the already depressed LTM number and the company earns only its cost of capital from this point on, my value per share is $13.60.

    Valuing Lukoil
    I followed a similar path for Lukoil. In my base case, I left operating income at 20% below the estimated 2014 and valued the firm as a stable growth firm (with a 2% growth rate) and with a cost of capital that reflects an updated equity risk premium for Russia (9.50%). Even if I assume that oil prices drop by another 20% and that the standoff over Ukraine will not end soon (translating into higher equity risk premiums), the value per share that I get is $50.56, higher than the stock price of $45.30.

    At $45.30 a share on November 18, 2014, I am again either missing something profound or the stock is massively under priced. Here again, you can download the spreadsheet and make your own choices.

    What now?
    It is easy to come up with reasons not to buy Vale and Lukoil right now and wait for things to get better. Could things worse? Of course? With Vale, there are two Doomsday scenarios. In the first, and I hope that this does not happen, more for the sake of my Brazilian friends more than because of concerns about my investment portfolio, Brazil could become Argentina, with spiking country risk and shaky ownership rights. In the second, Chinese infrastructure investment comes to a standstill and iron ore prices drop back to pre-2003 levels. I think that these are low-likelihood events and that is precisely why I already own Vale (and I am not in the least bit ashamed to admit that I bought my shares at $12/share) and plan to add to my holdings.

    With Lukoil, there is the Putin wild card, where the troubles in Ukraine expand into Poland, Hungary and the rest of the old Soviet empire. That, combined with a collapse in oil prices, would make me regret my investment, but I plan to buy Lukoil to my portfolio, and live with the discomfort of having no power to exert change. After all, at the right price, you can live with a lot of discomfort!

    If you are tempted to complain about how much uncontrollable risk you face investing in Vale and Lukoil, keep in mind two facts. The first is that they are bargains precisely because of the uncertainty, as global investors flee from he companies, abandoning good sense along the way. The second is that it could be worse, since you could be holding Petrobras (instead of Vale) and Rosneft (instead of Lukoil) where the concerns are multiplied.

    Attachments:
    Vale: Financial Summary (Historical)
    Lukoil: Financial Summary (Historical)
    Valuation of Vale (November 2014)
    Valuation of Lukoil (November 2014)



    Twitter's Bar Mitzvah! Is Social Media coming of age?


    Life's transitions, from single to married, from renter to homeowner, and from employed to retired, just to name a few, are never easy, since the rules change, as do the measures of success and failure and that is perhaps the reason that they are accompanied by ceremonies (weddings, housewarming, retirement parties). The life of a business is also full of transitions, and not only are they just as difficult for investors, traders and managers, but they often occur without ceremony, and can go unnoticed. In the last three years, social media companies have claimed center place in market conversations, first when they went public at prices that old-time value investors found inconceivable, and then as their ups and downs became part of market lore. In the last few weeks, we have seen this fascination with social media companies play out again, first in the market reaction to Mark Zuckerberg's post earnings statements about Facebook's future investment needs and then in Twitter’s struggles to reclaim its narrative at its analyst meeting last week. I get a sense that we are on the cusp of a transition, where the time for pure story telling (and its metrics) is ending and more traditional metrics (revenues, profitability) will come to the fore. That does not presage, as some are suggesting, the end of the social media party and a collapse of social media market capitalizations, but it does mean that investors, traders and managers have to recalibrate to a different game, where they will be judged not on pure sector momentum but on their capacity to cull winners from losers and find the right metrics for making those judgments.

    The Business Life Cycle: Investing and Valuation Dynamics
    In an earlier post, I made the argument that the center of gravity in both valuing and pricing shifts as a business evolves from an idea to a product to a profit-generating business. The figure below summarizes those shifts and expands on the implications.


    When a business is at the idea stage, both value and price are driven by market potential and by narrative, rather than numbers. As the business transitions to a product phase, the questions become more specific, with both investors and traders looking at how well the product/service attracts customers, with usage statistics driving pricing. Further along the life cycle, the test becomes whether usage can be converted to revenues and revenues to profits, with numbers driving narrative. The table also highlights what I see as the biggest dangers at each stage of the life cycle. In the early phases, the dependence on the macro story (the macro delusion) can lead investors to value companies in a promising market too highly, in the aggregate. The perils become more company-specific as you move through the life cycle. 

    The Social Media Reality Checklist
    The social media sector is a young one, with even its most established companies are still only a few years old, even if you throw Google into the mix. In the last three years, the first wave of social media companies have been listed in public markets and investors have had to price them. Using the life cycle framework developed in the last section, these companies were priced using “macro” stories about market potential (online advertising) generally, with revenue drivers (number of users, subscribers or downloads) more specifically determining market standing. That is neither surprising nor irrational, and reflects what investors have typically done in other young sectors (dot com in the 1990s, for instance) in the past.

    As the social media sector ages (and technology companies should have their lives measuring in dog-years, aging much faster than the rest of the market), the question becomes whether we are approaching a transition point, where investors start asking more pointed questions about revenue growth (and what it is costing) and profitability. I may be jumping the gun but the market’s shocked reaction to Mark Zuckerberg admitting that Facebook will be spending a lot to generate growth and Twitter’s attempt to sharpen its narrative suggests that the shift is close.  Consequently, if you are an investor, a potential investor or manager in a social media company, it is time for a reality check, both to prepare for the transition and to make better decisions.  While these reality checks will vary across social media companies, there are a few that I think apply specifically to those that are in the online advertising space. 
    1. We don't know much about the effectiveness (or lack thereof) of social media advertising:  While companies have jumped on the social media advertising bandwagon, the evidence on whether it is effective is mixed, partly because it is still too early to pass judgment. It is true that social media sites can use the information that they have accumulated about users to sharpen advertising focus, but I have not found many comparative studies that indicate that social media advertising is more effective than traditional (television or other) advertising. As someone who has never clicked on a sponsored tweet and finds them intrusive, I may be out of the loop, but I would be glad to hear from anyone who has strong evidence on this issue. In fact, surveys of advertising executives at the companies that use social media advertising show that they are just as unsure about this experiment and are withholding judgment.
      Source: Mashable, Does Social Media Advertising Really Work?
    2. The online ad market is growing but it is finite: At the risk of stating the obvious, the total advertising market is a finite one, since it is a cost item to (advertising) businesses, who have to watch their bottom line. It is true that online advertising is a growing part of the total advertising budget, but it also, by definition, finite. One troubling aspect of the sales pitches for social media companies that I have heard over the last few years has been an unwillingness to be specific about the size and limits of the online advertising market. Last year, when I valued Twitter for its IPO, a company that was promoted for its online advertising potential, I examined this question by looking at both the size of the overall advertising market and what percentage of it was in online (digital) advertising. Recapping and updating, global advertising revenues have grown about 4% a year for the last 5 years, and online advertising has surged from less than 5% of total advertising revenues, in 2008, to 25.76% of revenues, in 2014, with an increasing portion attributable to mobile advertising. Allowing for growth in the total advertising market and an increase in the online advertising share of it yields an estimated market of between $209 billion and $323 billion for the entire online advertising market in 2023. It is this market that social media companies are competing for and the revenues for each of them has to be measured against this whole.

    3. The Online Ad market is getting more competitive: The growth potential of the online advertising market is attracting new entrants, some of whom are still private (like Snapchat) and some in the process of being created. While much of the initial growth in social media companies has come at the expense of other types of advertising (print media, in particular), growth will become harder to find as online advertising becomes a larger piece of the pie. It is a given that at some point, sooner rather than later, the revenue growth at one online advertising company will have to come at the expense of another online advertising company. Thus, if you assume that Twitter will have revenues of $35 billion in a decade, you will then also have to identify the losers in the market (Facebook? Google?). This additional competition will also lead to pressure on operating margins, with companies cutting prices to get revenue growth, making the trade off between revenue growth and profitability front and center. 
    4. Growth will become more expensive and the accounting will remain opaque: As social media companies compete for a slower-growing online advertising market, they will have to reinvest more to generate growth. That reinvestment, though, will often take forms that accountants still do not categorize as capital expenditures and will not show up in balance sheets (as assets) or on cash flow statements (as capital expenditures). It will take the form of R&D, customer acquisition costs, product development costs or acquisitions of other companies in the space (often with stock, rather than cash) and none of these are dealt with well or consistently by accountants. Customer acquisition costs, R&D and product development costs are treated as operating expenses (when they should be considered to be capital expenditures) and stock-based acquisitions often disappear into thin air (or the footnotes to financial statements). The result of this confusion is that financial statements for social media companies don’t measure what they claim to: income statements do not measure earnings, balance sheets do not reflect the assets owned and the capital invested to get them and cash flow statements are skewed by the use of equity (to compensate employees and pay for new investments).
    While all of these have been true for the entire existence of social media companies, they can be glossed over in the early phases but cannot (and should not) be overlooked as companies age.
    Market Consequences
    If you buy into the notion that a transition is coming, there are predictable consequences for investors and markets:
    1. Unexplainable volatility: During transition periods, there will be struggles that play out in markets between investors on either side of the transition, some holding on to the old metrics and measures and others moving on to new metrics. With social media companies, the former will include investors who still focus on users and user intensity measures to price companies, whereas the latter will look at revenues, investment and earnings. The market will reflect this schizophrenia on the part of investors, with wild and completely unpredictable swings in prices, as one group or the other tries to assert its dominance.
    2. Market shake out: As the focus shifts to revenues and earnings, the market will start culling the herd, knocking down the prices of the losers and sustaining the pricing of the winners. The game will change for both traders and investors; traders will no longer be able to ride sector momentum (as they can in the early phases of a life cycle) and investors will find a bigger payoff to focusing on fundamentals. 
    3. Macro to micro focus: When a sector is young, the game belongs to the story tellers and especially those who tell macro stories (about shifts in the business and disruption). As the sector matures, it shifts to those who bring the more prosaic skills of assessing individual companies to the forefront.
    If this is a transition, there is stormy weather ahead but that can work to your advantage, and if you can keep your wits and make it through, you will be rewarded.
    Advice (unsolicited and perhaps unwelcome) for social media companies
    If life cycle transitions are difficult for traders and investors, they can be even more shocking for managers and especially so for those who were successful playing the old game. With social media companies, for instance, where increasing the number of users and user intensity has created positive payoffs for the last few years, managers will have to change how they manage companies, what they emphasize in earnings reports and how they frame their narratives. This is not going to come easily or without pain, even for the most successful and adaptable managers . I know that the they will get lots of advice (and will pay for it) from consultants and bankers, but here is mine, if they care:
    1. Manage for investors, not analysts: Don't operate under the presumption that the equity research analysts that tout your stock are market leaders and trend setters. Equity research analysts are more followers than leaders, creatures of momentum rather than arbiters of value and catering to their fickle demands will not protect your stock from getting battered, if the market mood turns.
    2. Be open about investment needs and market challenges: Growth is never free and while there are some investors who are willing to be deluded, most sensible investors would prefer honesty from you, where you lay out the costs that you think you will bear in your pursuit of growth. It is this context that I think Mark Zuckerberg was right to admit what should have been obvious from past history. Facebook is spending large amounts of money to maintain its pathway to dominance of online advertising. (After all, they just spent $22 billion consummating the Whatsapp acquisition.)
    3. Be transparent in your accounting: Dispense with the games that you may have played in the past. Stop adding back stock-based compensation to come up with adjusted EBITDA and acting like acquisitions made with stock really cost you nothing. It is true that accounting rules are neither logical nor consistent and that you may be bound by them in preparing your financial statements, but your pro-forma statements can be used to reveal more about your business (rather than to obscure it).
    It was through these lens that I looked at Twitter's presentation to analysts  during Twitter Analyst Day in San Francisco. While Anthony Noto, Twitter's CFO, may have impressed investors (to cause the price to jump 7.5%), old habits die hard and the presentation violates all three of my suggestions: the talk was tailored to analysts (violating rule #1), there was no mention in the presentation of how much Twitter will have to spend to grow (violating rule #2) and the report culminated with the obligatory adjusted EBITDA (completing the violation trifecta). There were, however, moments of substance, especially on what the company sees as its revenue path for the long term. In addition to presenting tweaks to the product (improved time line, boosting video and improving interaction), Mr. Noto announced that the company intended to be "one of the top revenue-generating Internet companies in the world", pushing implicitly to be put in the company of Google and Facebook and provided analysts with his projection for Twitter's revenues over the next decade:
    Source: Twitter's presentation at Analyst Day
    I must confess that I was underwhelmed by the end number, and here is why.  In a post in August 2014, I valued Twitter at $22.53/share, with a  projected revenue of almost $15.2 billion in 2024. If the projection in Twitter's own graph for revenues is credible, I may have been a little too optimistic in my valuation; using  a $14 billion revenue estimate in 2024 yields a value per share of $20.81. Put more bluntly, for Twitter to be valued at more than $41.85/share (the price on November 14, 2014), you would need a lot more revenues than Mr. Noto is projecting in this graph for 2024. The table below lists breakeven points to justify today's price:
    Valuation spreadsheet: TwitterAug2014.xls
    Twitter has its work cut out for it. It has to either find ways to grow much faster than it is projecting or it has to work at bringing investor expectations down, with the caveat that there are no soft landings for high-flying companies. If online advertising remains Twitter's primary business, getting the break-even revenues ($30-$40 billion) will be problematic, partly because of external factors (more competition and limited advertising budgets) and partly due to internal constraints (limits on the sponsored tweets users will accept in their time lines). There remains the possibility, perhaps even a probability, that Twitter will be able to find other ways to monetize their user base (retailing, for instance) but that is a work in progress, and the operating margins in these new businesses will not come close to the 25% operating margin that I am assuming for the online advertising business.

    Transition Breaks
    As I watched and read about the Twitter extravaganza, I was reminded of the ancient Jewish tradition (mirrored in other religions) of "bar mitzvah". In that ceremony, a Jewish adolescent "come of age", studying the Torah and with the guidance of a rabbi. The ceremony is designed to put the world on notice that the child has become an adult, with the associated responsibilities and accountability. Realistically, no one expects overnight changes, since a teenager will still be a teenager after the ceremony, but it still serves as an important reminder that the rules are changing. As an aside, the seeking out of venture capital by a start-up can be analogized to a much earlier and more painful ceremony that all Jewish infant boys have to go through, with the pain of giving up a slice of your business going with the relief when it is done.

    Though the notion of a ceremonial coming-of-age for companies may strike you as outlandish, that is the role that getting listed in a  public market played in the decades before the 1990s. Thus, companies like Apple and Microsoft both had established business models before they went public in the 1970s and 1980s. The rules changed in the 1990s, when dot-com companies leapfrogged the process to go public much earlier in the life cycle, and as that trend has continued in the social media space,  investors and managers have invented new (and sometimes bizarre) metrics to cope. It may not be a bad idea to have the equivalent of corporate bar mitzvahs, where investors, traders, and managers are reminded that a company has come of age. My one reservation with Twitter's bar mitzvah was that Anthony Noto, Twitter's CFO, seemed to be playing the role of the rabbi (because of his street cred with analysts) in the ceremony, with equity research reports operating as scripture. I think it is wisdom, not street credentials, that you look for in a rabbi and timeless truths, not passing glory, in your holy books. The Twitter ceremony would have been a lot more persuasive, if Warren Buffett had been officiating, reading out of Ben Graham's Security Analysis. Perhaps, next time!



    Focus Pocus: Is breaking up a cure for corporate attention deficit disorder?

    I could start this post by telling you that some of my best friends are corporate strategists, but I would be lying. I do have a few strategists as acquaintances, but perhaps not after this post. In my cynical view, the primary contribution of corporate strategy seems to be to supply buzzwords that can be used by managers to distract investors and justify the unjustifiable. In an earlier post, I highlighted some of these words of mass distraction, including disruption, synergy and strategic considerations, and argued that the repeated usage of these words by a manager, analyst or investor is a signal that the numbers don't work. In this one, I want to add focus to that list of words, as it shows up with increasing frequency in the context of corporate break ups. In this post, I propose to put focus under the microscope, using EBay (and its proposed break up) as my illustrative example.



    Focus, the new strategic buzzword?
    As we go through another wave of companies breaking up, it is worth remembering that this is not the first time that we have seen this phenomenon, nor will it be the last. Each break up wave, though, comes with its own overriding rationale, that CEOs highlight and journalists then parrot in their news stories. The theme for this break up wave can be seen in the rationale offered by the CEOs of HP and EBay for breaking up:
    “We’re in a better position to get focused companies who can respond more
quickly….
We felt like this was the right time to take advantage of setting up two scaled
 companies who will be a little bit more focused and a lot more nimble.” Meg Whitman, CEO of HP, on CNBC 
    “ This transaction creates two industry leaders, each with significant reach and scale, and will allow us to continue our focus on customers, innovation and execution. …That will allow a greater level of strategic focus, greater strategic agility, and greater strategic flexibility. Simply put, we believe the premium on focus and agility will allow each business to compete and win in this exciting environment going forward. So we can move more quickly and make targeted, focused investments.. So I think, an independent PayPal unequivocally will have the focus and agility to play across the board in this fast moving payment space.” John Donahoe, CEO of EBay, on conference call with analysts
    Notice that the “focus” shows up twice in Ms. Whitman’s brief statement and five times in Mr. Donahoe’s conference call brief. If you count in the use of the words “strategic”,“agility” and “innovation”, the Donahoe statement is strategy-speak, run amok. Taking both Ms. Whitman and Mr. Donahoe at face value, i.e. that breaking up into smaller units improves focus, there would be two questions that I would have for them.
    1. Until a few months ago, both Ms. Whitman and Mr. Donahoe were arguing, just as strongly as today, for keeping their companies as whole companies, using economies of scale and synergy as their strategic arguments. Were they wrong then or are they wrong now? Alternatively, if there were right both then and now, what’s changed? 
    2. If breaking up these companies is supposed to improve focus, these companies must have been unfocused before these break ups. If so, who was running these companies, what were causes for the lack of focus and how would breaking up deal with these causes?
    By being opaque about focus, I think we are missing an opportunity to understand it better and perhaps deliver more value from it. I think that you can look at focus both the perspective of managers and from that of investors. You can look at what caused the lack of management focus before the break up and what will change in terms of fundamentals after the break up (with the resulting effect on value). Breaking up a multi-business company can improve investor focus on the businesses owned by a company and lead to a price effect (even if value does not change).

    Management Focus and Value Enhancement
    The first principles of corporate finance are universal and apply whether you run a single business or a multi business company. The company still has to pick good investments, i.e., investments that generate returns that exceed the hurdle rate, finance these investments with the right mix of debt and equity, i.e., a mix that finds the optimal trade off between the tax benefits of debt and the added default risk created by it and return cash to stockholders (in the form of dividends or buybacks). It is true, though, that putting these principles into practice is more difficult at some multi business companies, on each dimension of corporate finance:
    1. Hurdle rate hiccups: If the businesses owned by a multi business company vary on the risk dimension, it is critical that the hurdle rates used to make investment judgments vary across the divisions (businesses), depending on their riskiness. This fundamental proposition is violated at many multibusiness companies which choose to use one hurdle rate across all their businesses, justifying the practice on the (erroneous) arguments that that is what stockholders in the company demand or that division (business) level hurdle rates cannot be estimated. Not surprisingly, capital misallocation follows, with riskier businesses over investing and safer businesses under investing (and subsidizing the riskier businesses).
    2. Capital structure fuzziness: The capacity of a business to carry debt is determined in large part by its ability to generate cash flows (with higher and more stable cash flows resulting in higher debt capacity), the types of assets owned by the business (with tangible assets providing more debt capacity) and the tax rate that it faces (with higher marginal tax rates leading to more debt). If a multi-business company has businesses that vary on these dimensions, it will have trouble finding one composite debt mix that works across time and businesses.
    3. Dividend policy mismatches: The cash return policy for a business will be driven by its growth potential (with higher growth potential requiring more reinvestment and less cash returns) and the nature of the business (with siome businesses requiring more intensive investments than others). Again, if a multi business company has businesses that vary in terms of growth and reinvestment needs, it may not be able to find a dividend policy that meets its overall requirement. This problem is exacerbated if the company have attracted an investor base that has a particular preference in terms of dividend policy and that dividend policy is at odds with what a business can afford to pay out.
    The argument that breaking up a company can improve capital allocation, allow for a more optimal capital structure and enable fine tuning of cash return policies to match the specifics of individual businesses will have the most resonance at those multi business companies, where the businesses vary widely in terms of risk, growth and asset characteristics. Thus, it will make more sense for a multi-business company that has a real estate division, a retailing unit, a financial service business and a manufacturing segment within its hold, and even more so, if these units are at different stages of the life cycle, than it will for a multi-business company that is in five mature, manufacturing businesses.

    Investor Focus and Price Enhancement
    Just as managers find it difficult to run multi-business companies, investors face challenges in pricing these companies. In particular, the standard rubric for pricing, which is to pick a pricing metric (earnings, book value, revenues), find comparable firms (by looking at the sector in which a company operates) and adjust for differences in growth or risk, is much more difficult to put into practice if you are valuing a multi-business company, with the magnitude of the challenge being a function of the following variables:
    1. Pricing Metric: A multi-business company that operates in businesses that should be valued using different metrics, it becomes more difficult to value the business. Thus, an infrastructure company (where EBITDA multiples may be the most widely used metric) with a financial service arm (where PE ratios or Price to Book ratios are more widely used) poses problems for analysts.
    2. Comparable firms: A related point is that pricing is always done relative to a group of comparable firms, usually defined as being other companies in the same business, with additional criteria added for size, growth and risk. With a multi-business company, finding a group of comparable firms becomes tricky, and especially so if the businesses range the spectrum.
    3. Controlling for differences: To price a company, you have to control for differences in growth, risk and cash flows across companies, and these comparisons sometimes require market or stand alone accounting information that may be unavailable or unreliable for a multi-business company.
    In effect, investors are more likely to misprice multi-business companies than single business companies, though the mistakes can cut in both directions and the degree of misplacing will be greater, if the reporting is opaque and the pricing approaches vary widely across the businesses. In my view, this may be just as good an explanation for why there is a conglomerate discount as the more conventional operating inefficiencies story.


    EBay: The History
    EBay was founded in 1995 in San Jose, California. It is coincidence that its CEO during its early years was Meg Whitman, who is in the news as the CEO of HP, the other big company announcing a break up. As online commerce picked up in the late 1990s, EBay benefited from the boom, reporting exponential growth in revenues, but it also stood out from the crowd as one of the few companies in e-commerce that had found a way to be profitable. In the graph below, you can see revenues and operating income at EBay from its inception through 2014, with the operating margin for the company overlaid on the graph:
    EBay: Operating History
    It was to facilitate transactions on EBay that Paypal was initially created, as a payment processing system that allowed buyers and sellers in the auction market to reduce time involved in payment processing, while also reducing the risk of not getting paid. In fact, Paypal formed such a small part of EBay’s revenues in its early years that the company did not start breaking out revenues into its marketplace and payment processing units until 2006 and operating income until 2011. The table below summarizes the revenues and operating income at the two businesses, with revenue growth from 2006-14 and operating margins for each from 2011-14:



    Looking at the evolution of the two businesses over time, they seem to be following different paths and operate in very different competitve spaces. The marketplace unit has seen slower revenue growth and higher operating margins that seem to be under pressure, dropping from 46% in 2006 to 35% in 2014. The payment-processing unit has higher revenue growth and while its operating margin is lower than that of the marketplace unit, it has also held up better over the last three years.

    EBay: Valuing the break up
    At the risk of stating the obvious, a break up can affect value, only if it affects the inputs into value, i.e., cash flows, expected growth, the cost of capital or the length of the growth period. In effect, if EBay breaks up into two units and the composite cash flows, growth rate, growth period and cost of capital for the two units remains the same as the consolidated unit, there will be no value created. In the table below, we start with this presumption, where we allocate the corporate costs across the two businesses, in proportion to revenues, and assume that the growth rates, growth period and debt ratios don't change for the broken up units.

    Note that in this valuation, the earnings and growth rates of the units aggregate to the earnings and growth rate of the consolidated company and that the units stick with the debt ratio that the consolidated company has. Not surprisingly, if you assume no fundamental changes in how the units are run or financed after the deal, there is no value created from the break up. So, what are the potential value enhancers? I can think of four possible changes:
    1. The corporate cost story: If the corporate costs, currently $1,819 million for the consolidated company could be lowered by a hundred or two hundred million dollars, there will be an immediate value effect. If the annual operating costs are cut by $100 million, for instance, the value of the combined firm will increase by $2.2 billion. Absent detailed information, I am in no position to argue for or against this possibility but EBay does not strike me as an excessively bloated company with significant (and easy) cost cuts for the taking and news stories like these don't seem to indicate belt tightening ahead.
    2. The unleashed growth story: If the broken up units can have a composite growth rate in revenues and operating income that exceeds that of the consolidated unit, there will be a value increase that comes with that higher growth. Of the two units at EBay, the one that seems most likely to benefit from being cut adrift is Paypal and using a 20% growth rate for the next few years, instead of 15.49%, increases the value of the combined firm by $13.6 billion. There is an argument to be made that the corporate tie between EBay and Paypal has made it both more difficult for Paypal to aggressively go after the payment processing business (especially if doing so will hurt the market place of the business) and for some competitors to adopt Paypal as a payment mechanism.
    3. The competitive advantage story: If the broken up units can improve their competitive advantages, relative to the consolidated unit, the higher return on capital and longer growth period that result will increase the value of the broken up units, relative to the consolidated company. Are EBay or PayPal, as stand alone units, likely to have stronger competitive advantages than EBay does has a consolidated company? I don't see a reason why but I am open to suggestions. 
    4. Lower cost of capital: If the broken up units are able to adopt financing mixes that better reflect their standing as businesses, it is possible that the costs of capital will decline at the broken up units, relative to the consolidated unit and increase value. This argument would have more basis, if either of these businesses had the capacity to carry substantial debt on their own but not as a consolidated unit. In fact, changing the debt ratio for the units to 20% (while increasing the cost of debt to 4.5%) from the current debt ratio of 10.71% increases value only by $479 million, increasing it to 30% (with a cost of debt of 5%) leads to an increase in value of $655 million and increasing it beyond 30% actually lowers value.
    The spreadsheet that I attach can be used to tweak each of these numbers, to see the impact. I remain skeptical on the cost-cutting, am open to the possibility of higher growth, but I don't see much of a basis for the increased competitive advantage or cost of capital stories.

    EBay: Pricing the break up
    It is possible that the motives for this break up have nothing to do with management focus and value enhancement and have more to do with investor focus and price enhancement. EBay has two very different businesses in its consolidated unit that should be priced relative to different sectors and using different multiples. It is possible that investors (and analysts) are comparing EBay to the wrong set of companies, using the wrong metrics, and are thus mispricing it. 

    To assess the pricing impact, I tried a very simple analysis, where I broke the company down into two businesses, the market place business and the payment processing business and priced each relative to what I thought were more relevant comparable firms: online retail firms for the former and payment processing companies for the latter.  Using information on firms operating in each of these businesses, I arrived at the following estimates for the multiples within each sector:


    The pricing effect of the break down will depend in large part on the comparable companies used to value each unit, the pricing metric used in that unit and any adjustments made to the multiple to reflect EBay's unique qualities. For instance, applying the median EV/Sales ratios for each sector to the revenues of the two EBay units would have yielded a  value of $47.8 billion for the company,  much lower than the consolidated company's current enterprise value of $68 billion. Using the median values of the EV/EBIT multiple to the stated operating income of the two EBay units would have resulted in a value of $113.3 billion for the equity, much higher than the current enterprise value.

    The wide variation in value can be attributed partly to the fact that EBay's units vary from the comparable companies in significant ways:
    • Bay's marketplace business model keeps its revenues low, since it reports only its cut of the price of items sold as revenues rather than gross revenues, giving it a much higher margin (24.47%) than the typical online retail firm (where the median is 3.71%). 
    • Like many of the companies on the comparable firm list, PayPal derives its revenues from transactions, but its profits are a function of how a transaction is funded, with its highest profits coming when it is funded with a PayPal account balance and its lowest profits from a (non-PayPal) credit card transaction.

    To adjust the enterprise values for both businesses, for these margin differences, I ran regressions of the EV/Sales ratio against operating margin within each sector and arrived at the following results:

    • In online retail: EV/Sales = 2.53 + 10.51 (Operating Margin) R squared = 51%
    • In payment processing: EV/Sales = 0.24 + 15.8 (Operating Margin) R squared= 84%

    At the bottom of the figure above, I used these regressions to estimate margin-adjusted EV/Sales ratios for the two businesses and arrive at an cumulated enterprise value for the two units of $69 billion, very close to the current value. (You can download the comparable data in this spreadsheet and check out or modify the regressions.)

    I also think that two big news stories from the last two months may have also prompted EBay's separation of PayPal. In September, Alibaba went public to acclaim and saw its stock price pop on the offerting date, drawing attention to the fact that Alipay, their payment processing system, would not be bundled with the company. A short while later, Apple announced Apple Pay, a payment mechanism for iPhone users, accepted for the moment by a handful of retailers. With both Alipay and Apple Pay, though, there was talk about their capacity to disrupt the credit card business and the profits that disruption would deliver. As the most established and widely used digital payment processing system in the world, PayPal may very well have resented the fact that they were not spotlighted and blamed their association with EBay for the treatment. Thus, one reason for the timing of the EBay break up may have been the rise in market interest (and valuations) for companies in the digital payment space.

    Bottom line
    In an earlier post, I argued that there was little reason to believe that HP’s break up would lead to higher value or higher price for the individual units, and based my argument not the fact that they are too similar in their fundamentals, with flat and declining growth, and shrinking margins for either value enhancement (from more focused managers) or price enhancement (from more focused investors) to pay off. I have a more optimistic take on EBay’s break up, though it is tempered by my suspicions on motives and timing. Ebay’s market place (the new EBay) and payment processing (the new PayPal) are different enough that managing them as a combined company must have posed head aches for managers. There is also a pricing rationale that comes to the surface, especially with Apple Pay and Alipay being viewed as disruptors in the financial services business, where a stand alone PayPal may attract more attention and perhaps a higher price from investors.

    Attachments:
    1. EBay Valuation and Pricing
    2. Corporate Breakups: Value and Pricing Effects
    3. HP Break Up: Value Enhancement, Pricing Game or Management Hype
    4. Focus Pocus: Breaking up as a cure for corporate attention deficit disorder





    The Oil Price Shock: Primary, Secondary and Collateral Effects


    In the last few weeks, financial markets have been rocked by the drop in oil prices, and in the process reminded us of three realities. The first is that for all the money that is spent on commodity price forecasting, there is very little that we have to show for it. The second is that all large macroeconomic events create winners and losers and the net effect of this oil price change, whether positive, neutral or negative, may take a while to manifest itself. The third is that investors are generally ill-served by either panicky selling of all things oil-related or the mindless buying of the most beaten-up oil stocks.

    Oil: Prices drop and uncertainty climbs
    At the start of 2014, the price per barrel of Brent crude oil was approximately $108/barrel, following three years of prices higher than $100/barrel. In fact, there seemed to be little reason to believe, given signs of economic recovery in the United States, that oil prices would drop any time soon. A combination of mild demand shocks (with reduced demand from China) and more noticeable supply shocks conspired to create the price drop, starting in September, accompanied by more uncertainty about future prices:


    While much of the attention has been directed at the 40% drop in oil prices, the tripling in implied volatility in oil prices is a worth paying attention to and as I will argue later, could have an effect on not just oil stocks but on the overall market.

    The initial stories about the oil price shock were almost all positive, suggesting that lower gas prices would allow consumers to spend more money on retail, restaurants and other businesses, thus boosting the economy. In the first two weeks of December, though, there was an abrupt shift in mood, as the same journalists who were lauding the oil price drop a few weeks ago were pointing their fingers at it as the primary culprit behind worldwide stock price declines in those weeks.

    The Clueless Trifecta: Forecasters, Companies and Investors
    The most sobering aspect of the oil price collapse is that is truly came out of nowhere, with none of the economic forecasters at the start of 2014 predicting the magnitude of the drop. In early 2014, Bloomberg's survey of the "most accurate" oil price forecasters yielded a forecast of $105 for oil prices for the year, illustrating that "accurate" is a relative term in this market. In a Reuter's poll in December 2013, which surveyed analysts about oil prices in 2014, the lowest price forecast was $75 by Ed Morse, Gobal Head of Commodities Research at Citibank and a longtime bear on oil prices. 

    If you believe that oil companies, being closer to the action, were prescient, you would be wrong. Early in 2014, Chevron announced that its budgeting would be based upon oil prices of $110/barrel, with John Watson, the company’s CEO, stating, “There is a new reality in our business… $100/bbl is becoming the new $20/bbl in our business… costs have caught up to revenues for many classes of projects.” and adding that, “If $100 is the new $20, consumers will pay more for oil.” Chevron was not alone in this assessment and oil companies globally made investment, acquisition and production decisions based upon the assumption that triple-digit oil prices were here to stay, which explains why at a $60 oil price or lower, almost a trillion dollars in investments made by oil companies were no longer viable. Looking at airlines, where fuel costs represent a large proportion of operating expenses, there is evidence that fuel hedging follows the oil price, rather than leading it. Fuel hedging peaked in 2008, just as oil prices peaked, and have tracked oil prices down in the years since. 

    Completing the clueless trifecta, investors have also been behind the curve on oil prices.  Institutional money continued to flow into oil stocks for most of the year and flowed out only in the last quarter as oil stocks tumbled.  The so-called smart money did worse, with hedge funds among the biggest losers in oil stocks, with big names like Icahn and Paulson leading the way with big money-losing bets. If there is any good news for oil price bulls, it is that oil forecasters are now predicting lower oil prices next year, oil companies are reassessing their assumptions about a normal oil price, airlines are reducing or even suspending their hedging and institutional investors are fleeing from oil stocks. Given their collective track record, this may be the best time to bet on rising oil prices.

    The Biggest Losers
    When oil prices drop, the most immediate impact is on oil producers and the ecosystem that serves them, including equipment and service providers. Within this group, though, the effect can vary depending on geography, size and leverage, as we will see in the nest section.

    a. Companies in the oil business
    The effect of an oil price change on a oil producing company may seem obvious, but it goes beyond the effect on revenues and earnings in the near term. By changing the payoff to growth and the risk in the company, a change in oil price can have a multiplier effect on value.


    With these effects in place, you should expect the most negative effects of declining oil prices to be at highly levered oil companies with costlier reserves and higher fixed costs

    Let’s look at the numbers. In the last three months, as oil prices have dropped, oil company stocks have taken a pummeling, losing a jaw-dropping $1.7 trillion in market capitalization, as evidenced in the table below, with companies broken down into different sub-businesses:
    Source: S&P Capital IQ
    Note that the companies at the production and drilling end of the oil cycle have been hurt the most by lower prices, while the companies that have been hurt the least are at refining and distribution end. Within the oil business, the damage also varies across companies. Breaking the numbers down further, here is what we see:



    Smaller, lower-rated companies have been hit harder than larger, investment-grade companies, with the carnage being greatest for Latin American companies. In the only surprising (at least to me) finding, firms with the highest profit margins (in terms of EBITDA/Sales) have seen bigger losses in market value than firms with lower margins.  (Update: My first thought on this was that firms with higher EBITDA/Sales might have higher debt ratios and that the debt effect was overwhelming the profitability effect. The table below gives partial support, since it is among the most highly levered firms that you see the high profitability/negative return relationship to be stronger, but there is something else also happening in the background. So, back to the grind..)
    Simple averages of 3-month returns across stocks
    Note that I was using this measure of profitability as a rough proxy for the cost of reserves owned by companies, since you should expect companies with higher cost reserves to be hurt more by lower oil prices than those with lower cost reserves. As higher oil prices have induced companies to explore for and develop new reserves, the cost of extracting oil is much higher at some of the newer reserves, as this chart for just shale oil reserves in the US indicates:
    Source: 

    I would take the breakeven prices that analysts report for reserves with a  grain of salt, because computing a true breakeven would require significantly more information about sunk versus incremental as well as fixed versus variable costs of product than we have access to, but the fundamental truth remains. As oil prices drop, the effect on value and viability will vary across reserves and that effect should then percolate through to companies.

    b. Oil Exporting Countries
    Moving from companies to countries, it is clear that the companies that lose the most from lower oil prices are the big oil exporters. Among those countries, though, the effects will vary (as they did with companies), based upon the cost of extracting oil from the reserves, how much sovereign debt is owed by the country and how dependent they are on oil revenues to balance their books. Countries with higher-cost reserves that are more dependent on oil revenues to meet debt obligations/balance books should be more negatively affected by oil price changes, and the table below provides these statistics:


    Between September 16 and December 16, as oil prices retreated, the most vulnerable country (partly because of its dependence on oil for revenues and partly because of geopolitical events) has been Russia. In the graph below, we capture the carnage in changes in the sovereign CDS spread for Russia (a measure of default risk in the country) and in the Russian Ruble.


    Looking more broadly, it is clear that the damage is not limited to Russia, as evidenced in this graph of sovereign CDS spreads for four oil exporting countries: Russia, Venezuela, Saudi Arabia and Mexico (with the September 16 CDS price being set at 100 for all four).


    The damage has been greatest in Russia and Venezuela, with the Russian CDS increasing 137.83%  and the Venezuelan CDS more than tripling. However,  Saudi Arabia and Mexico, though in much better shape, have also been affected with the Mexican CDS increasing about 58% and the Saudi CDS increasing 65%.

    The Ripple Effects
    The damage extends beyond the oil business to green energy companies, which have benefited from high oil prices in the last decade, and lenders to oil companies, who feel the effects of increased credit risk. In the table below, I estimate the effect of lower oil prices on green/clean energy companies and corporate bonds issued by energy companies:


    As with the oil sector, the extent of the damage varies across sub-groups, greater for the ten largest solar companies than it is for companies across the solar energy chain or more broadly in clean energy. Consistent with the behavior of returns across stocks across ratings classes, investment grade energy bonds were much less affected than below investment grade bonds. 

    The winners from lower oil prices are harder to find, at least in the short term. You would expect that companies that have a high proportion of their costs connected to oil prices to gain the most, and the two sectors that were mentioned as beneficiaries were the airlines and trucking companies.


    The airlines were the biggest gainers, but note that the collective market value added (about $55 billion across all companies in the sector, globally) was dwarfed by the losses of more than $2 trillion in oil and green energy companies.

    In the long term, the general consensus seems to be that lower oil prices will be good for the economy and perhaps, even for stock prices. Looking at oil price movements and their effect on the economy, inflation and stock prices over the last 40 years, here is what I find:
    Correlation between lagging oil price changes & leading macro variables: 1974-2013
    Between 1974 and 2013, there is little evidence that lower oil prices (in either dollar or percentage terms) have had any effect on economic growth (real GDP), interest & inflation rates or stock prices. In fact, the only variable where there is a relationship is with the US dollar, and lower oil prices have led to a weakening of the currency historically. Looking at the trade off, there are two key benefits that come from lower oil prices. The first is that consumers will be spending less on oil (for transportation and heating) and will thus have more money to spend on retail, leisure and other consumer discretionary items. The second is that lower oil prices will reduce inflation, at least in the near term, thus giving central banks a little more wiggle room in monetary policy. There are, however, two potential costs. The first is that with a large enough oil price drop, the financial distress at oil companies and oil exporting countries may spread into the rest of the economy; defaults by large oil companies or a large sovereign borrower can create chaos in the financial markets. The second is that oil prices in free fall are often accompanied by higher uncertainty about future oil prices, as has been the case in the last few weeks, which, in turn, can lead to more uncertainty about overall economic growth, interest rates and inflation. Since these are drivers of the overall equity risk premium, a higher equity risk premium and lower stock prices will ensue. It is true, that the oil price drop in the last few weeks, has been large, relative to history, and that the effects may therefore be different, but that may be one more reason not to wait and see what the macroeconomic effects of these prices will be.

    What now?
    You may not be a market timer or oil price forecaster but oil prices do have an effect on your portfolio and perhaps on your investment strategy. As you look at the damage created by plunging oil prices, at least to the oil in your portfolio, it is easy to second guess decisions that you made weeks, months or even years ago. I believe that regret and navel gazing is not only pointless but dangerous and that your time will be better spent picking up the pieces and looking forward. Generically, there are four viewpoints that you can have on oil prices: that they will continue to decline (the momentum story), that $60 is the new normal price ($60 is the new $100), that they have fallen too far and will bounce back (the contrarian play) or that any of the above (price agnostic). Within each viewpoint about oil, you can either go for a protective strategy or an aggressive one, with the latter becoming more attractive as your confidence in your viewpoint increases.


    You can put me firmly in the "price agnostic" category. The oil price exposure that I have in my portfolios reflects investments that I have made over time in stocks that I perceived as good value at the time that I made them and were not designed primarily to increase my oil price exposure. If I choose to sell them, it will be because I don't view them as good value, given oil prices at the time of the assessment, any more and not because I have a point of view on oil prices.  Thus, my Lukoil investment from about four weeks ago, when oil prices were $77/barrel,  is down about 15%, but  given today's oil price, it is under valued today. My investment timing clearly left much to be desired but selling it today will not get me my money back!

    Attachments:
    1. Companies in the oil sector: Price changes from 9/16/14 to 12/16/14
    2. Oil Prices and Macroeconomic Variables
    3. Sovereign CDS spreads for oil exporters: 9/16/14 to 12/16/16



    Up, up and away! A crowd-valuation of Uber!

    In June 2014, I tried to value Uber and arrived at an estimated value for the firm of $6 billion, an impressive number for a young firm, but well below the VC estimates of value of $17-$18 billion at the time of my post. Much of the reaction was predictable, with readers whose priors were confirmed by my assessment of value liking it and those whose priors were different disagreeing,and sometimes vehemently. Disagreement and debate don't bother me in the least, since they can only advance the valuation narrative, but I do think that putting my narrative and valuation front and center undercut my objective in two ways. First, it made for passive analysis, where you could pick and choose which one of my valuation inputs you agreed with and which ones that you found erroneous, the justifying your prior biases. Second, some who disagreed took the easy way out, arguing that it was my use of an intrinsic value (DCF) model that had led me down the wrong path and that it was therefore unfixable. 

    Now that Uber is in the news again, with value estimates of $40 billion and higher floating around, I decided to revisit the valuation, but from a different angle. Rather than presenting my valuation, I want to open the process up and I would like to invite you along for the journey. Like a book or movie where you get to write not just the ending but the entire story, I will provide the architecture and you can build your own valuation story (and value) for Uber. The good news is that this valuation will reflect your views (not mine) on Uber. The bad news is that if you don't like the value, you cannot blame me.

    When Narrative drives Value
    While my original valuation of Uber was all about the numbers, I followed it up with a post where I argued that if you disagreed with my value, it was not because you had a problem with my estimates (of growth or risk) but because you were taking issue with my narrative. Underlying my original valuation was a story that I was telling about Uber as an urban cab/limo service company that would continue to attract new users into the market, while maintaining its high profit margins. In response to a post by Bill Gurley, venture capitalist investor (and director) in Uber, where I was accused of missing the story by a mile, I conceded that I knew far less than he did about the company and that his narrative for the company - Uber as a car-service for the masses with global networking benefits - would lead to a much higher value for the company

    While that may sound abstract, the best way to see the link between story telling and number crunching is to take Uber on the valuation process, with you making your judgments at each step of the way. As you make this journey, a few (gentle) reminders of issues that you will face along the way:
    1. This is your valuation: Contrary to what you might have been taught in your valuation classes, valuations are and should never be just about the numbers. To the extent that you will be making choices on these number, this will be your estimate of valuation, reflecting not only what you know about the company (and its products, management etc.) but also your personal biases (whether you like the company or not). 
    2. You are almost certainly wrong: Lest you view this is an insult, so is my assessment of value and so are the VC’s valuations. It is not because we don't understand valuation or have not done our homework, it is because we are trying to play God and forecast the future. 
    3. You should be open to revisiting it: Following up on the last proposition, it stands to reason that the choices you make in valuing Uber today will not be the choices that you will make tomorrow or a week from now. So, keep the door open for changes not just at the margins but in your central narrative.
    4. Be willing to act on it: There is no point to valuing companies, if you are not willing to act on your valuations. With Uber, it is true that you and I are restricted in what we can do, since the company is still private. However, it is also clear that the explosive growth in the estimated value of the company sets it on a path to being public (sooner, rather than later), at which point our valuations will become actionable.
    Setting the stage
    The first step in valuation is assessing where the company is right now and we start off at a disadvantage, because it is amazing how little we know about the operating details of a company that is in the news as much as Uber. According to the company's website, it operates in 51 countries and in about 230 cities on six continents, and it has also expanded its product offerings, both within the car service market (with U4B, directed at businesses and UberPool, allowing for car pooling)and in new markets (with UberRUSH, its delivery service in New York City).

    The only updated revenue numbers came from an article in Business Insider, which seems to be one the company's preferred venues for leaking selective information. According to the article, the company projects gross receipts of $10 billion in 2015, up three times from gross receipts in 2014, which in turn more than tripled relative to receipts in 2013. While the company originally kept 20% of these receipts as revenues, it is unclear whether that number has slipped in recent months, as it has gone aggressively for new growth. While I am normally loath to value companies based upon second-hand information, and especially so if the information comes from a leaked corporate document, I am going to assume that the company will generate $3.5 billion in gross receipts for 2014 and that its slice has stayed at 20%, giving it revenues of $700 million for the year. I have no idea whether it is profitable after covering its operating costs, but the impact on the final value of these initial numbers is small enough that it is worth moving forward.

    Building your Uber narrative
    To set up the link between the narrative that you will be telling for Uber and its value, I will borrow the set-up that I used in this post on narrative and numbers, where I took the key inputs into my valuation and connected them to stories told about companies:


    There are thus six steps to the narrative process and your choices at each step will determine the numbers from which we estimate value.


    Step 1: Potential Market
    In my initial valuation of Uber, I treated it as an urban car-service company and was taken to task rightly for having too cramped a vision of the company. It is quite clear from both its words and actions that Uber has much larger designs and I will leave it to your judgment whether it will succeed. Based on rudimentary research of the potential markets that Uber could be in, here is what I get as a list:

    The potential starting market can range from $100 billion (for urban car service) to close to $300 billion (if you treat it as transportation company, going after all of the markets above). Since this is your narrative, its your choice to make and it will have significant value consequences. 
    Based on what you know (and think about) Uber, which of the following do you think is its potential market?

    Potential Market
    Market size (in millions)
    Description
    A1. Urban car service
    $100,000
    Taxi cabs, limos & car services (urban)
    A2. All car service
    $150,000
     + Rental Cars+ Non-urban car service
    A3. Logistics
    $205,000
     + Moving + Local Delivery
    A4. Mobility Services
    $285,000
     + Mass Transit + Car Sharing


    Step 2: Market Growth
    Uber is not only disrupting the existing players in the market that it disrupts but it is also attracting new users into the market, either by attractive non-cab users to try Uber or increasing the usage of car services, in general. Assuming that this process continues, the growth rates in these markets could increase if Uber's services (or Uber-like services) become more widely accessible. Here again, the choice is yours.
    Based on the potential market(s) you chose for Uber in step 1, what effect do you see Uber (and Uber-like services) having on the expected growth rate in the market?

    New user effect on market growth
    Annual growth rate (next 10 years)
    B1. No new users (no growth effect)
    3.00%
    B2. Increase total market by 25% over next 10 years
    5.32%
    B3. Increase total market by 50% over next 10 years
    7.26%
    B4. Double market size over next 10 years
    10.39%

    Step 3: Market Share
    Having chosen a potential market and a growth rate in that market, the third step is making a judgment on what market share you would expect Uber to command once the market hits steady stay (in ten years). That choice will depend in large part on whether you think Uber's products/services have network effects, where increased usage of Uber by customers in a market makes it more attractive to other potential customers, and whether you think these network effects are local (in the city/region of usage) or global (in other cities/regions). The arguments for local network effects are easy (the more Uber users there are, the more Uber cars there are, which in turn makes it easier/quicker to get an Uber ride)  but the ones for global network benefits may be more of a stretch (links to credit cards, inertia, uniformity of service, staying with the known). Once you have assessed the pluses and minuses, here are your choices.
    Based on your assessment of Uber, what type of network effect (if any) do you see for its products and services?

    Network Effect
    Market Share
    Description
    C1. No network effects
    5%
    Open competition in every market
    C2. Weak local network effects
    10%
    Dominance in a few local markets
    C3. Strong local network effects
    15%
    Dominance in multiple local markets
    C4. Weak global network effects
    25%
    Weak spillover benefits in new markets
    C5. Strong global network effects
    40%
    Strong spillover benefits in new markets

    Step 4: Revenue Slice & Operating Costs
    Uber gets to keep a portion of the gross receipts paid by users for an Uber service, representing their revenues. That slice was initially set at 20% of the receipts but whether it can stay at that level will depend upon both the markets that Uber decides to operate in and the competition within each market. Thus, if Uber decides to go into the logistics market (moving and local delivery), it will have to accept a much lower slice of revenues, since competition is more intense. Even within the urban car service market, more intense competition from existing players (Lyft) or new entrants could put Uber's revenue slice under pressure. This choice again is yours to make:
    Given the markets that you see Uber entering and the competition it faces within those markets, how strong and sustainable are Uber's competitive advantages?

    Competitive Advantage
    Revenue Slice
    Description
    D1. None
    5%
    Unrestricted entry + No pricing power
    D2. Weak
    10%
    Unrestricted entry+ Some Pricing Power
    D3. Semi-strong
    15%
    Unrestricted entry + Pricing Power
    D4. Strong & Sustainable
    20%
    Restricted entry + Pricing Power

    Step 5: Reinvestment Needs
    Uber's existing business model, where it acts as an intermediary and does not invest in cars or equipment, has low capital intensity and as a consequence, much of its growth has come with relatively low reinvestment. That could change, if Uber decides to change its business model or if it has to do acquisitions to continue to generate growth. 
    Based on the business model that you see Uber adopting as it goes for the market share (that you forecast) in your potential market, which of the following reinvestment policies best fits the company?

    Reinvestment
    Sales/Capital Ratio (Higher number= Less investment)
    E1. Minimal capital needs, no acquisitions
    10.00
    E2. Minimal capital needs, small acquisitions
    5.00
    E3. Service company median
    3.00
    E4. Technology company median
    2.50
    E5. US company median
    2.00
    E6. Capital intensive company median
    1.50

    Step 6: Risk (Cost of capital & Survival risk)
    As I noted in the table above, there are types of risk that you have to grapple with in valuation. The first is the risk in operations, which causes revenues and earnings to be volatile over time, and that risk is captured in the risk-adjusted return you demand for investing in the company. In valuation, the cost of capital becomes the measure of this risk-adjusted return and is generally estimated by looking at publicly traded companies (even though Uber is privately held still). Rather than wrestle with the minutiae of inputs into the model, you can make a judgment on where in the cross-sectional distribution of costs of capital across all companies you would put Uber.
    Based on your assessment of the risk in the market that Uber is entering and where the company is in its life cycle, what cost of capital would you pick for the company?

    Risk Profile
    Cost of Capital
    F1. Lowest decile of US companies
    7.00%
    F2. 25th percentile of US companies
    7.50%
    F3. Median of US companies
    8.00%
    F4. 75th percentile of US companies
    10.00%
    F5. Ninth decile of US companies
    12.00%
    The other risk for a young company is survival risk, i.e., the risk that you are one disaster from shutting operations. That risk increases for smaller companies with small cash holdings, large cash needs and limited access to capital. Given Uber's capacity to raise capital and cash holdings, this risk should be lower.

    Your Uber value
    Once you have made the choices on the potential market, growth in that market, Uber's market share and revenue slice, the valuation follows. While the number of combinations of assumptions is prohibitively high to show value estimates under each one, I have summarizes the value estimates for at least a subset of plausible choices. (using a sales to capital ratio of 5.00 and a cost of capital of 12% for all the cases)>

    If your set of assumptions is not listed above, you can download the spreadsheet, enter your choices and see what the value of Uber is with those choices. If you don't like the value that you get with your narrative choices, I am afraid that it is just a reflection of your choices.

    Looking at the range of values that you can obtain ($799 million to $90.5 billion), you may find your worst fears about DCF models, i.e., that they can be used to deliver whatever number you want, vindicated, but that is not the way I see it. Instead, here are four lessons that I draw from this table:
    1. Soaring narratives, soaring values: I know that some people view DCF models as inherently conservative and thus unsuited to valuing young companies with lots of potential. As you can see in the table above, if you have a soaring narrative of a huge market, a dominant market share and hefty profit margins, the model will deliver a value to match. Put differently, if you found my original valuation of Uber too low, the fault lies with me for having a cramped vision of what Uber can accomplish and not with the model. It also stands to reason that when you have big differences in value estimates, it is almost always because you have different narratives for a company, not because you have a disagreement on an input number.
    2. Not all narratives are made equal: While I have listed out multiple narratives, some of which deliver huge values and some not, not all are equal. Looking forward as investors, some narratives are more plausible than others and thus have better odds of succeeding. Looking back ten years from now, reality will have delivered its own story line for Uber and the narrative that came closest to that reality will be the winner.
    3. Narratives need reshaping: The narratives for Uber that you developed are based on what you know today. As events unfold, it is critical that you check your narrative against the facts and tweak, change or even replace the narrative if the facts require those adjustments, which was the point that I made in this post.
    4. Narratives matter: Success, when investing in young companies, comes from getting the narrative right, not the numbers. That may explain why some successful venture capitalists can get away being surprisingly sloppy with they numbers. After all, if your skill set includes finding start-ups with strong narratives and picking founders/entrepreneurs who can deliver on those narratives, the fact that you cannot tell the difference between EBITDA and free cash flow or compute the cost of capital will be of little consequence. 
    If you are waiting for me to reveal my narrative choices, you will be disappointed. This is your valuation, not mine, and I hope that you like it. If you could please go in and put your narrative choices and resulting value for Uber into this shared Google spreadsheet, we can get a crowd valuation of Uber!

    Attachments



    The Dance of the Disrupted: Observations from the front lines

    Teaching is my passion, writing gives me joy and finance is my playground. While I am blessed in being able to immerse myself in all three, my activities put me in three businesses, education, publishing and financial services, that are begging to be disrupted. In fact, as disruption starts to challenge the status quo in all three businesses, I have a front row seat to observe how they react to these changes and perhaps add to their discomfort. 


    The targets of disruption

    As technology and globalization disrupt one business after another, it is useful to start with a simple question. Why do some businesses get targeted for disruption and others left alone? As I see it, there are three characteristics that businesses that get disrupted seem to share:
    1. Sizable economic footprint: The probability of a business being disrupted increases proportionately with the amount of money that is spent on that business. Using this template, it is easy to see why financial services (active money management, financial advisory services, corporate finance) and education are attracting so many disruptors and why publishing offers a smaller target.
    2. Inefficient production and delivery mechanisms: A common characteristic that disrupted businesses share is that they are inefficiently run, and neither producers nor consumers seem happy. Consumers are unhappy because producers are non-responsive to their needs and deliver sub-standard products at premium prices, but producers seem to have little to show in surplus. In education, for instance, students (especially under graduates at research universities) complain that they get a bad deal for the money they spend but colleges collectively seem to have trouble balancing their budgets, as is evidenced by their frequent and frantic attempts to raise money from alumni to cover their unmet needs. Publishers claim that their business models are being threatened by Amazon, while textbooks still cost outlandish amounts of money. Even in finance, where there are a few big winners every period, it is becoming increasingly difficult to find entities that win big consistently, and consumers of financial services are not exactly happy campers.
    3. Outdated competitive barriers and inertia: If these businesses are so big and inefficiently run, you may wonder what has allowed them to continue in existence for as long they have. The strongest force that they have going for them is inertia, where consumers have been programmed to accept the status quo: that it should take four years to get an undergraduate degree, that you need professional (paid) help to invest and that it makes sense to pay outlandish amounts for new editions of textbooks (on accounting, economics or mathematics) that are little changed from the old editions. Adding to the protections are regulatory or licensing requirements that have long outlived their original purpose and serve to protect incumbents from insurgencies. I have posted previously on how universities have bundled together screening, classes, networking and entertainment into packages that students have to take whole or leave and publishers and financial service companies have their own bundling variants.
    The Dance of the Disrupted: The Five Stages
    One of the enduring challenges that we face is explaining why disrupted businesses take so long to respond to disruption. Why did retailers not react faster to online retailing, in general, and Amazon, in particular? In a more updated version, what is it that is stopping traditional cab service companies from responding better to the car-sharing services like Uber and Lyft? I will let corporate strategists hash out the answers to those questions, but watching the education business respond to disruption has given me some perspective. With apologies to Elizabeth Kubler-Ross, I see disruption working its way through disrupted businesses in five stages, starting with denial and ending with acceptance.

    Stage 1: Denial and Delusion
    The first reaction to a disruptive challenge at most established businesses is delusion and denial, the delusion coming from the belief on the part of the existing players that the established way of doing business is the only (and best) way, notwithstanding widespread dissatisfaction on the part of both producers and consumers, followed by denial that others can do it better. I see this clearly in the education business, where I hear university overseers, administrators and faculty all express shock that anyone would question the Rube Goldberg contraption that forms the modern university education and conviction that no one outside the hierarchy understands education like they do.

    Stage 2: Failure and False Hope
    In most businesses, the initial wave of disruption usually fails, both because the disruptors do not understand the businesses that they are trying to disrupt and/or ran foul of the rules of the game (written by the establishment). Thus, Napster’s initial foray into the music business ended in it being shut down and the online retailing challenge was derailed (at least temporarily) by the tech market collapse in 2000. In the education business, the MOOC phenomenon was the shooting star that challenged the education establishment five years ago but it looks like it has fizzled out, partly because its providers mistook a university degree for a collection of courses. That initial failure was a moment of relief for the education establishment, since it reinforced its sense of superiority, and has created the hope among some in it that the disruption has passed.

    Stage 3: Imitation and Institutional Inertia
    The threat of disruption scares the establishment, though it moves in conventional ways to counter the disruption: by mapping out long-term plans and trying to borrow ideas from the disruptors. Those moves, while initiated with fanfare and backed up by resources, are generally undermined by an unwillingness on the part of those who benefit from the status quo to give up or compromise any of their existing privileges. In the education business, this “me too” phase is in full force, as universities create online course and some even offer online degrees, with a few faculty contributing willingly and a large majority going along either grudgingly, or not at all. If the only way that traditional colleges can compete with online education is by forcing professors to be accountable for the classes they teach (tying hiring, pay and tenure to teaching quality more than to research output) and firing those who do not measure up (no matter how productive they have been in their research), do you think that proposal has any chance of succeeding at a modern research university? I do not!

    Stage 4: Regulation and Rule Rigging
    The initial disruption may fail but it exposes both the weaknesses of the existing system and ways of getting around its defenses. Just as Napster softened up the music business for the assault of Apple’s iTunes store, the failure of MOOCs has offered valuable clues to disruptors as to what they need to do differently to beat universities at their game. In this post from September 2014, I laid out what I think will characterize the first successful online university: a combination of student screening, top-notch classes, discussion and interaction forums and networking opportunities , and I remain convinced that it will happen sooner rather than later. I predict that the education status quo will respond as other disrupted businesses have in the past, with a combination of complaints about unfairness and bad quality of the disruptors and a demand for protection from regulatory and licensing authorities from competition. Anecdotal evidence about the poor quality of education at some online education portals will be used to tar all online education, as if traditional colleges do not churn out their own share of substandard graduates.

    Stage 5: Acceptance and Adjustment
    The end game in disruption is painful. There will be jobs lost not only at the disrupted institutions and there will be ripple effects in the communities that serve them. With universities that have tenure-protected older faculty, the pain will be borne disproportionately by younger faculty and doctoral students entering the academic job market, and even tenure-protected faculty will find out that a guaranteed job does not come with guaranteed pay or research support. I am not predicting that universities will cease to exist, but there will be fewer of them, and the ones that survive will do so because they have carved out niches for themselves. IT is unfair, but it will be easier for a Harvard, MIT or Oxford to make it than lesser schools, with less illustrious histories, smaller endowments and less connected alumni.

    My Disruption Plans
    As I watch the businesses that I am in face the threat of disruption and respond badly, I plan to contribute to the disruption with small (and perhaps futile) acts of my own.
    1. In the publishing business, there is nothing more perverse and irrational than the textbook game, where books are obscenely over priced (even in their e-book versions) and old editions are made obsolete with a few selected edits. Of my ten books, four are textbooks and the way they are priced is the reason that I don’t require them in my own classes. The first editions of these books were written more than 15 years ago, and I had no choice but to use a publisher, but if I were writing these books today, I would do things differently. Then again, I am not done writing and will perhaps get a chance to make amends to those who have read my books.
    2. The finance business is too big for me to even cause a ripple, but I will continue to make the case that investors need to stop paying financial advisors for useless (and often counter productive) investment advice, that businesses should be able to make fundamental corporate finance decisions without calling in consultants and that the valuations that you get from bankers in IPOs and acquisitions are more pricing than value. One reason that Anant Sundaram and I co-developed uValue, a (free) valuation app for the iPhone/iPad is to make it easier for investors/companies to do valuations on their own.
    3. On the education front, anyone who has been reading my blog for a while knows that I put my regular classes online, class webcasts, lectures and exams included. I will be teaching corporate finance and valuation to MBAs at Stern in the spring, with classes starting on February 2, 2015 and continuing through May 11, 2015. The corporate finance class is the first one in the sequence, offered to first year MBAs, and valuation is an elective. You have four forums where you can take these classes:


    Corporate Finance
    Valuation
    My site (Stern NYU)
    Apple iTunes U
    Yellowdig
    YouTube


    Each option has its pluses and minuses. My site will include everything I offer my regular class, including emails and announcements but it is an online site without any bells and whistles. The iTunes U site is the most polished in terms of offerings, but there is no forum for interaction and requires more work if you don't have an Apple device. Yellowdig is a new add-on to my menu and it is a site where you will be able to access the classes and material and hopefully interact with others in the class. (You will have to register on Yellowdig and it is restrictive on what email addresses it will accept.) YouTube is the least broadband-intensive forum, since the file size adjusts to your device, but you will be able to get only the class videos (and not the material).

    If you are wondering why I would disrupt businesses that I am part of, I have three responses. The first is that, with four children, I am a consumer of the products/services of these businesses and I am sick and tired of paying what I do for textbooks, college tuition and minor financial services. The second is that it is so much more fun being a disruptor than the disrupted and being in a defensive posture for the rest of my life does not appeal to me. The third is that with Asia's awakening, we face a challenge of huge numbers and the systems (education, public and financial services) as we know them don't measure up.



    The X Factor in Value: Excess Returns in Theory and Practice

    There are lots of reasons why we try to start and run businesses. Some of them are emotional but the financial rationale for starting and staying in business is a simple one. It is to not just to make money, but to make more than what you would have made elsewhere with the capital (human and financial) invested in the business. Of course, your competitors, the government and sometimes the entire world seems to conspire against you (or at least it seems that way) to prevent you from making these “excess” returns. 

    The Search for and Scarcity of Excess Returns
    In corporate finance, decision-making tools are constructed with the objective of earning and maximizing excess returns. Thus, the notion of net present value in capital budgeting is built on the presumption that an investment should earn more than what you would have generated as a return on an investment of equivalent risk.  In investing, the search for excess returns or alpha is just as intense, with traders, value investors and growth investors playing their own versions of the game.

    While you can plan, hope and pray for excess returns, to earn them consistently, you have to bring something unique that cannot be easily replicated to the game. In the case of businesses, that something is a competitive advantage or a barrier to entry that allows them to continue generating returns that exceed their costs of capital, without competition driving down profitability to more "normal" levels. These competitive advantages can range from economies of scale (Walmart), to brand name (Coca Cola) to patents (Amgen), and while they are have to be earned, they are not uncommon. In the case of investors, those competitive advantages are not only rarer but also more difficult to defend, perhaps explaining why so few active investors beat index funds or the market.

    The Measurement of Excess Returns
    Assume that you have been given the task of measuring whether a company’s past investments have generated returns for that exceed their cost, i.e. excess returns. To measure excess returns generated by companies on their investments collectively, you need two numbers, the expected return on the investments, given their risk and alternative investment choices today, and the actual return earned on those investments.
    1. The first number is the expected return on the investment, given its risk. As I noted in my last post, the cost of capital, computed right, should be an opportunity cost that reflects the expected return that investors in the company can generate by investing elsewhere in investments of equivalent risk. 
    2. The second number is easy to compute for investors in publicly traded securities, since it a function of how much cash the investments returned (in dividends or other forms) and the price change over the year. Measuring the return earned by companies is more problematic, especially for ongoing and evolving investments. The most logical place to start is with the earnings generated by the company on these investments, but that number,  is volatile and may not reflect the true quality of investments.  The actual earnings (and returns) for a company will move a lot from year to year, sometimes because of actions taken by the firm and sometimes because of macroeconomic shifts. In addition, a company’s earnings and investing history is framed by accounting statements. Thus, accounting profits (net income, operating income) become a proxy for true earnings and the book value of capital invested (book value of equity, invested capital) stand in for earnings and investments, and we get two of the most widely used accounting returns: the return on (invested) capital and the return on equity.


    While I have no qualms about using either return measure, the dependence on accounting statements for both the numerator and denominator trouble me.  It is not my objective in this post to belabor the definition of return on equity and capital. If you are interested, I have an extended discourse on the technical issues that you may face in computing accounting returns in this paper.

    In my last post, I looked at the simplifying assumptions that I made to compute the costs of capital for industries and for individual companies. To measure the excess returns, I do need to compute the return on invested capital, and I do make simplifying assumptions again to prevent getting bogged down.


    Note that I am using the effective tax rate to compute after-tax operating income, both at the industry and company level. For return on equity, I use a similar adjustment process:


    I am well aware of the weaknesses in these measures. The first is the use of the most recent year's operating income in the numerator. Earnings at companies can vary over time and the most recent year may yield a number that is not representative of the company. (I did also use a ten-year average income to generate returns to try to counter this problem). The second is that the book value of equity is an accounting number and as such, is affected by accounting decisions on capitalization/expensing, depreciation and write offs. The third is that netting out the most recent period's cash balance, especially at technology or growth companies, can result in a negative invested capital. Finally, this measure, even if the earnings and invested capital are measured right, will be biased against young companies and companies investing in long-gestation period investments (infrastructure, toll roads etc.), since it will be low in the early years.

    The Evidence on Excess Returns
    Notwithstanding the many limitations of the excess return measure that I have described, I do think that there is value in looking at how firms measure up on it, across sectors and across the globe.

    a. Across Sectors
    To compute the return on capital for a sector, I used aggregated values for the operating income and invested capital across companies in the sector, rather than a simple average of the returns on capital of individual companies. I did this for two reasons. The first is that it allows me to keep all of the firms in my sample, rather than only the ones for which I can measure excess returns. The second is that it prevents outliers (hugely positive or negative excess returns that I may estimate for a firm, usually because of quirky accounting) from affecting the average. The third is to get a measure of weighted performance, where larger firms in a sector count for more than smaller firms.

    I report the industry averages in this data in this dataset. In the table below, I report on the five industries, in the US and globally, that report the highest return spreads (a return on capital that most exceeds the cost of capital) and the five that had the lowest return spreads.
    Return spreads based on trailing 12 month returns: January 2015
    As with any measure, the rankings reveal as much about the quality of the measure as they do about the quality of the sectors. Tobacco companies are at the top of the list partly because repeated stock buybacks have depleted the book values of equity and invested capital, at last in the United States. Aerospace and defense is a volatile business and the high positive excess returns in 2014 can turn negative, if the airline business is troubled. 

    b. Across Countries
    To look at excess returns across countries, I consolidated companies into five groups: US, emerging markets, Europe, Japan and Australia/NZ/Canada. I then looked at the individual companies within each group and how much they earned, relative to their costs of capital. The table below summarizes the distribution of companies, in terms of excess returns, in each region:

    The most striking feature of the data, to me, is that the proportion of companies that earn less than their cost of capital, 65.36% of all companies and 53.99% of companies with market capitalizations that exceed $50 billion. That indicates either that competition is a lot more intense in more businesses than we think and/or that management at many of these companies are either unaware or indifferent that their businesses are not generating sufficient profits, given the risk. 

    What next?
    This may reflect my biases but everyone should care about these excess returns. Investors should be valuing companies, based on their expectations of future expected returns, and pushing for change in companies that don't deliver them. Anti-trust regulators can use them as proxies for determining whether competition is adequate in markets and lawmakers should consider excess returns rather than absolute profits, in making public policy.

    Dataset attachments
    1. Excess Returns by sector (USEmerging MarketsEuropeJapan, Australia/CanadaGlobal)



    Putting the D in the DCF: The Cost of Capital

    If there were a contest for the most measured number in finance, the winner would be the cost of capital. Corporate finance departments around the world compute it as an integral part of investment analysis. Appraisers estimate it as a step towards estimating intrinsic or discounted cash flow value. Analysts spend disproportionate amounts of their time working on it, though not always for the right reasons or with the right inputs. Since I have spent a significant portion of my life, writing and talking about cost of capital, it stands to reason that it is one of the numbers that I compute for all the companies in my data base at the start of every year.

    Defining the cost of capital
    There are three different ways to frame the cost of capital and each has its use. Much of the confusion about measuring and using cost of capital stem from mixing up the different definitions:
    1. For businesses, the cost of capital is a cost of raising financing: The first is to read the cost of capital literally as the cost of raising funding to run a business and thus build up to it by estimating the costs of raising different types of financing and the proportions used of each. This is what we do when we estimate a cost of equity, based on a beta, betas or some other risk proxy, a cost of debt, based upon what the business can borrow money at and adjusting for any tax advantages that might accrue from borrowing.
    2. For businesses, the cost of capital is an opportunity cost for investing in projects: The cost of capital is also an opportunity cost, i.e., the rate of return that the business can expect to make on other investments, of equivalent risk. The logic is simple. If you are considering investing in a new asset or security, you have to earn more than you could make by investing the money elsewhere. There are two subparts to this statement. The first is that it is the choices that you have today that should determine this opportunity cost, not choices that you might have had in the past. The second is that it has to be on investments of equivalent risk. Thus, the cost of capital should be higher for riskier investments than safe ones.
    3. For investors, the cost of capital is a discount rate to value a business: Investors looking at buying into a business are effectively buying a portfolio of investments, current and future, and to value the business, they have to make an assessment of the collective risk in the portfolio and how it may change over time. 
    A good measure of cost of capital will find a way to bridge the differences between the three definitions and I believe that we can do so, with a little common sense and some data.


    For this process to yield a number to meet all three requirements for cost of capital, i.e., that it be a cost of raising funding, an opportunity cost and a required return for investors, here are the requirements:
    1. Investors price companies based upon a reasonable assessment of the company’s business mix (and country risk exposure) and what they can generate as expected returns on alternative choices of equivalent risk. The former requires companies to provide information on their business mixes and the latter generally is easier to do in a liquid, public market.
    2. A company that operates in multiple businesses and many countries cannot use a single, “company-wide” cost of capital as its hurdle rate in investments. It has to adjust the cost of capital for both the riskiness of the business in which the investment is being planned and the part of the world that it is going to be located in.
    3. The overall company’s cost of capital has to be a weighted average of the costs of capitals of the businesses that it operates in, and as the business mix changes, the cost of capital will, as well.
    Estimating the Cost of Capital
    Having laid the groundwork, let’s get down to specifics. If you, as an investor, are given the task of estimating the cost of capital for a company, here is the sequence of steps. First, you have to estimate the business risk in the company by taking a weighted average of the risks of the businesses that the company operates. Second, you have to adjust that risk measure for the effects of debt, which effectively magnifies your business risk exposure, and use the consolidated risk measure to estimate a cost of equity. Third, you have to bring in the cost of borrowing, net of any tax benefit, which will reflect the default risk in the company. Finally, taking a weighted average of the cost of equity and after-tax cost of debt yields a cost of capital. If you are approaching the same task as a CFO, you have to follow the same sequence to get a cost of capital for the company but you have to go further and estimate the costs of capital for the individual businesses that the company is invested in.

    As someone who teaches corporate finance and valuation, I am equally interested in both sides of this estimation process and one of my objectives in providing data is to help both sides. To help companies in investment analysis, I try to estimate costs of capital by sector, in the hope that a multi-business company will be able to find the information here to build up business-specific costs of capital. While investors may also find this information useful in valuation/investment analysis, I also estimate costs of capital for individual companies, and while my data providers no longer allow me to share these company-specific costs of capital, I can still provide information on the distribution of costs of capital across companies that can be useful to investors.

    a. Cost of capital by sector
    In my data updates each year, I estimate the cost of capital, by sector, for companies both globally and classified by region (US, Europe, Japan, Emerging Markets). In making these estimates, I first begin by breaking my total sample of 41,410 companies down into 96 industry groups, some of which may be far broader than you would like to see. I prefer this broad categorization for two reasons. First, I estimate a beta for each industry group by averaging the betas of the individual companies in that group, and these estimates are more precise with larger sample sizes. Second, from a first principles perspective, I believe that since betas measure risk from a macro risk perspective, you are better served with broader categories than narrow ones. Thus, rather than estimate the beta for shrimp fishing as a business, I would rather estimate the beta for food processing businesses (assuming that the only reason that people buy shrimp is to eat them.). Once I have the industry groups, I estimate the cost of equity for each group (in US dollar terms, by using a US dollar risk free rate and a equity risk premium in US dollar terms, though the magnitude of the premium can vary across countries and regions) by using the average beta across companies in the sector. For the cost of debt, I do have a problem, since all I usually have at the industry level is a book interest rate (obtained by dividing the interest expense by the book value of debt) which is not very useful from a cost of capital perspective. I use the variance in stock prices as an indicator of the risk and use it to estimate a default spread in US dollar terms, which then allows me to compute a cost of debt. As the final step, I use the industry average debt to capital ratios (in market value terms) to compute a cost of capital; in keeping with my view that lease commitments are debt, I convert lease commitments to debt for all companies in my database:


    The results from the start of 2015 are captured in the attached spreadsheet, which includes costs of capital by sector not only for global companies, but also includes my regional estimates.

    b. Cost of Capital - By company
    As part of my data analysis, I also try to estimate the cost of capital for each of the 42,410 companies in my database. Since it is impractical to analyze each company in detail, I do have to make some simplifying assumptions.

    • First, I assign each company to one primary business in estimating business risk and use the unlevered beta for that business as the beta for the company. Optimally, I would compute the unlevered beta for each company, using the mix of businesses it is in, but with my sample size and data access, it is close to impossible to do. 
    • Second, I assume that the company gets all its revenues in the country in which it is incorporated and assign it the equity risk premium of that country. Thus, a Russian company’s cost of equity is computed using the Russian ERP (see my earlier post on country risk) and a German company’s cost of equity is computed based on the German ERP. I know that this violates my earlier point of multinational companies, and I would never make this assumption in building up an individual company’s cost of capital but I am afraid I have no choice with the larger sample. 
    • Third, I estimate a default spread for the company by using the variance in its stock prices. It is true that some of the companies (about 4000 or about 10% of my sample) have bond ratings available on them, but the bulk of my companies do not. In addition, if the company is incorporated in a country with sovereign default risk, I add the default spread for the country on to that of the company. I also use the marginal tax rate of the country that the company is incorporated in to estimate an after-tax cost of debt. 
    • Finally, to keep the numbers comparable, I compute the costs of capital for all companies in US dollars.

    While I cannot provide you with the company-level costs of capital, I can provide the cross sectional distribution of my estimates. As you look at companies, I hope that you can use this for perspective, i.e., in making judgments on what comprises a high, low and median cost of capital. With US companies, the cost of capital distribution across all companies is below:

    Cost of capital in US dollars: US companies in January 2015

    Thus, if you use a cost of capital of 10% in the United States, you would effectively be assuming that your company is in the 98th percentile of US companies, in terms of cost of capital. With global companies, the cost of capital distribution is as follows:
    Cost of capital in US dollars: Global companies in January 2015

    Note that I have used a larger equity risk premium and incorporated sovereign default spreads into the cost of debt, yielding a larger spread in the cost of capital. A cost of capital of 12.5% for a global company would put it in the 94th percentile of companies.

    A Cost of Capital Computation Template
    If you work in finance, you will run into the challenge of estimating the cost of capital for a company sometime during the course of the year. I hope that the datasets that I have created are useful to you in that endeavor and if you decide to use them, here is a simple template for arriving a company's cost of capital in the currency of your choice.


    Input
    Measure
    Comments/ Data sets
    1
    Risk free rate
    Use the prevailing 10-year US T.Bond rate as the risk free rate in US dollars, even if you plan to compute the cost of capital in another currency.
    Fight the urge to normalize, tweak or otherwise mess with this rate. It is what you can make today on a risk less investment, no matter what your views on it being too low or high.
    2
    Business Risk (Unlevered beta)
    Break the company down into businesses, using an operating metric (revenues work best) and compute the weighted unlevered beta across the businesses.
    Company breakdown: In company’s annual report or financial filings
    Beta of businesses: My unlevered betas by business (broad groups) or you can create your own subgroups.
    3
    Financial Risk (Debt to equity and levered beta)
    Lever the beta using the market debt to equity ratio for the company today. (If you prefer to use a target debt to equity ratio, make sure it is based on market values.
    Market value of equity: Use the market capitalization as market value of equity. 
    Market value of debt: For debt, use book value as your proxy for market value, or better still convert book value to market value.  Add the present value of operating leases to debt.
    4
    Equity Risk Premium
    Obtain the geographical breakdown of the company’s revenues (or other operating metric, if you don’t like revenues). Take a weighted average of the ERP of the countries/regions that the company operates in.
    Geographical Breakdown:  The company’s revenues will be in its financial statements, though it is not always as clear and detailed as you would like it to be.
    ERP by country: My ERP by country.
    5
    Cost of debt
    If you can find a corporate bond rating for your company, use it to get a default spread and a cost of debt. If you cannot find a bond rating, estimate a bond rating for the company and a default spread on that basis. If you are doing the latter, add a default spread for the country to get the pre-tax cost of debt.
    Bond Rating: If available, you should be able to find it at S&P or online.
    Synthetic Rating: You can use this spreadsheet to get a synthetic rating for your company.
    Rating-based default spread: My lookup table of default spreads for ratings classes.
    Country default spreads: My estimates
    6
    Marginal tax rate
    Multiply the pre-tax cost of debt by (1- marginal tax rate) to get the after-tax cost
    Marginal tax rate by country: KPMG estimates of country tax rates
    7
    Debt Ratio
    Use the market values of debt and equity (from step 3)
    See step 3
    8
    Currency change
    If you want to convert the US dollar cost of capital into another currency, add the differential inflation rate (between that currency and the US dollar) or better still, scale up the  US$ cost of capital for the difference in inflation.
    The inflation rate in the US can be estimated as the difference between the US 10-year T.Bond Rate and the US TIPs rate. For other countries, you can use the actual inflation rate last year as a proxy for expected inflation. 

    If you are interested, I have a spreadsheet that has these steps incorporated into it. Give it a shot!

    Implications
    Looking at the costs of capital across sectors and companies, there are lessons that I take away for valuation and corporate finance:
    1. A rising (falling) tide lifts (lowers) all boats: The first reaction that most analysts and CFOs will have to my estimates of the cost of capital is that they look too low, with a median value of 7.40% for US companies and 8.32% for global companies. In fact, the longer that you have been around in markets, the lower today's numbers will look like to you, because what you consider a normal cost of capital will reflect your experiences. The low costs of capital, though, are appropriate, given the level of risk free rates today.
    2. The cost of capital does not (and should not) reflect all risk faced by a business: Even if you accept the proposition that the costs of capital are lower because of low risk free rates, you may still feel that the costs of capital don't look high enough for what you view as the riskiest companies in the market. You are right but that is because the cost of capital captures risk to a diversified investor in a going concern. Consequently, it will not reflect risks that are sector-specific but not market-wide, such as the risk to a biotechnology company that its newest drug will not be approved for production. Those risks are better reflected in the expected cash flows. The cost of capital also does not reflect truncation risk, i.e., that a firm may not survive the early stages of the life cycle or an overwhelming debt burden. That risk is better captured through decision trees and probabilistic approaches.
    3. Don't sweat the small stuff: In my view, analysts spend too much time finessing and tweaking the cost of capital and not enough on the cash flows. After all, the cost of capital, even if you go with the global distribution, varies within a tight range (6% to 12%, if you use the 10th and 90th percentile) and your potential for making mistakes is therefore also restricted. In contrast, profit margins and returns on capital have a much wider distribution across companies and getting those numbers right has a much bigger pay off.
    Dataset attachments



    The Aging of the Tech Sector: The Pricing Divergence of Young and Old Tech Companies

    As the NASDAQ approaches historic highs, Apple’s market cap exceeds that of the Bovespa (the Brazilian equity index) and young social media companies like Snapchat have nosebleed valuations, there is talk of a tech bubble again. It is human nature to group or classify individuals or entities and assign common characteristics to the group and we tend to do the same, when investing. Specifically, we categorize stocks into sectors or groups and assume that many or most stocks in each group share commonalities. Thus, we assume that utility stocks have little growth and pay large dividends and commodity and cyclical stocks have volatile earnings largely because of macroeconomic factors. With “tech” stocks, the common characteristics that come to mind for many investors are high growth, high risk and low cash payout. While that would have been true for the typical tech stock in the 1980s, is it still true? More specifically, what does the typical tech company look like, how is it priced and is its pricing put it in a bubble? As I hope to argue in the section below, the answers depend upon which segment of the tech sector you look at.

    A Short History of Tech Stocks
    My first foray into investing was in the early 1980s, as the market started its long bull market run that lasted for almost two decades. In 1981, the technology stocks in the market were mainframe computer manufacturers, led by IBM and a group of smaller companies lumped together as the seven dwarves (Burroughs, Univac, NCR, Honeywell etc.). Not only were they collectively a small proportion of the entire market, but of the list of top ten companies, in market capitalization terms, in 1981, only one (IBM) could have been categorized as a technology stock (though GE had a small stake in computer-related businesses then):

    During the 1980s, the personal computer revolution created a new wave of technology companies and while IBM fell from grace, companies catering to the PC business such as Microsoft, Compaq and Dell rose up the market cap ranks. By 1991, the top ten stocks still included only one technology company, IBM, and it had slipped in the rankings. However even in 1991, technology stocks remained a small portion of the market, comprising less than 7% of the S&P 500. During the 1990s, the dot-com boom created a surge in technology companies and their valuations, and while the busting of that boom in 2000 caused a reassessment, technology has become a larger piece of the overall market, as evidenced by this graph that describes the breakdown, by sector, for the S&P 500 from 1991 to 2014:

    Market Capitalization at the end of each year (S&P Capital IQ)
    There are two things to note in this graph. 
    1. The first is that technology as a percentage of the market has remained stable since 2009, which calls into question the notion that technology stocks have powered the bull market of the last five years. 
    2. The second is that technology is now the largest single slice of the equity market in the United States and close to the second largest in the global market. So what? Just as growth becomes more difficult for a company as it gets larger and becomes a larger part of the economy, technology collectively is running into a scaling problem, where its growth rate is converging on the growth rate for the economy. While this convergence is sometimes obscured by the focus on earnings per share growth, the growth rate in revenues at technology companies collectively has been moving towards the growth rate of the economy.
    The Diversity of Technology
    As technology ages and becomes a larger part of the economy, a second phenomenon is occurring. Companies within the sector are becoming much more heterogeneous not only in the businesses that they operate in, but also in their growth and operating characteristics. To see these differences, let’s start by looking at the sector and its composition in terms of age at the start of 2015. In February 2015, there were 2816 firms that were classified as technology companies, just in the United States, accounting for 31.7% for all publicly traded companies in the US market. Some of these companies have been listed for only a few years but others have been around for decades. Using the year of their founding as the birth year, I estimated the age for each company and came up with the following breakdown of tech stocks, by age:

    Age: Number of years from founding of company to 2015
    Note that 341 technology companies have been in existence for more than 35 years and an additional 427 firms have been in existence between 25 and 35 years, and they collectively comprise about 41% of the firms that we had founding years available in the database. While being in existence more than 25 years may sound unexceptional, given that there are manufacturing and consumer product companies that have been around a century or longer, tech companies age in dog years, as the life cycles tend to be more intense and compressed. Put differently, IBM may not be as old as Coca Cola in calendar time but it is a corporate Methuselah, in tech years.

    The Pricing of Technology
    The speedy rise of social media companies like Facebook, Twitter and Linkedin from nothing to large market cap companies, priced richly relative to revenues and earnings, has led some to the conclusion that this rich pricing must be across the entire sector. To see if this is true, I look at common pricing metrics across companies in the technology sector, broken down by age.
    Pricing as of February 2015, Trailing 12 month values for earnings and book value
    To adjust for the fact that cash holdings at some companies are substantial, I computed a non-cash PE, by netting cash out of the market capitalization and the income from cash holdings from the net income. While it is true that the youngest tech companies look highly priced, the pricing becomes more reasonable, as you look across the age scale. For instance, while the youngest companies in the tech sector trade at 4.34 times revenues (based upon enterprise value), the oldest companies trade at 2.44 times revenues. 

    How do tech companies measure up against non-tech companies? After all, any story that is built on the presumption that tech companies are the sources of a market bubble has to backed up by data that indicates that tech companies are over priced relative to the rest of the market. To answer this question, I looked at the youngest (<10 and="" companies="" oldest="" tech="" years="">35 years) relative to the  youngest (<10 and="" companies:="" div="" non-tech="" oldest="" years="">
    Based on  February 2015 Pricing & Trailing 12 month numbers: 2807 US technology and  6076 non-technology companies.
    The assessment depends upon what part of the technology sector you are focused on. While the youngest tech companies trade at much higher multiples of revenues, earnings and book value than the rest of the market, the oldest tech companies actually look under priced (rather than over priced) relative to both the rest of the market and to the oldest non-tech companies. In fact, even focusing just on the youngest companies, it is interesting that while young tech companies trade at higher multiples of earnings (EBITDA, for instance) than young non-tech companies, the difference is negligible if you add back R&D, an expense that accountants mis-categorize as an operating expense.

    Does this mean that you should be selling your young tech companies and buying old tech companies? I am not quite ready to make that leap yet, because the differences in these pricing multiples can be partially or fully explained by differences in fundamentals, i.e., young tech companies may be highly priced because they have high growth and old tech companies may trade at lower multiples because they have more risk and tech companies collectively may differ fundamentally from non-tech companies.

    The Fundamentals of Tech Companies
    There are three key fundamentals that determine value: the cash flows that you generate from your existing assets, the value generated by expected growth in these cash flows and the risk in these cash flows. Again, rather than look at tech stocks collectively, I will break them down by age and compare them to non-tech stocks.

    a. Cash Flows and Profitability
    To measure profitability, I looked at two statistics, the percentage of money making companies in each group and the aggregate profit margins (using EBITDA, operating income and net income):


    Young technology companies are far more likely to be losing money and have lower profit margins that young non-technology companies, even if you capitalize R&D expenses and restate both operating and net income (which I did). At the other end of the spectrum, old technology companies are much more profitable, both in terms of margins and accounting returns, than old non-technology companies, adding to their investment allure, since they are also priced cheaper than non-technology companies.

    b. Growth – Level and Quality
    To test the conventional wisdom that technology companies have higher growth potential than non-technology companies, I looked at both past and expected future growth in different operating measures starting with revenues and working down the income statement:


    The results are surprising and cut against the conventional wisdom, on most measures of growth. Young non-technology companies have grown both revenues and income faster than young technology companies, though analyst estimates of expected growth in earnings per share remains higher for young tech companies. With old tech companies, the contrast is jarring, with historic growth at anemic levels for technology companies but at much healthier levels for non-tech companies, perhaps explaining some of the lower pricing for the former. It is true, again, that the expected growth in earnings per share is higher at tech companies than non-tech companies, reflecting perhaps an optimistic bias on the part of analysts as well as more active share buyback programs at tech companies.

    c. Risk – Financial and Market
    Are tech companies riskier than non-tech companies? Again, the conventional wisdom would say they are, but I look at two measures of risk in the table below: standard deviation in stock prices and debt ratios across groups:


    I get a split verdict, with much higher volatility in stock prices in tech companies, young and old, than non-tech companies, accompanied by much lower financial leverage at tech companies, again across the board, than non-tech companies. As we noted in the earlier table, young tech companies are more likely to be losing money and that may explain why they borrow less, but I think that the high price volatility has less to do with fundamentals and more to do with the fact the investors in young tech companies are too busy playing the price and momentum game to even think about fundamentals. 

    d. Cash Return – Dividends, Buybacks and FCFE
    In the final comparison, I look at how much cash is being returned in the form of dividends and buybacks by companies in each group, as well as how much cash is being held back in the company as a percent of overall firm value (in market value terms):
    FCFE = Cash left over after taxes, debt payments and reinvestment; Firm value = Market Cap + Total Debt; Cash Return = Dividends + Buybacks - Stock Issues

    Note that both young tech and young non-tech companies have raised more new equity than they return in the form of dividends and buybacks, giving them a negative cash return yield. Old tech companies return more cash to stockholders both in dividends and collectively, with buybacks, than old non-tech companies. Finally, notwithstanding the attention paid to Apple's cash balance, old tech companies hold less cash than old non-tech companies do. 

    In summary, here is what the numbers are saying. Young technology companies are less profitable, have higher growth, higher price risk and are priced more richly than the young non-tech companies. Old technology companies are more profitable, have less top line growth and are priced more reasonably than old non-tech companies. 

    Bottom line
    The size of the technology sector and the diversity of companies in the sector makes it difficult to categorize the entire sector. In my view, the data suggests that we should be doing the following:
    1. Truth in labeling: We are far too casual in our classifications of companies as being in technology. In my book, Tesla is an automobile company, Uber is a car service (or transportation) company and The Lending Club is a financial services company, and none of them should be categorized as technology companies. The fact that these firms use technology innovatively or to their advantage cannot be used as justification for treating them as technology companies, since technology is now part and parcel of even the most mundane businesses. Both companies and investors are complicit in this loose labeling, companies because they like the “technology” label, since it seems to release them from the obligation of explaining how much they need to invest to scale up, and investors, because it allows them to pay multiples of revenues or earnings that would be difficult (if not impossible) to justify in the actual businesses that these firms are in.
    2. Age classes: We should start classifying technology companies by age, perhaps in four groups: baby tech (start up), young tech (product/service generating revenues but not profits), middle-aged tech (profits generated on significant revenues) and old tech (low top line growth, though sometimes accompanied by high profitability), without any negative connotations to any of these groupings. If we want to point to mispricing, we should be specific about which group the mispricing is occurring. In this market, for instance, if there is a finger to be pointed towards a group, it is not technology collectively that looks like it is richly priced, but baby and young technology companies. By the same token, if you follow rigid value investing advice, where you are told to stay away from technology on the grounds that it is high growth, high risk and highly priced, that may have been solid advice in 1985 but you will be missing your best “value” opportunities, if you follow it now.
    3. Youth or Sector: When we think of start-ups and young firms, we tend to assume that they are technology-based and that presumption, for the most part, is backed up by the numbers. However, there are start-ups in other businesses as well, and it is worth examining when mispricing occurs, whether it is sector or age-driven. It is true that young social media companies have gone public to rapturous responses over the last few years but Shake Shack, which is definitely not a technology company (unless you can have a virtual burger and an online shake) also saw its stock price double on its offering day and biotechnology companies  had their moment in the limelight in 2014, as well. 
    4. Life Cycle dynamics: I have talked about the corporate life cycles in prior posts and as I have noted in this one, there is evidence that the life cycle for a technology company may be both shorter and more intense than the life cycle for a non-technology company. That has implications for how we value and price these companies. In valuation, we may have to revisit the assumptions we make about long lives (perpetual) and positive growth that we routinely attach in discounted cash flow models to arrive at terminal value, when valuing technology companies, and perhaps replace them with finite period, negative growth terminal value models for fading technologies. In pricing, we should expect to see a much quicker drop off in the multiples of earnings that we are willing to pay, as tech companies age, relative to non-tech companies. I will save that for a future post.
    I am under no illusions that this post will change the conversation about technology companies, but it will give me an escape hatch the next time I am asked about whether there is a technology bubble. If nothing else, I can point the questioner to this post and save myself the trouble of saying the same thing over and over again. 





    DCF Myth 1: If you have a D(discount rate) and a CF (cash flow), you have a DCF!

    Earlier this year, I started my series on discounted cash flow valuations (DCF) with a post that listed ten common myths in DCF and promised to do a post on each one over the course of the year. This is the first of that series and I will use it to challenge the widely held misconception that all you need to arrive at a DCF value is a D(iscount rate) and expected C(ash)F(lows). In this post, I will take a tour of what I would term twisted DCFs, where you have the appearance of a discounted cash flow valuation, without any of the consistency or philosophy.

    The Consistency Tests for DCF

    In my initial post on discounted cash flow valuation, I set up the single equation that underlies all of discounted cash flow valuation:


    For this equation to deliver a reasonable estimate of value, it is imperative that it meets three consistency tests:

    1. Unit consistency: A DCF first principle is that your cash flows have to defined in the same terms and unit as your discount rate. Specifically, this shows up in four tests:
    • Equity versus Business (Firm): If the cash flows are after debt payments (and thus cash flows to equity), the discount rate used has to reflect the return required by those equity investors (the cost of equity), given the perceived risk in their equity investments. If the cash flows are prior to debt payments (cash flows to the business or firm), the discount rate used has to be a weighted average of what your equity investors want and what your lenders (debt holders) demand or a cost of funding the entire business (cost of capital).
    • Pre-tax versus Post-tax: If your cash flows are pre-tax (post-tax), your discount rate has to be pre-tax (post-tax). It is worth noting that when valuing companies, we look at cash flows after corporate taxes and prior to personal taxes and discount rates are defined consistently. This gets tricky when valuing pass-through entities, which pay no taxes but are often required to pass through their income to investors who then get taxed at individual tax rates, and I looked at this question in my post on pass-through entities.
    • Nominal versus Real: If your cash flows are computed without incorporating inflation expectations, they are real cash flows and have to be discounted at a real discount rate. If your cash flows incorporate an expected inflation rate, your discount rate has to incorporate the same expected inflation rate.
    • Currency: If your cash flows are in a specific currency, your discount rate has to be in the same currency. Since currency is primarily a conduit for expected inflation, choosing a high inflation currency (say the Brazilian Reai) will give you a higher discount rate and higher expected growth and should leave value unchanged.
    2. Input consistency: The value of a company is a function of three key components, its expected cash flows, the expected growth in these cash flows and the uncertainty you feel about whether these cash flows will be delivered. A discounted cash flow valuation requires assumptions about all three variables but for it to be defensible, the assumptions that you make about these variables have to be consistent with each other. The best way to illustrate this point is what I call the valuation triangle:


    I am not suggesting that these relationships always have to hold, but when you do get an exception (high growth with low risk and low reinvestment), you are looking at an unusual company that requires justification and even in that company, there has to be consistency at some point in time.

    3. Narrative consistency: In posts last year, I argued that a good valuation connected narrative to numbers. A good DCF valuation has to follow the same principles and the numbers have to be consistent with the story that you are telling about a company’s future and the story that you are telling has to be plausible, given the macroeconomic environment you are predicting, the market or markets that the company operates in and the competition it faces. 

    The DCF Hall of Shame

    Many of the DCFs that I see passed around in acquisition valuations, appraisal and accounting  don’t pass these consistency tests. In fact, at the risk of being labeled a DCF snob, I have taken to classifying these  defective DCFs into seven groups:
    1. The Chimera DCF: In mythology, a chimera is usually depicted as a lion, with the head of a goat arising from his back, and a tail that might end with a snake's head. A DCF valuation that mixes dollar cash flows with peso discount rates, nominal cash flows with real costs of capital and cash flows before debt payments with costs of equity is violating basic consistency rules and qualifies as a Chimera DCF. It is useless, no matter how much work went into estimating the cash flows and discount rates. While it is possible that these inconsistencies are the result of deliberate intent (where you are trying to justify an unjustifiable value), they are more often the result of sloppiness and too many analysts working on the same valuation, with division of labor run amok.
    2. The Dreamstate DCF: It is easy to build amazing companies on spreadsheets, making outlandish assumptions about growth and operating margins over time. With attribution to Elon
      Musk, I could take a small, money losing automobile company, forecast enough revenue
      growth to get its revenues to $350 billion in ten years (about $100 billion higher than  Toyota or Volkswagen, the largest automobile companies today), increase operating margins to 10% by the tenth year (giving it the margins of  premium auto makers) and make it a low risk, high growth company at that point (allowing it to trade at 20 times earnings at the end of year 10), all on a spreadsheet. Dreamstate DCFs are usually the result of a combination of hubris and static analysis, where you assume that you act correctly and no one else does.
    3. The Dissonant DCF: When assumptions about growth, risk and cash flows are not consistent with each other, with little or no explanation given for the mismatch, you have a DCF valuation
      where the assumptions are at war with each other and your valuation error will reflect the input
      dissonance. An analyst who assumes high growth with low risk and low reinvestment will get too high a value, and one who assumes low growth with high risk and high reinvestment will get too low a value.  I attributed dissonant DCFs to the natural tendency of analysts to focus on one variable at a time and tweak it, when in fact changes in one variable (say, growth) affect the other variables in your assessment. In addition, if you have a bias (towards a higher or lower value), you will find a variable to change that will deliver the result you want.
    4. The Trojan Horse (or Drag Queen) DCF: It is undeniable that the biggest number in a DCF is the terminal value, and for it to remain a DCF (a measure of intrinsic value), that number has to be estimated in one of two ways. The first is to assume that your cash flows will continue
      beyond the terminal year, growing at a constant rate forever (or for a finite period) and the second is to assume liquidation, with the liquidation proceeds representing your terminal value. There are many DCFs, though, where the terminal value is estimated by applying a multiple to the terminal year’s revenues, book value or earnings and that multiple (PE, EV/Sales, EV/EBITDA) comes from how comparable firms are being priced right now. Just as the Greeks used a wooden horse to smuggle soldiers into Troy, analysts are using the Trojan horse of expected cash flows (during the estimation period) to smuggle in a pricing. One reason analysts feel the urge to disguise their pricing as DCF valuations is a reluctance to admit that you are playing the pricing game.
    5. The Kabuki of For-show DCF: The last three decades have seen an explosion in valuations for legal and accounting purposes. Since neither the courts nor accounting rule writers have a clear
      sense of what they want as output from this process (and it has little to do with fair value), and there are generally no transactions that ride on the numbers (making them "show" valuations), you get checkbox or rule-driven valuation. In its most pristine form, these valuations are works of art, where analyst and rule maker (or court) go through the motions of valuation, with the intent of developing models that are legally or accounting-rule defensible rather than yielding reasonable values. Until we resolve the fundamental contradiction of asking practitioners to price assets, while also asking them to deliver DCF models that back the prices, we will see more and more Kabuki DCFs.
    6. The Robo DCF: In a Robo DCF, the analyst build a valuation almost entirely from the most recent financial statements and automated forecasts. In its most extreme form, every input in a
      Robo DCF can be traced to an external source, with equity risk premiums from Ibbotson or Duff and Phelps, betas from Bloomberg and cash flows from Factset, coming together in the model to deliver a value. Given that computers are much better followers of rigid and automated rules than human beings can, it is not surprising that many services have created their own versions of Robo DCFs to do intrinsic valuations. In fact, you could probably create an app for a smartphone or tablet that could do valuations for you. (I had originally listed Morningstar as a service that produced Robo DCFs but was alerted to the fact that it has substantial analyst input into its DCF.)
    7. The Mutant DCF: In its scariest form, a DCF can be just a collection of numbers where items have familiar names (free cash flow, cost of capital) but the analyst putting it together has
      neither a narrative holding the numbers together nor a sense of the basic principles of valuation. In the best case scenario, these valuations never see the light of day, as their creators abandon their misshapen creations, but in many cases, these valuations find their way into acquisition valuations, appraisals and portfolio management.
    DCF Checklist
    I see a lot of DCFs in the course of my work, from students, appraisers, analysts, bankers and companies. A surprisingly large number of the DCFs that I see take on one of these twisted forms and many of them have illustrious names attached to them. To help in identifying these twisted DCFs, I have developed a diagnostic sequence that is captured visually in this flowchart:



    You are welcome to borrow, modify or adapt this flowchart to make it yours. If you prefer your flowchart in a more conventional question and answer format, you can use this checklist instead. So, take it for a spin on a DCF valuation, preferably someone else's, since it is so much easier to be judgmental about other people's work than yours. The tougher test is when you have to apply it on one of your own discounted cash flow valuations, but remember that the truth shall set you free!

    1. If you have a D(discount rate) and a CF (cash flow), you have a DCF.  
    2. A DCF is an exercise in modeling & number crunching. 
    3. You cannot do a DCF when there is too much uncertainty.
    4. The most critical input in a DCF is the discount rate and if you don’t believe in modern portfolio theory (or beta), you cannot use a DCF.
    5. If most of your value in a DCF comes from the terminal value, there is something wrong with your DCF.
    6. A DCF requires too many assumptions and can be manipulated to yield any value you want.
    7. A DCF cannot value brand name or other intangibles. 
    8. A DCF yields a conservative estimate of value. 
    9. If your DCF value changes significantly over time, there is either something wrong with your valuation.
    10. A DCF is an academic exercise.




    How low can you go? Doing the Petrobras Limbo!

    A few months ago, I suggested that investors venture where it is darkest, the nether regions of the corporate world where country risk, commodity risk and company risk all collide to create investing quicksand. I still own the two companies that I highlighted in that post, Vale and Lukoil, and have no regrets, even though I have lost money on both. At the time of the post, I was asked why I had not picked Brazil’s other commodity colossus, Petrobras, as my company to value (and invest in) and I dodged the question. The news from the last few days provides a partial answer, but I think that the Petrobras experience, painful though it might have been for some investors, provides an illustration of the costs and benefits of political patronage.

    Petrobras: A Short History

    Petrobras was founded in 1953 as the Brazilian government oil company, and for the first few decades of its life, it was run as a government-owned company from its headquarters in Rio De Janeiro. Until 1997, it had a legal monopoly on oil production and distribution in Brazil, when the domestic market was opened up to foreign oil producers. Petrobras was listed as a public company in 1997 on the Sao Paulo exchange and as a depository receipt on the New York Stock Exchange soon after. The arc of fortunes for the company can be traced in the changes in its market capitalization over time, reported in US dollars in the figure below:
    Market Capitalization & Enterprise Value at end of each year
    In the last decade, Petrobras has seen both highs and lows, becoming the fifth largest company in the world, in terms of market capitalization, in 2011 and then seeing a precipitous drop off in market prices in the years since. To understand where Petrobras is now and to make sense of where it is going, you have to look at both its rise in the last decade and its fall in this one.

    The rise of Petrobras from minor emerging market oil company to global giant between 2002 and 2010 can be traced to three factors. The first was the discovery of major new reserves in Brazil in the early part of the last decade, which catapulted the company towards the top of the list of companies with proven reserves. The fact that these reserves would be expensive to develop was mitigated by a second development, which was the sustained surge in oil prices to triple digit levels for much of the period, making them viable. The third was an overall reduction in Brazilian country risk from the stratospheric levels of 2001 (when the country default spread for Brazil reached 14.34%, just before the election of Lula Da Silva as President) to 1.43% in 2010, when Brazil looked like it had made the leap to almost-developed market status. In 2010, the company signaled that its arrival in global markets and its ambitions to be even more by raising $72.8 billion from equity markets.

    The hubris that led to the public offering may have been the trigger for the subsequent fall of the company, which has been dizzying because of the magnitude of the decline, and its speed. After peaking at a market capitalization close to $244 billion in 2010, the company has managed to lose a little bit more than $200 billion in value since, putting it in rarefied company with other champion value destroyers over time. While a large portion of the blame for the decline in the last few months (especially since September 2014) can be attributed to the drop in oil prices, note that Petrobras has already managed to destroy $160 billion in value prior to that point in time.

    Petrobras: Governance Structure
    To understand the Petrobras story, you have to start with an assessment how the company is structured. When the government privatized the company, it did so with the objective of raising capital for its treasury but it did not want to release control of the company to the shareholders who bought shares in the company. Using "national interest" as a shield, the government devised a game where it would be able to control the company, while raising billions in capital from investors. The basis for that game, and it is not unique to Petrobras, was to create two classes of shares, one with voting rights (common shares) and one without (called preferred shares, in an Orwellian twist), and offering the latter primarily to investors. The government retains control of more than 50% of the voting shares in the company and another 11% is controlled by entities (like the Brazilian Development Bank, BNDES, and Brazil's sovereign wealth fund) over which the government has effective control. Not quite satisfied with this rigging of the game, the government also retains veto power (a golden share) over major decisions.
    Shareholding as of February 2015
    Using this control structure, the government has created the ultimate rubber stamp board, whose only role has been to protect the government's interests (or more precisely the politicians who comprise the government at the time) at all costs. Brazilian company law does require that the minority shareholders (anybody but the government) have board representatives, but as this story makes clear, these directors are not just ignored but face retaliation for raising basic questions about governance. To be fair to Ms. Dilma Rousseff, government interference has always been the case in Petrobras, and her predecessors have been just as guilty of treating Petrobras as a piggybank and political patronage machine, as she has. Lula, who stepped down with great fanfare, as president just a few years ago was equally interventionist, but high oil prices provided the buffer that protected him from the fallout.

    A Roadmap for Value Destruction
    Just as looking at companies that have created significant amounts of value over time is enlightening because of the insights you get into what companies do right, Petrobras should become a case study for the opposite reason. Put in brutally direct terms, if you were given a valuable business and given the perverse objective of destroying it completely and quickly, you should replicate what Petrobras has done in five steps.

    Step 1 - Invest first, worry about returns later (perhaps never)
    Invest massive amounts of money in new investments, with little heed to returns on these investments, and often with the intent of delivering political payoffs or worse. Between 2009 and 2014, Petrobras stepped up its capital expenditures and exploration costs to more than 35% of revenues, well above the 15-20% invested by other integrated oil companies, while seeing its return on capital drop to 5% (even as oil prices stayed at $100+/barrel for the bulk of the period).

    Step 2 - Grow, baby, grow, and profitability be damned
    Petrobras has grown its revenues from $17.4 billion in 1997 to $135.8 billion in 2014 and displaced Exxon Mobil as the largest global oil producer in the third quarter of 2014, while letting profit margins drop dramatically. The government contributes to this dysfunctional growth by putting pressure on the company to sell gasoline at subsidized prices to Brazilian car owners.

    Step 3 - Pay dividends like a regulated utility (even though you are not)
    Petrobras has a history of paying large dividends, partly because it had the cash flows to pay those dividends in the 1990s and partly to supports it voting share structure. The preferred (non-voting) shares that the company has used to raise capital, without giving up control, come with dividend payout requirements that are onerous, if you have growth ambitions.

    Step 4 - Borrow money to cover the cash deficit
    If you want to eat your cake (by investing large amounts to generate growth) and have it too (while paying large dividends), the only way to make up the deficit is to raise fresh capital. In 2010, Petrobras did raise $79 billion in fresh equity but it has been dependent upon debt as its primarily financing in every other year. As a consequence, Petrobras had total debt outstanding of $135 billion at the end of 2014, more than any other oil company in the world.

    Step 5 - Destroy value (Mission accomplished)
    If you over invest and grow without heeding profitability, while paying dividends you cannot afford to pay and borrowing much more than you should be, you have created the perfect storm for value destruction. In fact, the way Petrobras has been run so defies common sense and first principles in corporate finance, that if I were a conspiracy theorist, I would be almost ready to buy into the notion that this is part of a diabolical plan to destroy the company hatched by evil geniuses somewhere. I have learned through hard experience, though, that you should not attribute to malevolence what can be explained by greed, self-dealing and bad incentive systems.


    It is worth noting that none of the numbers in the last section can be attributed to the drop in oil prices. In the most recent twelve month data that you see in these graphs represent the year ending September 30, 2014, and the average oil price during that year exceeded $100/barrel.The government of Brazil, working through the management that they installed at Petrobras, have pulled off the amazing feat of destroying more than $200 billion in value with no help from outside.

    A Contrarian Bet?
    When a company falls as fast and as far as Petrobras has, it attracts the interests of contrarian investors and the company looks attractive on the surface, at least using some conventional multiples.

    Petrobras looks very cheap, at least using equity multiples (PE and Price/Book) but the results are mixed with enterprise value multiples.

    All of these multiples are affected by the fact that oil prices have dropped dramatically since the most recent financial statements and that the earnings numbers, in particular, will dive in the coming quarters. Given that Petrobras was already reporting sagging profits, before the oil price drop, I am almost afraid to think of what the numbers will look like at today's oil prices (which are closer to $50)., but I will try anyway. Looking at the annual revenues over time at the company and relating them to the average oil prices each year, here is what I find:
    Revenues at Petrobras = -4,619 million + 1276 (Average Oil price during year)     R squared = 92%
    Thus, if you assume that the current oil price of $51.69 is close to the average for this year, the normalized revenues for Petrobras will be $61.3 billion, a drop off of about 55% from the $135.8 billion revenues in the 12 months ending September 30, 2014.
    Revenues at Petrobras = -4,619 million + 1276 (51.69) = $61,337 million or $61.3 billion
    If you apply the operating margin of 10.82% that Petrobras reported in the trailing 12 months to these revenues, you arrive at an operating income of $6,638 million, prior to taxes. At that level of earnings, the value that I get for the company is $62.4 billion, well below the $135.1 billion owed by the company, making its equity worth nothing. In the matrix below, I look at the value per share under different combinations of base year income (ranging from $6,638 million at the low to $28.7 billion at the high) and return on invested capital on new investments (again ranging from a low of 2.67%, with income normalized for low oil prices, to 13.36% as the high):
    Assuming no high growth period, stable growth rate of 2% and cost of capital of  11.17%. Adding a high growth period reduces value in all the return on capital scenarios, except one (average over last 10 years)
    The red numbers represent the dead zone, where the value of the business is less than the debt outstanding and they dominate the table.  In spite of the reckless abandon shown by its management, there remain some bright spots, if you are an optimist. The first is that the company is one of the largest oil producers in the world and if oil prices rebound, they will see a jump in revenues. The second is that the exploration and investments over the last decade have given the company the fifth largest proven oil reserves in the world, though the proportion of these reserves that will be viable at today's oil prices is open to question. The third is that if the Brazilian government stops pulling the strings and management stops its self destructive behavior, profit margins and returns will improve. In the most optimistic spin, you can assume that Petrobras will be able to keep its trailing 12-month intact at $135.8 billion, improve its operating margin to the 21.1% that it earned in 2010 and its return on capital to 13.36% (10-year average), while reducing its debt ratio to 43.5% (average over last 5 years). With those assumptions, which border on fantasy, Petrobras would be worth $8.11/share (R$ 22.55/share) well above the current stock price of $3.28/share (R$ 9.12/share).  You are welcome to try out different combinations of your assumptions in this spreadsheet and see what you get.

    Unsolicited (and perhaps unwelcome) advice for a new CEO

    A couple of weeks ago, Ms. Maria das Gracas Foster, Petrobras CEO since February 2012, stepped down, and the Brazilian government announced that it has chosen Mr. Aldemir Bendine, former head of Banco do Brazil, as the next CEO. The market response was almost universally negative, partly because Mr. Bendine does not have any experience in the oil business and partly because there is no trust left in the Brazilian government. I do not know Mr. Bendine and it would be unfair of me to tar him as a government stooge, just because he was appointed by the government. In fact, I am willing to not only cut him some slack but to also provide advice on what he should do in the coming weeks. Here are my suggestions:
    1. Hire a chief operating officer who knows the oil business and turn over operating responsibilities to him.
    2. Fire anyone in the top management who has any political connections. That may leave lots of empty offices in Petrobras headquarters, but less damage will be done by no one being in those offices than the current occupants.
    3. Side with directors for the minority stockholders and push for a more independent, accountable board.
    4. Refuse to go along with the cap on gasoline prices for Brazilian consumers, a subsidy that has already cost the company $20-$25 billion between 2011 and 2013. With oil prices low, the consumer backlash will be bearable.
    5. Push openly for a move to one class of shares with equal voting rights. Accompany this action by cutting dividends to zero.
    6. Clean up the investment process with less auto-pilot exploration, production that is in line with oil prices and less focus on growth, for the sake of growth.
    7. Start paying down your debt.
    What is the worst that can happen to you? If the government is set on a path of self-destruction, you will be fired. If that happens, wear it as a badge of honor, since your reputation will be enhanced and you will emerge looking like a hero.  If you go along with the status quo, you will preside over the final destruction of what was Brazil’s crown jewel and face the same fate as your predecessor.  Unless the new CEO can come up with a way to remake the company,  my guess is that, at least for the next few months, here is the song that will be playing out in the market:



    Final Thoughts
    There are always lessons to be learned from every calamity and Petrobras qualifies as a calamity. The first is to recognize that there every reason to be skeptical when politicians claim "national interest" and meddle incessantly in public corporations. In most cases, what you have are political interests which may or may not coincide with national interests, where elected politicians and government officials use stockholder money to advance their standing. The second is that those who have labeled "value maximization" as the "dumbest idea" and pushed for stakeholder wealth maximization, a meaningless and misguided objective that only strategists and Davos organizers find attractive, as an alternative, should take a close look at Petrobras as a case study of stakeholder wealth maximization gone amok. In the last five years, Petrobras has enriched countless politicians and politically connected businesses, subsidized Brazilian car owners and provided jobs to tens of thousands of oil workers, leaving stockholders on the outside looking in. Anyone who argues that this is a net good for Brazil has clearly not grasped the damage that has been done to the country in the global market place by this fiasco.

    Corruption update: I have been asked by many of you as to why have sidestepped the corruption stories that have been swirling around the company. I did so, not because I want to avoid controversy (which I don't mind at all) but because I thought that at least in this case, being subtle delivers the message about political game playing better than brute force. At Petrobras, I treat corruption as a really bad investment with horrible returns to stockholders, but I believe that with its management structure, the company was destined for trouble, and that the corruption just greased the skids.

    Attachments

    1. Petrobras valuation spreadsheet



    Blood in the Shark Tank: Pre-money, Post-money and Play-money Valuations

    My kids are inclined to binge TV-watching, especially in the winter, and this Christmas break, when they were all home, they were at it again. Having gone through all the Walking Dead episodes during the summer and  Criminal Minds multiple times, they chose Shark Tank as the show to watch in marathon format. For those of you who have never watched an episode, it involves entrepreneurs (current or wannabe) pitching business ideas to five 'sharks', who then compete (if interested) in offering capital (cash) for a share of the business.  Like some large families, we make even TV watching a competitive sport, especially when there are multiple shark offers on the table, with family members ranking the offers from best to worst. In one episode, a contestant was faced with two offers: the first shark offered $25,000 for 20% of the business and the second one jumped in with $100,000 for 50% of the business. While one family member suggested that the second offer was obviously better and everyone else in my family concurred, I was tempted to argue that it was not that obvious, but wisely chose to say nothing. A late night family gathering is almost never a good teaching moment, especially when your own children are in the audience. 

    Pre-money & Post-money: The VC playbook
    In public company valuation, the contrast between pre-money and post-money valuations almost never is an issue, but in venture capital valuation, it is front and center. Given the central role it plays in venture capital investing, and the consequential effects it has both on capital providers and capital seekers, I assumed that the venture capital playbook would have detailed instructions on the contrast between pre-money and post-money valuation, but I was wrong. In fact, here is what I learned from the playbook. If you pay $X for y% of a business, the post-money value is the resulting scaled-up value and netting out the cash influx yields the pre-money value:
    • Post-money value = $X/y%
    • Pre-money value = $X/y% - $X
    Using the Shark Tank episode in the last paragraph, you can compare the two offers now in post-money and pre-money terms:


    Thus, the two offers effectively attach the same value to the business and at least on this dimension, the entrepreneur should find them equivalent. While the VC definition is technically right, it is sterile, because if you have a pre-money value for a business, you can always extract the post-money value, or vice versa, but both estimates are only as good as your initial value estimate. It is also opaque,  because the process by which value is estimated is often unspecified and and made more so when the simple exchange of capital for a share of ownership is complicated by add ons, with options to acquire more of the business, first claims on cash flows and voting rights thrown into the mix.

    While some of the opacity that accompanies pre-money and post-money valuations is related to the fact that you are dealing with young, start-ups, often without operating histories or clear business models, I believe that some of it is by design. By leaving the discussion of value vague and/or making the exchange of capital for proportion of the business complicated, venture capitalists can create enough noise around the process to confuse entrepreneurs about the values of their businesses. By the same token, the sloppiness that accompanies much of the discussion of pre-money and post-money valuations in venture capital can also lead to excesses during periods of exuberance, where the fact that too much is being paid for a share of a business is obscured by the confusion in the process.

    Pre-money and Post-money in an Intrinsic Value World
    I know that intrinsic valuations (and DCF valuations, a subset) are considered to be unworkable by many in the venture capital community, with the argument given that the young, start-ups that VCs have to value do not lend themselves easily to forecasting cash flows and/or adjusting for risk. I disagree but I think that even if you are of that point of view, the path to understanding pre-money and post-money values is through the intrinsic valuation of a very simple business.

    The Franchise Stage
    Let's assume that you are politically connected and that the government has given you a license to build a toll road. The cost of building the road is $100 million and to keep things really simple, let's assume that the government has agreed to pay you $10 million a year in perpetuity, that you live in a tax-free environment and that the long-term government bond rate is 5%. To get a measure of the value of the license, all you have to do is take the present value of the expected cash flows, net of the cost of building the road:
    • NPV of road = -100 + 10/.05 = $100
    While a conventional accounting balance sheet would show no assets and no value for the business (since the road has not been built), an intrinsic value balance sheet will show this value:


    Note that the $100 million value attributed to you (as the equity investor) in the intrinsic value balance sheet is based on a notional toll road, not one in existence. 

    The Capital Seeking Stage
    Now, let's assume that you don't have the capital on hand to build the road and approach me (a venture capitalist) for $100 million in capital that you plan to use to build the road. Assuming you convince me of the viability of the business and that I invest $100 million with you, here is what the balance sheet will look like the instant after I invest.


    Note that the business value has doubled to $200 million, with half of the value coming from the cash infusion. That cash is transitory and will be used by you to invest in the toll road, and the minute that investment is made, the balance sheet will reflect it.


    While the value of the business has not changed from the post-cash number, the nature of its assets has, with a physical toll road now setting value, rather than a license and cash. Thus, the value of the business after the cash infusion is $200 million and this is the post-money valuation of the company

    The Negotiation Stage
    The question at this point is what proportion of your business I should get as the venture capitalist. At first sight, the answer may seem obvious. The value of the business, after the capital infusion (and investment) is $200 million, and the capital I am providing is $100 million, entitling me to 50%, right? Not so fast! The actual answer will depend upon your bargaining power (as the entrepreneur) and mine (as the venture capitalist), and the easiest way to see this is in the limiting cases:

    • Case 1 - Only entrepreneur in market, Lots of capital providers: Assume that you are the only entrepreneur with a valuable franchise in the economy and there is a large supply of capital (from banks, venture capitalists, private equity investors). You (as the entrepreneur) have all the power in this negotiation and I will end up with a 50% share of the post-money valuation ($200 million).
    • Case 2 - Lots of entrepreneurs with valuable franchises, a monopolist capital provider: At the other extreme, if I (the VC) am the only game in town for capital, I will argue that without me your franchise is worth nothing, and that I should end up with all of the value (thus giving me close to 100% of the business). 
    The reality will fall somewhere in the middle. In general, the value that you will use to compute your percentage ownership will be neither the pre-money, nor the post-money value. It will be the value of the business, with the next best capital provider providing the $100 million in capital. In the toll road example, assume that you can borrow $100 million from a bank at 7.5%, a rate that is much too high, given the risk of the investment (zero). The value of your equity in this toll road will now have to reflect the interest payments on this debt.
    Cash flows after debt payments = $10 million - .075 (100) = $2.5 million
    Value of equity = $2.5 million/.05 = $50 million
    The new balance sheet of the business will reflect this expensive debt:


    Note that the bank has effectively claimed $50 million of the value of the business by charging you too high a rate and netting out the bank's surplus yields a value of $150 million for the toll road, the "ownership value", since the ownership stake will be based on it. As the venture capitalist, I recognize that this is your next best option and demand two-thirds of your business for my $100 million. In summary, then the ownership percentage of your business that I will get in return for my capital provision can range from 50% to close to 100%, depending on the relative  supply of entrepreneurs and venture capital in a market.


    Implications
    1. A DCF valuation, done right, always yields a pre-money value for a business.
    2. The value of a business, after a capital infusion, will have to incorporate the cash that comes into the business, pushing up the post-money value.
    3. The "ownership value on which the ownership proportion is negotiated will move towards the post-money value, when there is an active and competitive (venture) capital market, and towards the pre-money value, when there is not one.

    The Pricing World: Pre-money or Post-money?
    As I noted at the start of the last section, most venture capitalists swear off DCF for many reasons, some justified and some not. Instead, they price businesses using a combination of a forecasted metric and a multiple of that metric (given what others are paying for similar businesses right now). Thus, if you were valuing a start-up money-losing technology firm with no revenues today, you would forecast out revenues three years (or five) from now and apply a multiple to those revenues (based on what the market is paying for public companies in this space) in the third year to get an exit value, which you will then proceed to discount back at a "target" rate of return to get a value today:


    Pricing: Pre or post-money?
    When you price companies, the question of whether the value you arrive at today is a pre-money or post-money valuation becomes murkier. The forecasted revenues that you forecast in year 3 is not (and often are) only based on the assumption that there is a capital infusion in the firm today but that there may be more capital infusions in the future, in which case it is a post-post-post money valuation and adding cash to this value will be double counting. (As an analogy, consider the toll road example that I used in the intrinsic value section. The earnings on the toll road are expected to be $10 million a year and the toll road should trade at about twenty times earnings, given its fundamentals. Using the VC approach, the value that I would get is $200 million, which is the post-money valuation). 

    A pre-money pricing?
    Can you modify the VC approach to deliver a pre-money pricing? Yes, and here is what you would have to do. You would have to forecast two measures of future earnings, one with the capital infusion and one without. In the extreme scenario where the start-up will cease to exist without the capital and there are no other capital providers, the expected earnings in year 3 will be zero, yielding a pre-money valuation of zero for the company. Consequently, you will demand all or almost all of the company in return for your investment.

    Implications

    1. Pricing is opaque: While pricing is market-based, quick and convenient, the cost of pricing an asset rather than valuing it is that the process glosses over details and makes it difficult to figure out what exactly you are getting for your investment today and what you have already incorporated in that number. 
    2. The Target rate is Swiss Army knife of VC valuation; In the VC approach, the target rate (though called a discount rate) is like a Swiss Army knife, serving multiple purposes. First, it is a reflection of the expected return you should make, given the risk in the investment, i.e., the conventional risk-adjusted rate.  Second, it incorporates the survival risk in the company, i.e., the reality that many of the companies  that VCs invest in don't make it and that you have to lower the value of start-ups to reflect this risk. Third, it includes a component to cover the future capital needs of the business, with a higher discount rate being used for companies that will need more rounds of capital. Finally, it is a negotiating tool, with VCs pushing up the target rate, if they feel that they have a strong bargaining position. While it is impressive that so much can be piled into one number, it does make it difficult to figure whether you have counted all of these variables correctly and not double counted or miscounted it. It also implies that the actual returns generated by VCs will bear little resemblance to the target returns; the table below summarizes venture capital returns across VC funds over the last year, three years, five years and ten years and compares them to returns on growth equity mutual funds and the S&P 500.
      Through Sept 30, 2014; Source: National Venture Capital Association (NCVA)
    3. Winners and Losers: It is not clear who wins and loses in the pricing game, when sloppiness rules. In periods where entrepreneurial investments are plentiful and venture capital funding is scarce, it probably leads to venture capitalists claiming too large a stake in the businesses that they invest in, given the capital invested. During periods when entrepreneurial investments are scare and venture capitalists are plentiful, my guess it that it leads venture capitalists to overpay for businesses.

    A Plea for Transparency
    I am not making an argument that venture capitalists and other early stage investors shift to intrinsic valuation. While I believe that they under use and often misunderstand intrinsic valuation, I think that the attachment to pricing is too deep for them to shift. I do believe though that everyone (founders, entrepreneurs, venture capitalists) would be better served if there was more transparency in the process and we were more explicit about the basis for assessing ownership rights (and proportions). Perhaps, I will start by making myself unpopular in my household and bringing up the discussion of pre and post money valuations during Shark Tank!





    Discounted Cashflow Valuations (DCF): Academic Exercise, Sales Pitch or Investor Tool?

    In my last post, I noted that I will be teaching my valuation class, starting tomorrow (February 2, 2015). While the class looks at the whole range of valuation approaches, it is built around intrinsic valuation, reflecting my biases and investment philosophy. I have already received a few emails, asking me whether this is an academic or a practical valuation class, a question that leaves me befuddled, since I am not sure what an academic value is.  As some of you who have read this blog for awhile know, I do try to value companies, but I do so not because I am intellectually curious (I don't lie awake at night wondering what Twitter is worth!) but because I need investments for my portfolio. In the context of these valuations, I have been accused of being a valuation theorist, and I cringe because I know how little theory there is in valuation or at least my version of it. In fact, my entire class is built around one simple equation:


    Put in non-mathematical terms, the equation posits that the value of an asset is the value of the expected cash flows over its lifetime, adjusted for risk and the time value of money. If that sounds familiar, it should, because it is the starting point for every Finance 101 class, a rite of passage that in conjunction with buying a financial calculator sets you on the pathway to being a Financial Yoda! 

    That is the only theory that you need for valuation! The rest of the class is about the practice of valuation: defining and estimating expected cash flows for different types of assets and businesses at different stages in the life cycle and estimating and adjusting the discount rate for risk and time value. Note that there is nothing in this fundamental equation that has not been known to investors and business people through the ages, i.e., the value of a business has always been a function of its cash flows, growth potential and risk and that you certainly don’t need to be mathematically inclined to be able to do valuation. So, if you don’t remember how to take first differentials or solve algebraic equations, never fear. You can still value companies.

    DCF : Neither Magic Bullet nor Bogeyman
    If DCF valuation is simple as its core, why does it intimidate so many? The fault lies both with its proponents and its critics. The proponents, and I would include myself on the list, have undercut the approach's usage and acceptance by:
    1. Over complicating DCF: It is undeniable that most discounted cash flow models suffer from bloat, with layers of detail that we not only don't need, but also make no difference to the ultimate value. These details and complexities are sometimes added with the best of intentions (to get better estimates of cash flows and risk) and sometimes with the worst (to intimidate and to hide the big assumptions). No matter what the intentions are, they make people on the receiving end suspicious.
    2. Over selling DCF: In the hands of bankers, analysts, consultants and managers, DCF models are less analytical devices and more sales tools, backing up a recommendation to buy, sell or change the way we do things.  While that is neither surprising nor newsworthy, it does make those who are the targets of these sales pitches cynical about the process, and who can blame them?
    3. Over sanitizing DCF: I don't know whether DCF's proponents feel that it cannot be defended on its merits or that it is too weak to stand up to scrutiny, but they seem to want to cover up the uncertainties that are embedded into every valuation and play down any hint of story telling that may underlie the numbers or uncertainty in their estimates.
    Like anyone who has ever used a DCF, I have been guilty of these practices and therefore understand the motivation. At the core, it is because we are insecure both about our understanding of DCF and our capacity to explain in intuitive terms why we do what we do. If paid to do valuation, we over compensate and believe that we will be more credible if we churn out overcomplicated, number-driven models and that our clients would not pay us, if they realized how simple the process actually was.

    Those who critique discounted cash flow models (and I certainly agree that there is often to disagree with), are driven by their own share of sins, where they conflate disagreements that they have with input estimation techniques, the model-builder and model output with disagreements with the DCF process itself.
    1. The Baby/Bathwater syndrome: While it is an analogy that makes me cringe each time I use it, with visions of babies flying out of bathroom windows, it is apt in its description of those who take issue with how an input is estimated in a DCF and then extrapolate to conclude that the entire process is flawed. The input that creates the most angst, of course, is the risk measure used in the valuation, with even a mention of beta generating the gag reflex among old-time value investors. 
    2. Dislike you, dislike your model: The line between a DCF model and its builder must be a gray one, since many critics seem to have trouble finding it. Not surprisingly, dislike of a user because of his or her investment philosophy, personality or style of presentation can very quickly translate into disdain about the process by which he or she values companies.
    3. Don’t like your answer: It is human nature but investors tend to like DCF models that deliver answers that they like and dislike models that do not. Even in my limited blog posting experiences, I have been lauded for using sound intrinsic value models, by Apple Bulls, when my valuations have suggested that Apple is cheap. I have also been blasted by often the same investors for using a flawed DCF model, when my valuations suggest otherwise.
    As with the proponents, I think I understand where critics are coming from. After all, if you were constantly the target for sales pitches by analysts who use complicated DCF models to sell snake oil, you would be suspicious too.

    A Return to Basics
    The first step in spanning the divide is to strip away the layers of complexity that we have built into valuation over the decades and return to the equation that I started this post. At the risk of stating the obvious, I would like to draw on four simple and self-evident propositions that get overlooked or ignored frequently in the discussion of discounted cashflow valuation (DCF).
    1. The Duh Proposition: For an asset to have value, its expected cash flows have to be positive at some point in time, but that does not imply that the cash flow has to be positive every single year and it is quite clear that you can have a valuable business (asset) with negative cash flows in the first year, the first three years or even the first seven or eight, if it can deliver disproportionately large positive cash flows later in their lives. It is true that those whose DCF toolbox has only one model in it, usually the Gordon Growth Model (a stable growth dividend discount model), have trouble with such companies, but using the Gordon Growth Model to value most equities is the equivalent of doing surgery with a  hammer: painful, ineffective and designed to come to a bloody end.
    2. You can hate beta (or modern portfolio theory or all of academic finance), but still love DCF: This may come as news to its worst critics but the DCF model does not come prepackaged with modern portfolio theory and its most famous handmaiden, the beta. In fact, while the discount rate in the discounted cash flow model is usually risk-adjusted and reflects the time value of money, the model itself is completely agnostic about how you adjust for risk (you can come up with your own creative ways of making the adjustment) or even whether you adjust for risk. The DCF model is a descriptive equation of a cash-flow generating asset or business, not a theory or a hypothesis.
    3. It is the asset's life, not your time horizon: A DCF model is designed to value an asset over it's life, and is really not malleable to what you (as the investor looking at the asset) believe your time horizon to be. If the value of an asset is the present value of cash flows over its life, what is that life? It clearly depends on the asset. If you are valuing a machine whose functioning life is only one year, all you need is one year's cash flows, but if estimating a value for a rental building with a 20-year life, it would be twenty years. With public companies that at least in theory can last forever, we do stop estimating cash flows at a point in time and assume that cash flows beyond that point continue in perpetuity, but this is an assumption of convenience, not necessity. In fact, there is nothing that stops you from replacing that perpetuity assumption with one that assumes that cash flows will continue for only 20 or 30 years after your closure year.
    4. You will be wrong, and it is not your fault: If you take expected cash flows (where the expectations are across a wide spectrum of outcomes) and discount those expected cash flows at a risk-adjusted discount rate, it should go without saying (but I am going to say it anyway) that the present value that you get is an estimate of value. Thus, you are almost guaranteed to be wrong when valuing assets with any uncertainty about the future, and more wrong when there is more uncertainty. So what? The market price is just as affected by uncertainty, and you are judged not by how wrong you are in absolute terms but how wrong you are, relative to other people valuing the stock.
    Ten Myths about the DCF Model
    While the architecture of the DCF model is simple and the truths that emerge from it are universal, there is a great deal of mythology around DCF valuation, some of it promoted by model-users and some by model-haters.
    • Myth 1: If you have a D(discount rate) and a CF (cash flow), you have a DCF. As a DCF-observer, I see a lot of pseudo DCF, DCFs in drag and other fake DCFs being pushed as discounted cash flow valuations. 
    • Myth 2: A DCF is an exercise in modeling & number crunching. There is no room for creativity or qualitative factors.
    • Myth 3: You cannot do a DCF when there is too much uncertainty, thus making it useless as a tool in valuing start-ups, companies in emerging markets or during macroeconomic crises.
    • Myth 4: The most critical input in a DCF is the discount rate and if you don’t believe in modern portfolio theory (or beta), you cannot use a DCF.
    • Myth 5: If most of your value in a DCF comes from the terminal value, there is something wrong with your DCF, since the value rests almost entirely on what you assume in that terminal value.
    • Myth 6: A DCF requires too many assumptions and can be manipulated to yield any value you want.
    • Myth 7: A DCF cannot value brand name or other intangibles. 
    • Myth 8: A DCF yields a conservative estimate of value. It is better to under estimate value than over estimate it.
    • Myth 9: If your DCF value changes significantly over time, there is either something wrong with your valuation (since intrinsic value should not change over time) or it is pointless (since you cannot make money on a shifting value)
    • Myth 10: A DCF is an academic exercise, making it useless for investors, managers or others who inhabit the real world.
    Each of these myths deserves its own post and I plan to cover all of them in the next year (one myth a month). Stay tuned!

    A Trial Run
    I know that some of you are skeptical about my pitch but if you are, at least give the process a try. If you feel a little rusty on the basics or have questions about details, you are welcome to take my class in real time or the online version of it (which is less trying and has shorter webcasts).



    The GM Buyback: Beyond the Hysteria!

    Here is a script for a movie about the evils of stock buybacks, with the following players. The victim is an well-managed company in a business with significant growth opportunities and profit potential. The company has delivered products that its customers love, while paying its workers top-notch wages & benefits and invested heavily and prudently in its future. The villain is an activist investor, and for added color, let's make him greedy, short term and a speculator. In the story, he forces the  company to redirect money it would have spent on more great investments to buy back stock. The white knight can be a regulator, the government or a noble investor (make him/her successful, wealthy and socially conscious, i.e., Buffett-like) who rides in and saves the hapless company from the villain and stops the buyback. The story ends happily, with the defeat and humiliation of the activist investor, and the moral  is that stock buybacks are evil (and need to be stopped). As you read some of the over-the-top responses to GM's buyback, such as this one, you would not be alone in thinking that you were reading about the mythical company in the movie. But given GM's history and current standing, do you really want to make it the basis for your case against buybacks? 

    GM is not well managed now, and has not been so, for a long time
    Is GM a well managed firm? The answer might have been yes in 1925, when GM was the auto industry's disruptor, challenging Ford, the established leader in the business at the time. It would have definitely been affirmative in 1945, when Alfred Sloan’s strategy of letting GM's many brands operate independently won the automobile market race for GM, and it was the largest and most profitable automobile company in the world. It may have still been positive in 1965, when GM was on top of the world, a key driver of the US economy and US equity markets. 

    By 1985, the bloom was off the rose, as GM (and other US auto makers) were late to respond to the oil crisis and had let Japanese car makers not only take market share but also the mantle of reliability and innovation. In 2005, GM remained the largest car maker in the world, but it was in serious financial trouble, with an ageing customer base and huge legacy costs, from promises made to employees in good times. In 2008, the problems came to a head during the financial crisis, as GM had trouble  making its debt payments, attracted government attention and a bailout. As part of the bargain, equity investors in GM were wiped out and lenders had to accept significantly less than they had been promised. If the objective of the bailout was GM's survival, it worked, as the company was able to reverse a steep drop in revenues (in 2008) and start making profits again. That recovery came at a significant cost to taxpayers, who lost $11.2 billion in the bailout.

    GM was able to go public again in 2010 and since it is the new version of the company that is buying back stock and it would be unfair to burden the incumbents with the mistakes of prior managers, I focus the bulk of my attention on how well the management of this new incarnation has done in its stewardship of the company. The picture below captures the new GM's evolution as a company over the last five years:
    The New GM: Investment, Revenues and Profits from 2010-2014
    GM has been reinvesting actively since it went public again in 2010, adding almost $25.5 billion in investments (in plant, equipment and working capital) to it base. The good news is that revenues have gone up, albeit at an anemic rate (3.56% a year between 2010 and 2014) but the bad news is that these increasing revenues have been accompanied by declining profitability. Even in 2011, the best of the five years in terms of profitability, GM's return on capital of 6.86% lagged its cost of capital.

    Does this imply that the existing management of GM is not up to the task? Not necessarily, since they were dealt a bad hand to begin with. They were saddled with brand names that evoke nothing but nostalgia, a cost structure that put them at a disadvantage (still) relative to other automobile companies and a legacy of past mistakes. At the same time, there is little that this management has done that can be viewed as visionary or exciting in the years since the IPO (in 2010). In fact, the end game for the new GM seems to be the same one that doomed the older version of the company: a fixation on market share (and number of cars sold), a desire to be all things to all people and an inability to admit mistakes. In the last two years, GM’s fumbling response to its "ignition switch" problem seem to have pushed GM back into the  “troubled automobile company” category again. The bottom line is that the best case that you can make for GM's current management is that it is a "blah" management,  keeping the company alive and mildly profitable. The worst case is that this is still a management stuck in a time warp and in denial over how much the automobile business has changed in the last few decades and that it is only a matter of time before the government is faced again with the question of whether GM is too "big to fail".

    The auto business a bad one, with disruption around the corner
    My measure of the quality of a business is simple and perhaps even simplistic. In a good business, the companies collectively in that business should be able to generate a return on capital that exceeds the cost of capital (based on the risk in the business) and the “best” companies in the business should earn significantly more than their costs of capital. The auto business fails both tests. In my most recent data update in January 2015, I computed the aggregated return on capital at auto companies globally (about 125+) in the trailing 12 months leading into January and arrived at 6.47%, a little more than 1% below the collective cost of capital of 7.53% that I computed for auto companies. Lest this be viewed as an outlier, the table below summarizes the aggregated return on capital and cost of capital for companies in the global automobile business each year for the last ten years:

    If you are wondering whether this collective miasma is caused by the laggards in the group, I isolated the twenty largest automobile companies in the world in 2015 and estimated profitability and leverage numbers for them in March 2015:


    Note that, if anything, the return on capital (which is based on operating income and invested book capital) is biased towards making a company look better than it really is (largely because accountants are quick to write off mistakes), but even on this measure, only one of the ten largest companies (Audi) earned a return on capital that is higher than its cost of capital in 2014. In fact, mass-market auto companies like Volkswagen, Toyota and Ford have abysmal returns on capital, suggesting that the club that GM is trying to rejoin is not an attractive one. The typically large automobile company in 2015 is a highly levered behemoth, which struggles to earn enough to cover its cost of capital in a market with anemic revenue growth. 

    Given that the business model for automobile companies seems to have broken down, it should come as no surprise that the business is being targeted for disruption. While I have argued against the pricing premiums that the market is paying for Tesla, it is undeniable that it's entry into the market has speeded up the investments that other auto makers are making in electric cars. Given their track record of poor profitability, I would not be surprised if the next big disruption of this market comes from companies in healthier businesses and that will bring more pressures on existing automobile companies. If there is a light at the end of this tunnel for incumbent automobile companies, I don't see it.

    A GM Buyback: Value Effects?
    In an earlier post on buybacks, I used a picture to illustrate how a buyback may affect value and I think that picture can help in assessing the GM buyback:


    Looking at the picture, I can see why activist investors were pushing GM to return more cash. It is a middling company in a bad business, where even the very best companies struggle to earn their costs of capital. Since it is possible that I am blinded by my stockholder-focus, I considered what GM could have done with the $5 billion, instead of buying back stock.
    1. Invest the cash: GM could have invested the cash back into the auto business, but given the state of the business and the returns generated by players in it, this effectively throws good money after bad. In fact, looking at how little the $25.5 billion in reinvestment has done for GM in the last five years, I think a stronger argument can be made that they would perhaps have been better off not investing that money and returning it to stockholders as well. 
    2. Hold the cash or pay down debt: Auto companies are natural cash hoarders, arguing that as cyclical companies, they need the cash to survive the next recession or downturn. In fact, that argument seems to have added resonance at a company like GM, which has just come out of a near-death experience with default. At the risk of sounding heartless, I would counter that survival for the sake of survival makes little sense. A corporation is a legal entity and there is a corporate life cycle, a time to be born, a time to grow, a time to harvest and finally a time to shut down. If your response is that you cannot let that happen to an American icon like GM, there was a time when Xerox was so dominant in its business that it's corporate name  became synonymous with its product (copies) and Eastman Kodak was the 'camera' company, but pining for those days will not bring them back. The actions driven by the "too big to fail" ethos have cost the taxpayers $11 billion already. Do you really want to do this a second time around with GM?
    3. Return the cash to other stakeholders (labor, the government): You can argue that my view of buybacks fails to take into account the interests of other stakeholders in the firm, its workers, its suppliers and perhaps even the government. It is true that GM could use the $5 billion to give its workers raises and replenish their pensions. That will be good news for those workers, but doing so will only push down the measly return on capital that GM is currently earning, make future access to capital (debt or equity) even more difficult, and set the company on the pathway to financial devastation.
    The Root of the Disagreement
    There are "corporate finance" reasons for arguing against buybacks in some companies and they include concerns about damaging growth potential (where buybacks come at the expensive of good investments), about timing (when companies buy back shares when prices are high, rather than low) , or managerial self-interest (if buybacks are being used to push up stock prices ahead of option exercises). Since it is almost impossible to use any of these with GM, those arguing against a GM buyback are really against all stock buybacks, no matter who does them. While I don't agree with these critics, I think that there is a simple way to understand the vehemence of their opposition and it is rooted in ideology and philosophy, not finance.  If you believe, as I do, that as a publicly traded automobile company, GM's mission is to take capital from investors and generate higher returns for them that they could have made elsewhere, in investments of equivalent risk, with that money, you can justify the buyback and perhaps even argue that it should be more. If you believe that GM's mission as a car company is to build more auto plants and produce more cars, hire more workers and pay them premium wages and save the cities of Flint and Detroit from bankruptcy (as a side benefit), this or any buyback is a bad idea. In fact, it is not just buybacks that you should have a problem with but any cash returned (including dividends) to investors, since that cash could have been used more productively (with your definition of productivity) by the company. It is also extremely unlikely that you will find anything that I have to say about buybacks to be persuasive since we have a philosophical divide that cannot be bridged. So, its best that we agree to disagree!

    Past posts on buybacks

    1. Stock Buybacks: What is happening and why (January 25, 2011)
    2. Buybacks and Stock Prices: Good news or bad news (January 25, 2011)
    3. The Shift to Buybacks: Implications for Investors (February 1, 2011)
    4. Stock Buybacks: They are big, they are back and they scare some people (September 22, 2014)






    Illiquidity and Bubbles in Private Share Markets: Testing Mark Cuban's thesis!

    It looks like Alibaba is investing $200 million in Snapchat, translating (at least according to deal watchers) into a value of $15 billion for Snapchat,  a mind-boggling number for a company that has been struggling to find ways to convert its popularity with some users (like my daughter) into revenues. While we can debate whether extrapolating from a small VC investment to a total value for a company make sense, there are two trends that are incontestable. The first is that estimated values have been climbing at exponential rates for companies like Uber, Airbnb and Snapchat. In venture capital lingo, the number of unicorns is climbing to the point where the name (which suggests unique or unusual) no longer fits. The second is that these companies seem to be in no hurry to go public, leaving the trading in the private sharemarket space. These rising valuations in private markets led Mark Cuban to declare last week that this "tech bubble" was worse (and will end much more badly) than the last one (with dot-com stocks). In the article, Cuban makes four assertions: (1) There is a tech bubble; (2) A large portion of the tech bubble is in the private share market which is less liquid than the public markets; (3) The bubble will be larger and burst more violently because of the absence of liquidity; and (4) This bubble is worse than the dot-com bubble, though it not clear on what dimension and from whose perspective. In his trademark fashion, Cuban ends his article with a provocative questions,  "If stock in a company is worth what somebody will pay for it, what is the stock of a company worth when there is no place to sell it ?" I like Mark Cuban but I think that he is wrong on all four counts.

    This is not a tech bubble
    In my last post, I took issue with the widespread view that the rise in stock prices from the depths of 2008 has been largely due to tech companies using a simple statistic: the proportion of overall equity market capitalization in the United States coming from tech stocks. Unlike the 1990s, when tech companies climbed from single digits in 1990 to almost 30% of the overall market capitalization by the end of 1999, tech stocks collectively have stayed at about 20% of the overall market.

    Tech stocks in S&P 500
    There are other indicators that also support the argument that this is not a tech bubble, since a bubble occurs when market prices disconnect from fundamentals. Unlike the 1990s, the market capitalization of technology companies in 2014 is backed up by operating numbers that are commensurate with value. In the figure below, I compare tech companies to non-tech companies on market values (enterprise and equity) as well as on operating statistics such as revenues, EBITDAR&D, EBITDA, operating income and net income, across the entire US market (not just the S&P 500):
    Tech vs Non-tech companies in US market (Source: Cap IQ)
    One measure of whether a sector is in a bubble is if it accounts for a much larger share of overall market value than it delivers in revenues, earnings and cash flows. In February 2015, tech companies account for about 13.84% of overall enterprise value and 19.94% of market capitalization and they hold their own on almost every operating metric. While tech companies generate only 11% of overall revenues, they account for 19.99% of EBITDA+R&D, 17.93% of operating income and 16.46% of EBITDA, all much higher than tech's 13.84% share of enterprise value, and 18.65% of net income, close to the 19.94% of overall market capitalization. On the cash flow measure, tech firms account for almost 29% of all cash flows (dividends and buybacks) returned to investors, much higher than their share of market capitalization. To provide a contrast, in 1999, at the peak of the dot-com bubble, tech firms accounted for 30% of overall market capitalization but delivered less than 10% of net income and dividends & buybacks. That was a bubble!

    Note, though, that this is not an argument against a market bubble but one specifically against a collective tech bubble. If you believe that there is a bubble (and there are reasonable people who do), it is either a market-wide bubble or one in a specific segment of the tech sector, say baby tech or young tech. In my earlier post, I broke tech companies by age and noted that young tech companies are richly priced. If Cuban's assertion is that young tech companies are being over priced, relative to fundamentals and potential earnings/cash flows, it is a more defensible one, and if it is just about young tech companies in the private share market, it may even be a likely one. Even on that front, though, the question remains whether this over pricing is a tech phenomenon or a young company phenomenon.

    Illiquidity is a continuum 
    Cuban's second point is that this bubble, unlike the one in the nineties, is developing in private share markets, where venture capitalists, institutional investors and private wealth funds buy stakes of private businesses and that these private share markets are less liquid than publicly traded companies. While the notion that public markets are more liquid than private ones is widely held and generally true, illiquidity is a continuum and not all private markets are illiquid and not all publicly traded stocks are liquid. 

    The private share market has made strides in the last decade in terms of liquidity. NASDAQ's private market allows wealthy investors to buy and sell positions in privately held businesses and there are other ventures like SecondMarket and Sharespost that allow for some liquidity in these markets. To those who would argue that this liquidity is skin deep and will disappear in the face of a market meltdown, you are probably right, but then again, what makes you believe that public markets are any different? While it is true that some of the big names in technology have high trading volume and deep liquidity, many of the smaller technology companies often have two strikes against them when it comes to liquidity:
    1. Low Float: The proportion of the shares in these companies that are traded is only a small proportion of the overall shares in the company. Just to illustrate, only 10.5% of the shares in Box, the latest technology listing, are traded in the market and small swings in mood in this market can translate into big price changes. Looking across all stocks in the market, the notion that young tech companies tend to have lower floats is backed up by the data:
      Source: S&P Capital IQ (February 2015 data)
    2. Here today, forgotten tomorrow: The young tech space is crowded, and holding investor attention is difficult. Consequently, while many young tech companies go public to high trading volume, that volume drops off in the weeks following as new entrants draw attention to themselves, as evidenced by the trading activity on Box:
      Box: Stock Price & Volume (Yahoo! Finance)
    The bottom line is a simple one. The liquidity in tech companies in public markets is uneven and fragile, with heavy trading in high profile stocks, in good times, and around earnings reports masking lack of liquidity, especially when you need it the most.  While Mark Cuban worries about the illiquidity of the private share market, I am not sure that it is any more illiquid than the public markets in dot-com stocks were in the 2000, as the market collapsed.

    Liquidity can feed bubbles
    Let us, for purposes of argument, accept that Mark Cuban was talking about baby tech companies in the private share market and that he is right about the private share market being less liquid than public markets, is he right in his contention that bubbles get bigger and burst more violently in less liquid markets? Intuitively, his contention makes sense. With start-ups and very young companies, it is a pricing game, not a value game, and that price is set by mood and momentum, rather than fundamentals (cash flows, growth or risk). If you cannot easily trade an asset, it would seem logical to assume that any shift in mood or momentum in this market will be accentuated. If you bring them together in a private share market, you should have the ingredients for a bigger bubble, right?

    My intuition leads me down the same path, but if there is a lesson that I have learned from behavioral finance, it is that your intuition is not always right. Some of the most interesting research on bubbles, on what allows them to form, and causes them to burst, comes from experimental economics. Vernon Smith, who won a Nobel Prize in Economics for his role in developing the field, has run a series of experiments where he illustrates that adding liquidity to a market makes bubbles bigger, not smaller. To illustrate, he (with two co-authors) ran a laboratory market, where participants traded a very simple asset (that paid out an expected cash flow of 24 cents every period for 15 periods, giving it a fair value of $3.60 at the start of the trading, dropping by 24 cents each period).  Not only did they find bubbles forming in this market, where the price increased to well above the fair value in the intermediate periods, but that these bubbles were bigger and lasted longer, when they gave traders more money (liquidity) to trade in the market:


    In addition, they found that adding liquidity made the bubble bigger earlier in the game. (I strongly recommend this paper to anyone interested in bubbles, because they also explored the effects of adding price limits (like futures markets do), short sales restrictions and experience.) Extrapolating from one experimental study may be dangerous, but if this study holds true, the fact that the private share market is less liquid than a public market may be a check on the market's exuberance, and especially so for young start-ups. Put differently, if liquidity adds to bubbles, Uber, Airbnb and Snapchat would be trading at even higher prices in a public market than they are in the private share markets today.

    If you are struggling with the question of why liquidity adds to market bubbles, let me offer one possible explanation. A market bubble needs a propagating mechanism, a process by which new investors are attracted into the market to keep the price momentum going (on the way up) and existing investors are induced to flee (on the way down). In a public market, the most effective propagating mechanism is an observable market price, as increases in the price draw investors in and price declines chase them out. If you add, to this phenomenon, the ease with which we can monitor market prices on our online devices (rather than wait until the next morning or call our brokers, as we had to, a few decades ago) and access to financial news channels (CNBC, Bloomberg and Fox Business News, to name just the US channels) which expound and analyze these price changes, it is no surprise to me that bubbles have steeper upsides and downsides today than they used to. In a private market, we hear about Uber, Airbnb and Snapchat's valuations only when venture capitalists invest in them and our inability to trade on these valuations may be a restraint on their rising. 

    A big bubble is not necessarily a bad one
    The final component of Mark Cuban's thesis (though I believe that the first three are flawed) is that this bubble is "worse" than prior bubbles. But what is it that makes one bubble worse than another? To me, the cost of a bubble is not whether those invested in the bubble lose money but whether others who are not invested in the bubble are forced to bear some costs when the bubble bursts. It is that spillover effect on other players that we loosely call systemic risk and it is the magnitude of these systemic costs which made the 2007-08 banking bubble so costly.

    With this framework in mind, is this young (baby) tech bubble more dangerous than the one in the late nineties? I don't see why. If the bubble bursts, the immediate losers are the wealthy investors (VCs, private equity investors, and private banking clients) who partake in the private share market. Not only can they afford the losses, but perhaps they need a sobering reminder of why they should not let their greed get ahead of their common sense. In a public market collapse, there will be far more small investors who are hurt, and though they deserve the same wake-up call as wealthier investors, they may less equipped to deal with the losses. This could change if institutions that have no business playing in the private share market (like university endowments and public pension funds) decide to invest big amounts in it and screw it up big time.

    It is true that there will be side costs, as there are in any bubble. First, when a bubble bursts, the lenders/banks that lent money to companies in the bubble will feel the pain (which does not bother me) and then pass it on to taxpayers (which does). Since young tech companies are lightly levered, these costs are likely to be small.  Second, the bursting of a bubble can have consequences for governments that collect tax revenues from these companies (corporate tax), their employees  (income tax) and investors (dividends & capital gains taxes). Again, since young tech companies are money losers, the vast majority of employees settle for deferred compensation and investors in private markets don't cash out quickly, the tax revenue loss will be contained. Third, every burst bubble carries consequences for the real estate in the region (of the bubble). So, yes, the Bay Area will see a drop in real estate value, and is that a bad thing? I don't think so, since anyone in that area, who is not part of the tech boom, has been reduced to living in cardboard boxes. Finally, I believe that the collapse in the private share market, if it happens, will follow a collapse of young tech companies in the public markets (Facebook, Twitter, Box, Linkedin et al.), which I will take as an indication that it is public markets that lead the bubble, not private markets. 

    If this is a bubble, I don't see why its bursting is any more consequential or painful than the implosion of the dot-com bubble. There will undoubtedly be books written by people who claimed to see it coming (perhaps Mark Cuban is vying for a front spot), warnings from the Merchants of Doom (you know who they are) pointing out that this is what happens when greed runs its course and there will be government/market/regulatory action (almost all of it bad, and most of it ineffective) to stop something like this from happening again. So, don't be surprised to see curbs on private share markets or on institutions investing in these markets, as if those curbs will stop the next bubble from occurring. 

    Bottom line
    Mark Cuban's entry into the ranks of the very rich was greased by the 1990s dot-com boom where he built a business of little value, but sold at the right time . Since that is how you win at the pricing game, I tip my hat to him. For him to point fingers at other people who are playing exactly the same game and accuse them of greed and short-sightedness takes a lot of chutzpah. In fact, Cuban's assertion about this being a worse bubble than the dot-com bubble gives us some insight into one very self-serving way to classify bubbles into good and bad ones. A good bubble is one where you are making money of the excesses and a bad one is one where other people are making money (or more money than you are) from the over pricing. If Cuban is serious about staying out of bubbles, he should look at the largest investment in his portfolio, which is in a market where prices have soared, good sense has been abandoned and there is very little liquidity. In a market where the Los Angeles Clippers are priced at $2 billion and the Atlanta Hawks could fetch a billion, the Dallas Mavericks should go for more, right?



    Is your CEO worth his (her) pay? The Pricing and Valuing of Top Managers!

    It is the time of the year when stories about CEO compensation are the news of the day, and investors and onlookers alike get to ask whether a CEO can really be worth tens or even hundreds of millions of dollars, in annual compensation. Before I join the crowd, it behooves me to list my biases to start, because it will allow you to make a judgment on whether I am letting these biases color my conclusions. First, I believe that in some companies, CEOs not only add very little in value to the company but may actively be value destroyers, and that in many companies, what CEOs get paid is out of sync with the value that is created by them. Second, before you put me in the economic populist camp, I also believe the only group that should have a role in deciding how much a CEO gets paid in a publicly traded company is its stockholders, and that politicians, regulators and societal nannies should not get involved. Third, if you, as a stockholder, are disconcerted by the disconnect between CEO pay at your company, and CEO value added, you should be cheering on activist investors and pushing for more power to stockholders, rather than less.

    CEO Compensation: The Landscape
    Companies in the United States are required to break out and report what they pay their CEOs in summary compensation tables, filed with the Securities Exchange Commission (SEC). The numbers are still trickling in from 2014, but here is what we have learned so far:
    1. The early returns suggest that CEOs were paid more this year than they were last year, with collective pay increasing about 12.1% at the largest companies. 
    2. The portion of that compensation that was in cash increased to 37% from 35% in the prior year, with the bulk of the the remaining coming from stock grants (31%) and options (23%); pension gains (6%) and perks (2%) rounded out the rest. 
    3. The highest paid CEO in 2014 was Nick Woodman, CEO of GoPro, who was granted 4.5 million restricted stock units, valued at $284.5 million. 
    Both the New York Times and the Wall Street Journal have visual links, where you can compare CEO pay across sectors, at least for larger companies, though the data is still from 2013.

    It is true, as many others have pointed out, that CEO pay has been increasing at rates far higher than pay for those lower in the pay scale, for much of the last three decades. In the graph below, I look at the evolution of average CEO pay since 1992, broken down broadly by sector:

    Source: Compustat ExecuComp
    Since 1992, the annual compounded increase in CEO pay of 7.64% has been higher than the growth in revenues, earnings or other profitability measures.  Of all the drivers of CEO pay changes over time, none seems to be as powerful as stock market performance, as is clear in this graph going back further to 1965:

    Source: Economic Policy Institute (EPI)
    For those clamoring for legislative restrictions on CEO pay, note that it was a law designed to restrict executive compensation, passed by Congress in 1993, that set in motion an explosion of stock-based compensation that we have seen since. If you break down CEO compensation by its component parts (salary, bonus, equity-based compensation and other), you can see the shift towards equity-based compensation over time:

    Source: Compustat ExecuComp

    While there has been much talk about the ratio of CEO pay to that of an average employee, and that ratio has indisputably jumped over the last three decades, I found this ratio of how much a CEO gets paid, relative to the next highest paid employee in the company, for S&P 500 companies, using 2012-2014 data to be a more useful statistic.
    Source: Compensation Advisory Partners
    The median CEO is paid 2.30 times the next highest-paid employee at an S&P 500 company, which raises the follow up question of whether he or she adds that much more in value. While we can debate that question, the bottom line is that CEO compensation is large, rising and increasingly equity-based, that the growth in pay has accelerated in the last 20 years, and more so in the United States than in the rest of the world.

    Determinants of CEO Pay 
    Not only is CEO pay high, but it varies across time and across companies. There are three broad theories, not mutually exclusive, as to why you see that variance.
    1. Reward for performance: If a CEO is paid to run a company, it stands to reason that he or she should do well when the company does well, though you can measure "doing well" on three dimensions. The first is profitability, with higher profits (and growth in those profits) translating into higher pay. The second is the quality of the profitability, where the focus is on profit margins and returns on invested capital, with higher numbers on either measure resulting in bigger payoffs for CEOs. The third is to use a market measure of performance, by looking at stock price movements, with CEOs who deliver superior returns (either in absolute terms or relative to the market or the sector) getting fatter paychecks.
    2. CEO Market: If you start off with the presumption that it takes a unique skill set to become a CEO and that there is a market for CEOs, the compensation package that the company negotiates with a CEO will be determined by how the market prices his or her skills.
    3. CEO Power: If a CEO is powerful, he or she may be able to get a pay package (from a captive board) that is at odds with performance and much higher than what the market price would have been. There are multiple factors that determine CEO power, starting with his or her stock ownership. CEOs who own controlling stakes (and control does not require 50%+) in companies will be more powerful than CEOs that do not. The second is corporate governance, with all of the inputs that determine whether it is strong or weak; companies with weak or compliant boards of directors and little accountability to shareholders will be more likely to over pay their CEOs. The third is CEO tenure, since there is evidence that the longer a CEO stays in place, the more likely it is that the board will be moulded to meet his or her needs.
    This excellent survey article on the topic  summarizes the evidence, and it is both supportive and inconsistent with each of these theories. Xavier Gabaix, my colleague at the Stern School of business, finds that dominant variable explaining changes in CEO pay over the last three decades has been changes in market value, with CEO pay increasing as market value increases. However, that theory in inconsistent with what happened in the 1950s and 1960s, when US stock market capitalization increased with no dramatic jump in CEO pay. There is some evidence that there are market forces at play, especially in the variation of CEO pay across sectors, but it is difficult to see how market forces can explain the rise in CEO pay in the aggregate. Finally, there is evidence that CEO pay is both more constrained and more tied to performance at companies where activist investors have stakes. At the same time, CEO pay seems to increase (rather than decrease) at firms, after they adopt good corporate governance practices or at least the appearance of such practices. In addition, none of these theories explain why CEO compensation in the US has gone up so much more than CEO compensation in the rest of the world. At the risk of muddying the waters further, I would suggest three more theories that may better explain the pricing of CEOs across time, companies and markets.
    1. The Stock Compensation Delusion: The delusion that stock-based compensation is cheap or even costless seems to be widespread among accountants, analysts and companies. Until the accounting rules changed in 2007, options were valued at exercise value in accounting statements, creating the illusion that you could give away millions of options to CEOs costlessly. Even though the accounting rules have changed, analysts and companies seem intent of reversing the effect of the rules, adding back stock-based compensation to earnings, a senseless practice that I have taken issue with before. One of the more dangerous consequences of this mistreatment of stock-based compensation is that boards of directors continue to be cavalier about granting large stock-based compensation awards to CEOs.
    2. The Momentum Game: The way companies set CEO pay is more evidence of the me-tooism that characterizes so much of what companies do in corporate finance, where they base how much to invest, how much to borrow and how much to pay in dividends/stock buybacks on what other companies in their peer group do. In deciding pay packages for CEOs, boards look at how much CEOs are paid at the peer groups (a subjective grouping to begin with). Like any other market, this relative pricing game can lead to CEO compensation packages climbing the ladder, since all it takes is one company over paying its CEO to set off overpayments across the entire sector. Put more bluntly, the answer that a board generally offers to the question of why it is paying so much to a CEO is that everyone else is doing it.
    3. The Celebrity CEO: In the last two decades, we have seen the rise of celebrity CEOs, more interested in developing superstar status than in managing the companies they are put in charge of, and boards that are willing to pay premium prices (in pay packages) to attract them. The consequences are predictable, with CEOs making big bets (even if the odds are against them), hoping that they will pay off, with the payoff measured less in profits and performance and more in social media mentions and online exposure. (Rakesh Khurana, a professor at the Harvard Business School and Dean of Harvard College, had made this point persuasively in his work on superstar CEOs.)
    There is little new or original that I am adding to the discussion. There is a market for CEOs that sets compensation levels, but the prices that emerge from this market may have little correlation with performance and have more to do with mood, momentum and celebrity status. If you add to that the fact that directors seem to either have no interest or no understanding of the value of stock-based compensation grants, you have the makings of a perfect storm.

    A Framework for analyzing the value added by a CEO
    If the market for CEOs sets CEO pay, the big question then becomes how this market pricing measures up to the value that these CEOs can be expected to add to the company. To measure the value added (or destroyed) by a CEO at a company, you have to identify how the CEO affects the drivers of value. At the risk of over generalizing, here is how I see the effect of good and bad CEOs on value:

    Can you actually value a CEO? I think it can be done, though it will require you to understand how that CEO plans to change the company and quantify the effects. Thus to measure the impact of a CEO on a company's value, you would have to value the company twice, once with an Auto CEO and the other with the CEO in question. With an Auto CEO, the company will stick with the tried and the true, doing what it has done historically in terms of market focus, marketing strategies and risk profile. With the CEO in question, the value effect will depend upon the changes you see that CEO making in the company on one or more of these dimensions. If you are willing to be specific about those changes, you can use this spreadsheet to see the value added by a new CEO and how much you would be willing to pay on an annual basis for that CEO.

    I took the spreadsheet for a spin, using Microsoft as my example, partly because Satya Nadella, Microsoft's CEO, topped the list of highest paid CEOs last year and partly because I have been a stockholder in Microsoft since this post in 2013. If you assume that all that Mr. Nadella can do is slow the slide in margins, he will be able to add $7.74 billion in value to the company (about 2.25% of the company's value), translating into annual compensation of $670 million a year. While I do not agree with everything that Mr. Nadella has done over the last year at Microsoft, I think that he has done enough for me as a stockholder that I don't begrudge him his $84 million pay package.  I believe that Microsoft's board will have to monitor revenue growth and margins to see if he continues delivering, but this analysis indicates how dangerous it is to conclude that a CEO is being paid too much, just because he or she has a large pay package. Using this framework, we can make judgments on the types of companies that CEOs are most likely to make a difference, in good or bad ways.
    1. Life Cycle: A CEO should be able to make a much bigger difference in value early in the life cycle, when potential markets are still being defined and setting and having a coherent and consistent narrative can make the difference between winners and losers. As the firm matures, the CEO's capacity to affect value positively will decrease, though the capability of creating damage (by over reaching) may increase.
    2. Market and Competition: A CEO should have a much bigger impact on value in companies that operate in competitive businesses, where finding and maintaining a competitive edge separates the winners from the losers. In fact, there is research that backs up this contention, with CEO pay being higher, on average, and more tied to performance in more competitive businesses.
    3. Macro versus micro firms: I believe that the value effect that a CEO has on a company is more muted at companies whose value is driven primarily by macro forces (commodity prices, exchange rates, interest rates) than at companies where value is more determined by micro factors (markets targeted, pricing policies etc.). After all, if 80% of the variation in earnings across time is caused by oil price movements, there is not a whole lot that you can do, as a CEO, to affect earnings, an argument that Harold Hamm, CEO of Continental Resources, used in his recent divorce fight.
    4. Small versus Large firms: The value impact that a CEO can have at a large firm will be much higher in absolute terms than at a small firm, simply because the effects of small operating changes in the company can translate into large absolute changes in value. While this may seem to contradict the life cycle argument, we can reconcile the two, if we think about percentage changes in value. A CEO at small, young company will have a much higher percentage effect on value than the CEO at a larger, more mature company, but the latter will still have the larger effect on dollar value.
    The skill set and qualities that make for a value-adding CEO will vary across companies. For a start-up or young growth company, the qualities that create a stand out CEO will be imagination, charisma and narrative skills. For a mature company, CEO greatness may stem from understanding capital markets and sector dynamics and less from vision and imagination. In decline, a company may be best served by a CEO who can deal with slipping revenues and shrinking margins, while managing the return of cash to stockholders and lenders in the firm. It should come as no surprise then, that what makes a founder CEO an asset early in a company's life may him a liability, as the firm matures, and that the skills that made a CEO successful in turning around one company may not be the ones that work in another. 

    The End Game
    If it is true that CEOs are priced and not valued, and that as stockholders in many companies, we are overpaying for our CEOs, what can we do to remedy this problem? I would not look to regulators, governments or tax laws to fix this problem, since these fixes (like the 1993 compensation law) not only operate as bludgeons, but have unintended and perverse consequences. I think that the answer has to be in good corporate governance in the true sense of the words, where shareholders are provided the information and the power to make decisions about CEO pay in the companies that they invest in, and use both effectively. I believe that information on CEO compensation should be revealed to stockholders on a comprehensive and timely basis, that shareholders should have a say on how much CEOs get paid and the power to replace directors who are casual about compensation. The SEC has moved in the right direction on all three fronts, with increased disclosure requirements on CEO pay, by requiring that shareholders be given a "say on pay" at companies and by easing challenges to incumbent directors. On each one, though, there has been push back from defenders of the status quo and the SEC has been unable or unwilling to go the distance.

    Even in a world where disclosure is complete and shareholders are empowered, I recognize that giving shareholders the power to challenge and change management at public companies does not mean that they will use that power often or wisely. Just as voters in a democracy get the government that they deserve, shareholders in companies get the CEOs (and CEO pay packages) that they deserve. Paraphrasing Shakespeare, shareholders who complain loudly and often about CEO excesses should recognize that "the fault is not in their stars but in themselves", have to stop looking to others to make things right and start voting with their shares rather than their feet.

    Spreadsheeets
    1. The Value of a CEO 
    2. Valuing Satya Nadella's value to Microsoft
    3. Microsoft 10K and historical financials
    Data Attachments
    1. Aggregate CEO Compensation breakdown by sector from 1992-2013



    The Search for Investment Serenity: The Look Back Test!

    Late last year, in a post titled “Go where it is darkest”, I argued that the best investment opportunities are likely to be found in the midst of fear and uncertainty. I looked at two companies, Vale and Lukoil, that were caught up in perfect storms, where commodity prices had moved against them, the countries (Brazil and Russia) that they were located in were in turmoil, the local currencies were in retreat and the companies themselves faced corporate governance questions. I concluded that post with the statement that I was investing in Vale and Lukoil, notwithstanding the high risk in each one and the uncertainty that I felt about valuing them, because the risk/return trade off seemed to be tilted in my favor. A few months later, with my investment in Vale down substantially and the investment in Lukoil treading water, I decided to revisit the valuations.

    Looking Back: Testing your investment serenity!
    Satchel Paige is rumored to have once said “Don’t look back. Something might be gaining on you” and most of us take his advice to heart, especially when it comes to investments that have gone bad. We spend almost all of their time thinking about investments that we can add to their portfolios, we repeatedly check on our "winners", crediting ourselves for our foresight in picking them, and we studiously avoid looking at the "losers". Studies of investor behavior find substantial evidence that investors hold on to losers too long and that they are quick to blame outside sources or bad luck for these losers, while attributing winners to their stock picking skills.  

    I believe that the biggest mistakes in investing are made not in what or when you buy, but in what or why you choose not to buy and what and when you sell (what you have already bought). I know that I need to look at my past investments, not to lament mistakes I have made or to wallow in regret, but because each investment in my portfolio has to meet the same test to remain in my portfolio, as it did when I first bought it. As an intrinsic value investor, that test is a simple one. I should buy when a stock trades at a price below its value and should not if it trades above value. Consequently, when I look at my portfolio this morning, I should apply the same rule to every investment in it, asking whether at today’s price and today's estimated value, I should buy more of that stock (if it has become even more under valued), hold on to it (it is remains under valued or has become fairly valued) or sell the stock (if it has become over valued).

    Simple, right? Yes, if are a serene investor who can be dispassionate about past mistakes and rational in your judgments. I am anything but serene, when it comes to assessing past investments and I know that what I choose to do will often be guided by the worst of my emotions, rather than good sense. I will double up (or down) on my losing investments, not because they have become more under valued, but because of hubris, will hold on to my losers, because denial is so much easier than admitting to a mistake, and sell because of panic and fear. While I cannot will myself to rationality, there are things that I try to do to counter my all-too-human emotions. 
    1. Due Process: Left to my own devices, I know that I will selectively revalue only those investments that I like, and only at the times of my choosing, and ignore revaluations that will deliver bad news. It is for this reason that I force myself to revalue each investment in my portfolio at pre-specified intervals (at least once a year and around significant news stories). 
    2. Spread my bets: I have found that I am far more likely to both panic and be defensive about investments that are a large portion of my portfolio than for investments that are small, one reason I stay diversified across many stocks (each of which passes my investment test) rather than a few. 
    3. Be explicit in my valuation judgments: I have found that is far easier to be delusional when you buy and sell based upon secretive, complex and closed processes. It is one reason that I not only try to keep my valuation assumptions explicit but also share my valuations. I know that someone will call me out on my delusions, if I try to tweak them to deliver the results that I want.
    4. Admit publicly to being wrong: I have tried to be public about admitting mistakes, when I make them, because I have found that it frees me to clear the slate. I must admit that it does not come easily to me, but each time I do it, I find it a little easier than the last time.
    5. Have faith but don't make it doctrine: I have faith (misplaced though it might be) that I can estimate intrinsic value and that the price will eventually converge on the value and that faith is strong enough to withstand both contrary market movements and investor views. At the same time, I know that I have to be willing to modify that faith if the facts consistently contradict it. 
    I can hope that one day my investment decisions will not be driven by need to defend, deny or flee from past mistakes, but I am still a work in progress in my quest for investment serenity.

    Vale and Lukoil: The Original Rationale
    I invested in both Vale and Lukoil at the time of my original post (November 19, 2014) and justified my decisions on two fronts:
    1. The Macro Argument: I argued that since both companies were being weighed down by a combination of commodity price, country, currency and company risk, a lifting of any one of these weights would work in favor of my investment. I did confess that I had no market timing skills on any of these fronts and that I was drawing on statistical likelihood that one or another of these weights would lift.
    2. The Micro Story: I picked these companies in particular, rather than others in these markets that faced the same risks, because I felt that they were better positioned both in term of surviving continued market troubles and that they were under valued. In November 2014, I felt that Vale was a better bet than Petrobras, partly because it carried less debt and partly because the Brazilian government had not been as active in directing how the firm was run. At that time, Lukoil carried less debt, was less entangled with the Russian government and had better corporate governance (everything is relative) than Gazprom or Rosneft, two other Russian commodity companies. 
    My valuation of Vale at the time of the post is summarized below:
    Spreadsheet
    At $8.53/share, it looked under valued to me, even with significant drops built into its operating income.

    With Lukoil, the valuation at the time of the post is summarized below:
    Spreadsheet
    It was not as under valued as Vale was, but under valued enough that I was comfortable buying the stock. With both investments, it was the micro bet (that the stock was under valued) that drove my investment but I held out hope that one or more of the macro variables would move in my favor.

    Vale: The Petrobras Blowback?
    Almost five months after my initial foray, I took at look at Vale, fully aware that I would see numbers that I did not like:

    The stock stands as testimonial to one of the dangers of investing on the dark side. Just as you think things are very dark, they can get even darker. In the five months, iron ore prices have dropped 31.07% and Vale, as the largest iron ore producer in the world, has felt the pain. The pain is accentuated by Brazil’s slide in international markets, as its currency has lost almost 15% of its value, relative to the US dollar. The news story that has dominated the news is the ongoing corruption scandals at Petrobras and Vale, in my view, has been caught int he under currents. Vale, after all, shares many characteristics with Petrobras, with the Brazilian government controlling management through a golden share and control of voting shares, a captive board of directors and a dividend policy on auto pilot. 

    With the benefit of hindsight, you could argue that I should have waited but lacking the skills to make that timing judgment, the question I face now is whether I should continue to hold the stock. To answer that question, though, I should be asking whether I would buy the stock today at $6.19, given what the company looks like now. Updating the financials to reflect one more quarter of data and  a continued drop in iron ore prices, I revalued the company:
    At the value that I obtain, $10.71 per share, the stock is under valued by about 42% at its stock price of  $6.19 on April 15, but that value is down dramatically from the $19.40/share that I estimated last November. Part of the reason lies in the fundamentals (with commodity prices dropping and country risk expanding) but part of it reflects my valuation mistakes (a failure to adjust operating income adequately for the drop in iron ore prices). Notwithstanding my failures at forecasting, at today's price and value, I would have no qualms about buying the stock.

    I know that I may be letting my desire to be right override my good sense and setting myself for more pain in the future, and I am aware that there are three big dangers that await me. First, the reported earnings for 2014 reflect some, but not all, of the damage from lower iron ore prices,  and it is almost certain that there will be more bad news on earnings this year. Second, the decline in iron ore prices shows no sign of letting up and it is possible that there will be no bounce back in iron ore prices for a while. Third, now that the Petrobras goose has stopped laying golden eggs, the Brazilian government may turn its attention and interest to Vale and that would be deadly for investors. 

    Lukoil: The Russian Adventure continues
    The last five months have been interesting ones in the oil market, as oil prices have continued to slide. In the graph below, I look at Lukoil from the date of my original purchase through April 15.



    In a period where oil prices dropped 17.75%  and the global oil index declined by 4.66%, Lukoil held up remarkably well, increasing 4.23%. Much as I would like to claim credit for my stock picking skills, it is worth noting that  the MICEX was up 10.39% in local currency terms and about 5% in US dollar terms over the same period. 

    As with Vale, I revisited my valuation of Lukoil, updating the numbers to reflect an earnings report from the company and updated market numbers.
    Spreadsheet
    The value has dipped slightly to $48.49/share, largely as a consequence of lower oil prices, and the price has risen slightly to $51.69/share, leaving me with the end result that the stock is slightly over valued today. If I were making a decision on whether to buy the stock today, I would be not buy the stock, but since I have it in my portfolio already, I am inclined to hold on to it, since it is close to fairly valued.

    The Closing
    As you can sense from my ramblings during this post, what started as an assessment of whether Vale and Lukoil should continue to be part of my portfolio has become a rumination on the much bigger question of investing faith and  philosophy. In investing, I think it is dangerous to have both too little faith and too much. If you have too little faith,  you will abandon your investments too quickly, if the market moves against you or if others seem to be doing much better than you are. If you have too much faith, you can cross the line into fanaticism, where you are so convinced of your rightness that you ignore facts to the contrary. I hope that my faith in my intrinsic value is both strong enough to withstand short terms set backs and to adapt to changing market circumstances and that I can find some measure of investment serenity.

    Attachments
    Vale: Annual Financials for 2014 (20F)
    Lukoil: Annual Report for 2014 
    Vale Valuations: November 2014 and April 2015 
    Lukoil Valuations: November 2014 and April 2015






    The Small Cap Premium: Where is the beef?

    For decades, analysts and investor have bought into the idea of a small cap premium, i.e., that stocks with low market capitalizations can be expected to earn higher returns than stocks with higher market capitalizations. For investors, this has led to the pursuit of small cap stocks and funds for their portfolios, and for analysts, it has translated into the addition of "small cap" premiums of between 3-5% to traditional model-based expected returns, for companies that they classify as small cap. While I understand the origins of the practice, I question the adjustment for three reasons: 
    1. On closer scrutiny, the historical data, which has been used as the basis of the argument, is yielding more ambiguous results and leading us to question the original judgment that there is a small cap premium.
    2. The forward-looking risk premiums, where we look at the market pricing of stocks to get a measure of what investors are demanding as expected returns, are yielding no premiums for small cap stocks. 
    3. If the justification is intuitive, i.e., that smaller firms are riskier than larger firms, much of that additional risk is either diversifiable, better adjusted for in the expected cash flows (instead of the discount rate) or double counted.
    The small cap premium is a testimonial to the power of inertia in corporate finance and valuation, where once a practice becomes established, it becomes difficult to challenge, even if the original reasons for it have long since disappeared.

    The Basis
    The first studies that uncovered the phenomenon of the small cap premium came out in the 1970s. They broke companies down into deciles, based on market capitalization, and found that companies in the lowest decile earned higher returns, after adjusting for conventional risk measures, than companies in the highest decile. I updated those studies through the end of 2014, and the small cap premium seems intact (at least at first sight). In summary, looking at returns from 1926 to 2014, the smallest cap stocks (in the lowest decile) earned 4.33% more than the market, after adjusting for risk.
    Source: Ken French's online data
    This is the strongest (and perhaps) only evidence for a small cap premium and it is reproduced in data services that try to estimate historical risk premiums (Ibbotson, Duff and Phelps etc.).  This historical premium has become the foundation for both valuation and investment practice. In valuation, analysts have referenced this table to estimate a small cap premium (4-5%) that they then add to the required return from conventional risk and return models to estimate discount rates. For instance, in the conventional capital asset pricing model, it plays out as follows:
    Expected Return = Risk free rate + Beta * Equity Risk Premium + Small Cap Premium
    That discount rate is used to estimate the value of future cash flows, and not surprisingly, the use of a small cap premium lowers the value of smaller companies. 

    In investing, it has been used as a weapon both for and against active investing. Those who favor active investing have pointed to the small cap premium as a justification for their activity, and during the periods of history when small cap companies outperformed the market, it did make them look like heroes but it quickly gave rise to a counterforce, where performance measurement services (like Morningstar) started incorporating portfolio tilts, comparing small cap funds against small cap indices. Since almost all of the "excess returns" disappeared on this comparison, it was only a matter of time before index funds entered the arena, creating small-cap index funds for investors who wanted to claim the premium, without paying large management fees.

    The Problem with the Historical Premium
    In the decades since the original small cap premium study, the data on stocks has become richer and deeper, allowing us to take a closer look at the phenomenon. There are some serious questions that can be raised about whether the premium exists and if so, what exactly it is measuring:
    1. Trend lines and Time Periods: Small cap stocks have earned higher returns than large cap stocks between 1928 and 2014 but the premium has been volatile over history, disappearing for decades and reappearing again. While the premium was strong prior to 1980, it seems to have dissipated since 1981. One reason may be that the small cap premium studies drew attention and investor money to small cap stocks, and in the process led to a repricing of these stocks. Another is that the small cap premium is a side effect of larger macroeconomic variables (inflation, real growth etc.) and that the behavior of those variables has changed since 1980.
      Source: Ken French's online data
    2. Microcap, not small cap premium: Even over the long time period that provides the strongest support for existence of a small cap premium, one study finds that removing stocks with less than $5 million in market cap causes the small firm effect to vanish. In effect, what you have is microcap premium, isolated in the smallest of stocks, not just small stocks.
    3. Standard Error: Historical equity returns are noisy and any estimates of risk premium from that data will reflect the noise in the form of large standard errors on estimates. I have made this point about the overall historical equity risk premium but it becomes magnified when you dice and slice historical data into sub-classes. The table below lists standard errors in excess returns by decile class and reinforce the notion that the small cap premium is fragile, barely making the threshold for statistical significance over the entire period.
      Source: Ken French's online data
    4. The January Effect: One of the most puzzling aspects of the small cap premium is that almost all of it is earned in one month of the year, January, and removing that month makes it disappear. So what? If your argument for the small cap premium is that small cap stocks are riskier, you now have the onus of explaining why that risk shows up only in the first month of every year. 
      Source: Ken French's online data
    5. Weaker globally: The small cap premium seems to be smaller in non-US markets than in US markets and is non-existent in some. In contrast, the value effect (where low price to book stocks outperform the market) is strong globally. 
    6. Proxy for other factors: A host of papers argue that the bulk or all of the small size effect can be attributed to a liquidity effect and that putting in a proxy for illiquidity makes the size effect disappear or diminishes it.
    7. Works only with market cap: Finally, you can take issue with the use of a market-priced based measure of size in a study of returns. Others have tried other non-price size measures such as income or revenues but there seems to be no size effect in those variables. 
    A recent working paper by Asness, Frazini, Israel, Moskowitz and Pedersen tries to resurrect the size effect, but accomplishes it only by removing the subset of small companies that they classify as "low quality" or "junk". While the results are interesting and can be used by active small-cap fund managers as a justification for their activity, they are in no way a basis for adding a small cap premium to every small company, and asking analysts to add it on only for small, high quality companies is problematic. In summary, if the only justification that you can offer for the addition of a small cap premium to your discount rate is the historical risk premium, you are on thin ice. 


    Market-Implied Small Cap Premium

    If the historical data ceases to support the use of a historical risk premium, can we then draw on intuition and argue that since small companies tend to be riskier (or we perceive them to be), investors must require higher return when they invest in them? You can, but the onus is then on you to back up that intuition. In fact, you can check to see whether investors are demanding a forward looking "small cap" premium, by looking at how they price small as opposed to large companies, and backing out what investors are demanding as expected returns. Put simply, if small cap stocks are viewed by investors as riskier and that risk is being priced in, you should expect to see, other things remaining equal, higher expected returns on small cap stocks than large cap stocks.

    As some of you are aware, I compute a forward-looking equity premium for the S&P 500 at the start of each year, backing out the number from the current level of the index and expected cash flows. On January 1, 2015, this is what I found:

    In effect, to the extent that my base year cash flows are reasonable and my expected growth rate reflects market expectations, the expected return on large cap stocks on January 1, 2015 was 7.95% in the US (yielding an overall equity risk premium of 5.78% on that day).

    To get a measure of the forward-looking small cap premium, I computed the expected return implied in the S&P 600 Small Cap Index, using the same approach that I used for S&P 500. In spite of using a higher expected earnings growth for small cap stocks, the expected return that I estimate is only 7.61%:


    In effect, the market is attaching a smaller expected return for small cap stocks than large ones, stories and intuition notwithstanding. 

    I am not surprised that the market does not seem to buy into the small cap premiums that academics and practitioners are so attached to. After all, if the proponents of small cap premiums are right, bundling together small companies into a larger company should instantly generate a bonus, since you are replacing the much higher required returns of smaller companies with the lower expected return of a larger one. In fact, small companies should disappear from the market.

    The Illiquidity Fig Leaf
    Looking at the data, the only argument left, as I see it, for the use of the small cap premium is as a premium for illiquidity, and even on that basis, it fails at one of these four levels:
    1. If illiquidity is your bogey man in valuation, why use market capitalization as a stand-in for it? Market capitalization and illiquidity don't always go hand in hand, since there are small, liquid companies and large, illiquid ones in the market. Four decades ago, your excuse would have been that the data on illiquidity was either inaccessible or unavailable and that market capitalization was the best proxy you could find for illiquidity. That is no longer the case and there are studies that categorize companies based on measures of illiquidity (bid ask spread, trading volume) and find an "liquidity premium" for illiquid companies.
    2. If illiquidity is what you are adjusting for in the small cap premium, why is it a constant across companies, buyers and time? Even if your defense is that the small cap premium is an imperfect (but reasonable) measure of the illiquidity premium, it is unreasonable to expect it to be the same for every company. Thus, even if you are valuing just privately owned businesses (where illiquidity is a clear and present danger), that illiquidity should be greater in some businesses than in others and the illiquidity (or small cap) premium should be larger for the former than the latter. Furthermore, the premium you add to the discount rate should be higher in some periods (during market crises and liquidity crunches) than others and for some buyers (cash poor, impatient) than others (patient, cash rich).
    3. Even if you can argue that illiquidity is your rationale for the small cap premium and that it is the same across companies, why is it not changing over the time horizon of your valuation (and especially in your terminal value)? In any valuation, you assume through your company's cash flows and growth rates that your company will change over time and it is inconsistent (with your own narrative) to lock in an illiquidity premium into your discount rate that does not change as your company does. Thus, if you are using a 30% expected growth rate on your company, your "small" company is getting bigger (at least according to your estimates) and presumably more liquid over time. Should your illiquidity premium therefore not follow your own reasoning and decrease over time?
    4. If your argument is that size is a good proxy for illiquidity, that all small companies are equally illiquid and that that illiquidity does not change as you make them bigger, why are you reducing your end value by an illiquidity discount? This question is directed at private company appraisers who routinely use small cap premiums to increase discount rates and  also reduce the end (DCF) value by 25% or more, because of illiquidity. You can show me data to back up your discount (I have seen restricted stock and IPO studies) but none of them can justify the double counting of illiquidity in valuation.
    Why are we slow to give up on the “small cap” premium?

    It is true that the small cap premium is established practice at many appraisal firms, investment banks and companies. Given the shaky base on which it is built and how much that base has been chipped away in the last two decades, you would think that analysts would reconsider their use of small cap premiums, but there are three powerful forces that keep it in play.
    1. Intuition: Analysts and investors not only start of with the presumption that the discount rates for small companies should be higher than large companies, but also have a “number’ in mind. When risk and return models deliver a much lower number, the urge to add to it to make it "more reasonable" is almost unstoppable. Consequently, an analyst who arrives at an 8% cost of equity for a small company feels much more comfortable after adding a 5% small cap premium. It is entirely possible that you are an idiot savant with the uncanny capacity to assess the right discount rate for companies, but if that is the case, why go through this charade of using risk and return models and adding premiums to get to your "intuited" discount rate? For most of us, gut feeling and instinct are not good guides to estimating discount rates and here is why. Not all risk is meant for the discount rate, with some risk (like management skills) being diversifiable (and thus lessened in portfolios) and other risks (like risk of failure or regulatory approval) better reflected in probabilities an expected cash flow. A discount rate cannot and is not meant to be a receptacle for all your hopes and fears, a number that you can tweak until your get to your comfort zone. 
    2. Inertia (institutional and individual): The strongest force in corporate finance practice is inertia, where much of what companies, investors and analysts do reflects past practice. The same is true in the use of the small cap premium, where a generation of analysts has been brought up to believe (by valuation handbooks and teaching) that it is the right adjustment to make and now do it by rote. That inertia is reinforced in the legal arena (where many valuations end up, either as part of business or tax disputes) by the legal system’s respect for precedence and general practice. You may view this as harsh, but I believe that you will have an easier time defending the use of a bad, widely used practice of long standing in court than you would arguing for an innovative better practice.
    3. Bias: My experiences with many analysts who use small cap premiums suggest to me that one motive is to get a “lower” value". Why would they want a lower value? First, in accounting and tax valuation, the client that you are doing the valuation for might be made better off with a lower value than a higher one. Consequently, you will do everything you can to pump up the discount rate with the small cap premium being only one of the many premiums that you use to “build up” your cost of capital. Second, there seems to be a (misplaced) belief that it is better to arrive at too low a value than one that is too high. If you buy into this “conservative” valuation approach, you will view adding a small cap premium as costless, since even it does not exist, all you have done is arrived at “too low” a value. At the risk of bringing up the memories of statistics classes past, there is always a cost. While “over estimating” discount rates reduces type 1 errors (that you will buy an over valued stock), it comes at the expense of type 2 errors (that you will hold off on buying an under valued stock).
    A Requiem for the Small Cap Premium?

    I have never used a small cap premium, when valuing a company and I don’t plan to start now. Needless to say, I am often asked to justify my non-use of a premium and here are my reasons. First, I am not convinced by either the historical data or by current market behavior that a small cap premium exists. Second, I do believe that small cap companies are more exposed to some risks than large cap companies but there are other more effective devices to bring these risks into valuation. If it is that they are capital constrained (i.e., that it is more difficult for small companies to raise new capital), I will limit their reinvestment and expected growth (thus lowering value). If it is that they have a greater chance of failure, I will estimate a probability of failure and reflect that in my expected value (as I do in my standard DCF model). If it is illiquidity that is your concern, it is worth recognizing that one size will not fit all and that the effect on value will vary across investors and across time and will be better captured in a  discount on value.

    To illustrate how distorted this debate has become, note that those who routinely add small cap premiums to their discount rates are not put to the same test of justifying its use. So, at the risk of opening analysts up to uncomfortable questions, here are some questions that you should pose to anyone who is using a small cap premium (and that includes yourself):
    1. What is your justification for using a small cap premium? If the defense is pointing to history (or a data table in a service), it is paper thin, since that historical premium defense seems to have more holes in it than Swiss cheese. If it is intuitive, i.e., that small companies are riskier and markets must see them as such, I don't see the basis for the intuition, since the implied costs of equity for small companies are no higher than those of large companies. If the argument is that everyone does it, I am sorry but just because something is established practice does not make it right. 
    2. What are the additional risks that you see in small companies that you don't see in large ones? I am sure that you can come up with a laundry list that is a mile long, but most of the risks on the list either don't belong in the discount rate (either because they are diversifiable or because they are discrete risks) or can be captured through probability estimates. If it is illiquidity that you are concerned about, see the section on illiquidity above for my response.
    If you are investors, here are the lessons I draw from looking at the data. If you are following a strategy of buying small cap stocks, expecting to be rewarded with a premium for just doing that, you will be disappointed. Even the most favorable papers on the small cap premium suggest that you have to add refinements, with some suggesting that these refinements should screen out the least liquid, riskiest small cap stocks and others arguing for value characteristics (stable earnings, high returns on equity & capital, solid growth). I do think that there is a glimmer of hope in the recent research that the payoff to looking for under valued stocks may be greater with small companies, partly because they are more likely to be overlooked, but it will take more work on your part and it won't be easy!

    Data sets

    Spreadsheets



    Dealing with Low Interest rates: Investing and Corporate Finance Lessons

    A few months ago, I tagged along with my wife and daughter as they went on a tour of the Federal Reserve Building in downtown New York. While the highlight of the tour is that you get to see large stacks of US dollars in the basement of the building, I considered making myself persona non grata with my immediate family by asking the guide (a very nice Fed employee) about the location of the interest rate room. That, of course, is the room where Janet Yellen comes in every morning and sets interest rates. I am sure that you can visualize her pulling the levers that sets T.Bond rates, mortgage rates and corporate rates and the power that comes with that act. If that sounds over the top, that is the impression you are left with, not only from reading news stories about central banks, but also from opinion pieces from some economists and investment advisors. I know that investors, analysts and CFOs are all rendered off balance by low interest rates, but I will argue that the techniques that they use to compensate are more likely to get them in trouble than solve their problems.

    The what: Interest rates are at historic lows across the globe
    There is little to debate. Interest rates are lower than they have been in a generation and you can see it in this graph of the US 10-year treasury bond rate going back several decades:
    US 10-year T.Bond rates at the end of each year
    But it is not just the US dollar where low interest rates prevail, as illustrated by the German government 10-year Euro bond rate, the Japanese government 10-year Yen bond rate and the Swiss Government 10-year Swiss franc rate trend lines:
    Ten-year Government Bond Rates: End of each period
    In fact, on the Swiss Franc, the 10-year bond rates rates have not just dropped but have hit zero and kept going to -0.09%, leading to the almost unfathomable phenomenon of negative interest rates on long term borrowing. A world where savers have to pay banks to keep their savings and borrowers are paid money to borrow turns everything that we have learned in economics on its head and it is therefore no surprise that even seasoned investors and analysts are unsure of what to do next.

    The why: Its not just central banks
    Why are interest rates so low? I know that the conventional wisdom is that it is central bank policy that has driven them there, but is that true? To answer that question, I decided to do go back to basics.

    The Fundamentals
    While market interest rates are set by demand and supply, as they are in any other market, there are fundamentals that determine that rate. In particular, the interest rate on an investment with no default risk (a guaranteed or risk free investment) can be written as the sum of two components:
    Interest rate on a guaranteed investment = Expected inflation + Expected real interest rate
    This is the simplified version of the classic Fisher equation and it is true by construction. In fact, many analysts use it to decompose market interest rates; thus if the US treasury bond rate is at 2.00% and expected inflation is 1.25%, the real interest rate is backed out at 0.75%. In the long term, I would argue that a real interest rate has to be backed up by a real growth rate in the economy. After all, you cannot deliver a 2% real interest rate in an economy growing at only 1% a year in the long term, though you can get short term deviations between the two numbers. Thus, in the long term, the interest rate on a guaranteed investment can be rewritten as:
    Interest rate on a guaranteed investment = Expected inflation + Expected real growth rate
    How well does this simplistic equation hold up in practice? Testing it is hard, especially when you can observe only actual inflation and real growth but not expected inflation and real growth. However, we also know that expectations for inflation and real growth are driven, for better or worse, by recent history; thus expected inflation increases after periods of high inflation and decreases after periods of low inflation, thus making actual inflation and real growth reasonable proxies for expected values. The final number we need to test out this relationship is the interest rate on a guaranteed investment, and we use the US 10-year treasury bond rate as the stand in for that number, with the concession that the last 5 years have shaken investor faith in the guarantee.
    Source: FRED (Federal Reserve in St. Louis)
    Even if you take issue with my proxies for expected inflation (the actual inflation rate in the US each year, as measured by the CPI), real growth (the real growth rate in US GDP and the interest rate on a guaranteed investment, the graph sends a powerful message that risk free rates are driven by inflation and real growth expectations. If expected inflation is low and real growth is anemic, as has been the case since 2008, interest rates will be low as well and they would have been low, with or without central bank intervention.

    The Central Bank Effect
    Do central banks have influence over interest rates? Of course, but the mechanisms they use are surprisingly limited. In the United States, the only rate that the Fed sets is the Fed Funds rate, a rate at which banks can borrow or lend money overnight. Thus, if the Fed wants to raise (lower) interest rates, it has historically hiked (cut) the Fed Funds rate and hoped that bond markets (treasury and corporate) respond accordinly. One way to measure the effect of Fed action is to compute the difference between the actual US treasury bond rate each period and the “intrinsic” treasury bond rate (computed as the sum of inflation and real GDP growth that year):
    Source: FRED
    Note that the Fed Funds rate hit zero in 2009 and has stayed there for the last five years, effectively eliminating it as a tool for controlling rates. Perhaps driven by desperation and partly motivated by the savior complex, the Fed has turned to a relatively unused tool in its arsenal and bought large quantities of US treasury bond in the market for the last five years, the much-talked about Quantitative Easing (QE). While it is true that T.Bond rates have stayed below intrinsic interest rates over the last 5 years, the effect of QE (at least to my eyes) seems to modest.

    As the economy comes back to life, all eyes have turned towards Janet Yellen and the Fed and Fed-watching has become the central focus for many investors. While that is understandable, it is worth remembering that in today's economic environment, with low inflation and real growth, the removal of the Fed prop will not cause interest rates to pop to 5% or 6% . In fact, based upon the numbers in the most recent year, the intrinsic interest rate is 3.08% and if the central banking props disappear, that would be the number towards which US treasury bond rates move.

    Given the evidence to the contrary, it is puzzling that investors continue to hold on to the belief that central banks set interest rates and can change them on whim, but I think that the delusion serves both sides (investors and central banks) well. Investors, whipsawed by market and economic forces that are uncontrollable, feel comfort in attributing the power to set interest rates to central banks. It also allows investors to attribute every phenomenon that they have trouble explaining to central banking machinations and interest rates that are either "too high" or "too low". Quantitative Easing in all its forms has proved to be absolutely indispensable as a bogey man that you can blame for the failure of active investing, the rise and fall of gold, and bubbles of every type. Central banks, which are really more akin to the Wizard of Oz, in their powers, than Masters of the Universe, are glad to play along, since their power comes from the illusion that they have real power.

    The Crisis Effect
    There is another factor at play that may be more powerful than central banks, at least over short periods, and that is the perception of a crisis. Whatever the origins or form of the crisis, investors respond with fear, and flee to safety. That "flight to quality" often manifests itself in declining interest rates on bonds issued by governments that are perceived as "higher quality", and may push those rates well below intrinsic levels. Looking at the chart where we outline the gap between the T.Bond rate and its intrinsic value, the quarter where we saw the US 10-year treasury bond rate drop the most, relative to its intrinsic value, was the last quarter of 2008, where the crisis in financial markets led to a rush into US treasuries. That translated into a precipitous drop in treasury rates across the board, with the 10-year rate dropping from 3.66% on September 12, 2008,  to 2.2% at the end of 2008, and the T. Bill rate declining from 1.62% to 0.02% over the same period.
    Source: FRED- Constant Maturity Rates on 3-month and 10-year treasuries
    One of the few constants over the last six years has been that we lurch from one crisis to another, with local problems quickly going global. While there are some who may argue that this is a passing phase, I believe that this is part and parcel of globalization, one of the negatives that need to get offset against its positives. As economies and markets become increasingly interconnected, I think that the recurring crisis mode will be a permanent feature of market. One consequence of that may be that market interest rates on government bonds will settle below their intrinsic values, a permanent "crisis discount", with or without central banking intervention.

    The Interest Rate Effect 
    The level of interest rates matter for all of us, as investors, consumers and businesses. For investors, interest rates drive expected returns on investments of all types through a very simple process:
    Expected Return (r) = Interest rate on a risk free investment + Risk Premium
    That expected return then determines what we will be willing to pay for a risky asset, with lower expected returns translating into higher prices. For businesses, these expected return becomes hurdle rates (costs of equity and capital) that they use to decide not only whether and where they should invest their money but plays a role in how much they borrow and how much to return to stockholders (as dividends or buybacks).

    If the risk free rate drops and you leave the risk premiums and cash flows unchanged, the effect on value is unambiguously positive, with value rising as risk free rates drop. Thus, if you have a business that has $100 million in expected cash flows next year, with a growth rate of 4% a year in perpetuity and an equity risk premium of 4%, changing the risk free rate from 6% down to 2% will have profound effects on value. It is this value effect that has led some to blame the Fed for creating a "stock market bubble" and analysts across the world to wonder whether they should be doing something to counter that effect, in their search for intrinsic value.

    While the mathematics that show the link between value and interest rates is simple, it is misleading because it does not tell the whole story. As I argued in the last section, interest rate movements, up or down, almost never happen in a  vacuum. The same forces that cause significant shifts in interest rates affect other inputs into the valuation and those changes can reduce or even reverse the interest rate effect:

    To illustrate, the 2008 crisis that caused the T.Bond rate to plummet in the last quarter of the year also caused equity risk premiums to surge from 4.37% on September 12, 2008 to 6.43% on December 31, 2008. In the figure below, I back out the expected return on stocks and the equity risk premium from the index level each day and the expected future cash flows for each month from September 2008 to April 2015. Note that the cost of equity for the median US company rose in the last quarter of 2008, even as risk free rates declined. 
    Source: Damodaran.com (Implied ERP)

    The expected return on equities has stayed surprisingly stable (around 8%) for much of the last 5 years, nullifying the impact of lower interest rates and casting doubt on the "Fed Bubble" story. As the crisis has receded, investor concerns have shifted to real growth, as the developed market economies (US, Euro Zone and Japan) have been slow to recover and inflation has not only stayed tame but turned to deflation in the EU and Japan. Thus, looking just at lower interest rates and making judgments on value misses the big picture.

    Reacting to Low Interest Rates
    Given that low interest rates have shaken up the equation, what should we do to respond? Broadly speaking, there are four responses to low interest rates:
    1. Normalize: In valuation, it is common practice to replace unusual numbers (earnings, capital expenditures and working capital) with more normalized values. Some analysts extend that lesson to risk free rates, replacing today’s “too low” rates with more normalized values. While I understand the impulse, I think it is dangerous for three reasons. The first is that "normal" is a subjective judgment. I argue, only half in jest, that you can tell how long an analyst has been in markets by looking at what he or she views as a normal riskfree rate, since normal requires a time frame and the longer that time frame, the higher normal interest rates become. The second is that if you decide to normalize the risk free rate, you have no choice but to normalize all your other macro variables as well. Consequently, you have to replace today’s equity risk premium with the premium that fits best with your normalized risk free rate and do the same with growth rates. Put differently, if you want to act like it is 2007, 1997 or 1987, when estimating the risk free rate, your risk premiums and growth rates will have to be adjusted accordingly. The third is that unlike earnings, cash flows or other company-specific variables, where you are free to make your judgment calls, the risk free rate is what you can earn on your money today, if you don’t invest in risky assets. Consequently, if you do your valuation, using a normalized risk free rate of 4% (instead of the actual risk free rate of 2%), and decide that stocks are over valued, I wish you the very best of luck putting your money in that normalized treasury bond, since it exists only in your estimation.
    2. Go intrinsic: The second option, if you believe that the market interest rate on government bonds is being skewed by central banking action to abnormally low or high levels is to replace that rate with an intrinsic interest rate. If you buy into my estimates for inflation and real growth in the last section, that would translate into using a 3.08% “intrinsic” US treasury bond rate. To preserve consistency, you should continue to use the same inflation rate and real growth as your basis for forecasting earnings and cash flow growth in your company and going the distance, you should estimate an intrinsic ERP, perhaps tying it to fundamentals.
    3. Leave it alone: The third option is to leave the risk free rate at its current levels, notwithstanding concerns that you might have about it being too low or too high. To keep your valuation in balance, though, your other inputs have to be consistent with that risk free rate. That implies using forward-looking prices for risk (equity risk premiums and default spreads) that reflect the market today and economy-wide growth and inflation rates that are consistent with the current risk free rate. Thus, if you decide to use 0.21% as the risk free rate in Euros, the combination of inflation and real growth rates you have to assume in the Euro economy have to combine to be less than 0.21%. Doing so does not imply that you believe that nominal growth will be that low but ensures that you are making the same assumptions about nominal growth in the numerator (cash flows) as you are in the denominator (through the risk free rate).
    4. Leave it alone (for now) : The last option is to leave the risk free rate at current levels for now but adjust the rate in the future (perhaps at the end of your high growth period) to your normalized or intrinsic levels. Here again, the key is to make sure that your other valuation inputs are consistent with your assumption. Thus, for the period you use the current risk free rate, you have to use equity risk premiums, growth rates and inflation expectations consistent with that rate, and as you adjust the risk free rate to its normalized or intrinsic levels, you have to adjust the rest of your inputs.
    To illustrate the four options when it comes to risk free rates, I value a hypothetical average-risk company with an expected cash flow of $100 million next year, using all four options. The inputs I use for the company under each option are summarized below, with the value computed in the last column:

    The four choices yield different values but the most interesting finding is that the value that I get with the “leave alone” option is lower than the values that I obtain with my other options. Consequently, those who argue that we need to replace the current risk free rate with more normalized versions because it is the “conservative” path may be ending up with estimates of value that are too high (not too low).

    While I prefer the "leave alone" option, I think that the other approaches are defensible, if your macro views are significantly different from mine. The danger, as I see it, comes when you mismatch your assumptions, with two of the most egregious examples listed below:


    Note that while each input into these mismatched valuations may be defensible, it is the combination that skews the value vastly downwards or upwards. If you use  or do intrinsic valuations, checking for input consistency is more critical than ever before.
     
    Bottom line
    So, what is the bottom line? Like almost everyone else, I find myself in uncharted territory, with interest rates approaching zero in many currencies and like most others, I feel the urge to "fix" the problem. There are three broad lessons that I take away from looking at the data.

    1. Central banks tweak interest rates. They don’t set them. Consequently, I am going to spend less time worrying about what Janet Yellen does in the interest rate room and more on the fundamentals that drive rates. I will also grant short shrift to anyone who uses central banks as either an excuse or looks to them as a savior in their investing.
    2. When risk free rates are abnormally low or high, it is because there are other components in the market that are abnormal, and I am not sure what is normal. For investors in the US and Europe who yearn for the normality of decades past, I am afraid that normal is not returning. We have to recalibrate our assumptions about what is normal (for interest rates, risk premiums, inflation and economic growth) and pay less heed to rules of thumb that were developed for another market (US in the 1900s) and another time.
    3. As investors, we can rage against interest rates being too low but it is what it is. We have to value companies in the markets that we are in, not the markets we wished we were in. 
    Data to download



    The Value and Pricing of Cash: Why low interest rates & large cash balances skew PE ratios

    For an asset that should be easy to value and analyze, cash has been in the news a lot in the last few months, both when it has been returned (in buybacks especially) and also when it has been accumulated either domestically or offshore. Since companies have always returned cash and held cash balances, you may wonder why these stories are news worthy but I think that the cash is under the spotlight because of a convergence of factors, including the rise of technology companies in the market cap ranks, a tax law in the US that is increasingly a global outlier, and low interest rates.

    Accounting for, Valuing, and Pricing Cash
    I start my valuation class with a simple exercise. I hold up an envelope with a $20 bill in it (which everyone in the class has seen me put into the envelope) and ask people how much they would pay for the envelope.  While some find this exercise to be absurd, it does bring home a very simple rule, which is that valuing cash should not require complicated valuation models or the use of multiples. Unfortunately, I see this rule broken on a daily basis as investors mishandle cash in companies, both in intrinsic valuation and pricing models.

    To illustrate the divide between risky assets and cash, assume that you are trying to value a software company, with a cash balance (which is invested in liquid, riskless or close-to-riskless investments) of $200 million. Let's assume that the accounting income statement & balance sheet for the company looks as follows:


    If you believe the accounting balance sheet, this company is half software and half cash but that is misleading for two reasons. The first is that assets on accounting balance sheets are not marked to market and can remain at low values, even as their earnings power rises. The second is that accounting rules (absurdly) treat R&D, the biggest capital expenditure at technology firms, as operating expenses, which then results in those assets never showing up on the balance sheet. The ripple effects of understating the book value of equity can be seen in the high returns on equity that I report for the firm.

    Having established that book-value cash ratios will be skewed by the changing composition of the market, let's turn to the question of valuing this company. For simplicity, let's assume that the cost of equity for investing in the software business is 10% and that the expected growth in income from software is 2% in perpetuity. If we assume that the company can maintain its existing return on equity of 36% on its new investments in perpetuity, the value of the software business is:

    • Expected net income from software = $72 million
    • Expected reinvestment to generate growth = 2%/36% = 5.56%
    • Value of Software business = 72 (1-.0556)/ (.10-.02) = $850 million
    The cash is invested in liquid, riskless investments earning 2% (pre-tax). The fact that cash earns a low rate of return does not make it a bad investment, because that low rate of return is what you should expect to make on a short-term, riskfree investment. If you decide to do an intrinsic valuation of the income from cash, you should discount the income at the risk free rate:
    • Expected pre-tax income from cash = $ 200 (.02) = $4 million
    • Cost of equity = Riskfree rate = 2%
    • Value of equity = 4/.02 = $200 million
    The intrinsic value balance sheet for this company is shown below:
    Note that the software business is now worth a lot more than it was in the accounting balance sheet but that cash value remains unchanged. The value of equity on the balance sheet is an intrinsic equity value.

    In pricing, the tool used in comparisons is usually a multiple and the most commonly used multiple is the PE ratio. To set the table for that discussion, I have restated the intrinsic value balance sheet in the form of PE ratios for the software business, cash and equity overall.

    The PE ratios for software and cash are computed by dividing the intrinsic values of each one by the after income generated by each. The PE ratio for cash can be simplified and stated as a function of the risk free rate and tax rate:
    The PE ratio for cash is much higher than the PE for software (11.81) and it is pushing up the PE ratio for equity in the company to 14.11. Put differently, if the stock is priced based on its intrinsic value, it should trade at a PE ratio of 14.11.

    How will bringing in debt into this process change the game? Let's assume that you borrowed $300 million and bought back stock in this company, while leaving the existing cash balance unchanged. Reducing your market cap by roughly $300 million will augment the effect of cash on PE and make the non-cash PE ratio even lower.

    Cash Balances and PE: Determinants
    In the market, we observe the PE ratios for equity in companies, and those PE ratios will be affected by both how much cash the company holds and the interest rate it earns on that cash.  To the extent that cash balances (as a percent of value) vary across time, across sectors and across companies, the conclusions we draw from looking at PE ratios can be skewed by these variations. To observe how much of an impact the cash holdings have on the observed PE ratio for a company, I varied the cash balance in my software company from 0% to 50% of the intrinsic value of the company; at 50%, the cash balance is $850 million and is equal to the value of the software business. The PE ratio for equity in the company is shown in the graph below, with the cash effect on PE highlighted:



    The effect of holding cash is accentuated when the interest rate earned on cash, which should be a short term risk free (or close to risk free) rate, is low relative to the cost of equity. In the table below, I highlight the interest rate effect, by holding the cost of equity fixed at 8% and varying the risk free rate from 1% to 5%:
    Thus, a cash balance that amounts to 20% of firm value will push PE ratios from 15.38, when the short-term, risk free rate is 1% and to only 14.08, when it is 5%.

    It is true that companies with global operations are accumulating some of their cash overseas to avoid US taxes. Bringing in trapped cash into this process is easy to do and requires you to separate cash balances into domestic and trapped cash; the biggest problem that you face is getting that information, since most companies are not explicit about the division. While the domestic cash balance is its stated value, the trapped cash will see its value reduced by the expected tax liability that will be incurred when the cash is repatriated (which will require assumptions about when that will be and what the differential tax rate paid on repatriation will amount to.)

    The US Market: PE and Cash
    At this point in this discourse, you may be wondering why we should care, since companies in the US have always held cash and had to earn close to a short-term risk free rate on that cash. That is true but we live in uncommon times, where risk free rates have dropped and corporate cash holdings are high, as is evidenced in this graph that looks at cash as a percent of firm value (market value of equity+ total debt) for US companies, in the aggregate, from 1962 to 2015 and the one-year treasury bill rate (as a proxy for short term, risk free rates):
    Data from Compustat & FRED: Computed across all money-making companies
    With short-term risk free rates hovering around zero and cash balances close to historical highs, you would expect the cash effect on PE to be more pronounced now than in the past. To measure this effect, I computed PE ratios and non-cash PE ratios each year for US companies, using the following equations:

    The interest income from cash was estimated using the average cash balance during the course of the year and average one-year T.Bill rate for that year. In the graph below, I look at the paths of both measures of PE from 1962 through 2014. Note that while while both series move in the same direction, the divergence has become larger since 2008; in 2014, the non-cash PE was almost 30% lower than the conventional PE.

    Update: The PE effect is large, especially in the last five years. It is perhaps being exaggerated by the inclusion of financial service firms in the sample, since cash and short term investments at these firms can be huge and are really not comparable to cash holdings at other companies. If you remove them from the sample, the cash effect does get smaller. Rather than pick and choose which data I will report, I have included the year-by-year averages for the US for four sets of data: all companies, only non-financial service companies, all money-making companies and all non-financial money-making companies in this link

    I know that the talk of a bubble gets louder each day, and while there may be legitimate reasons to worry about the level of stock prices, those who base their bubble arguments entirely on PE ratios (normalized, adjusted, current) may need to revisit their numbers. All of the versions of the PE will be "pushed up" by the cash holdings of US companies and the low interest rate environment that we live in.

    Sector Differences in Cash and PE
    Cash balances have varied not only across time but they are also different across sectors and within sectors, across companies. Consequently, comparing PE across sectors or even across companies within a sector, without adjusting for cash, can be dangerous, biasing you away from companies with large cash balances (which will look expensive on an unadjusted PE) and especially so during periods of low interest rates.

    In the first part of the analysis, I estimated cash as a percent of firm value, PE ratios and non-cash PE for each sector in 2014. (I eliminated financial service companies from my sample, since I am not sure that I can categorize cash as a non-operating asset for these companies). While all of the industry averages can be downloaded at the link below, the sectors where the cash effect on PE was greatest are listed below:

    In the second part of the analysis, I computed the cash effect on PE for individual companies and then looked at the distribution of this cash effect across all companies:


    It delivers the message that there is no simple rule of thumb that will work across all companies or even across companies within a sector.

    Perhaps, the best way to check out the effect of cash on PE is to pick a company and take it through the cleansing process, a very simple one that requires relatively few inputs. Use this spreadsheet to try it on your favorite (or not-so-favorite) company.

    Rules for dealing with cash
    In an investing world full of complications, simple measures like PE retain their hold because they are easy to compute and easy to work with. However, there is a price that we sometimes pay for this simplicity, and in periods like this one, where interest rates are at historic lows, we may need to reassess how we use these measures to compare companies. In particular, I think we have to separate companies into their cash and operating parts, and deal with the two separately, because they are so different in terms of risk and earnings power. Thus, it we are using multiples, enterprise value multiples will work better than equity multiples, and with equity multiples, non-cash versions (where the cash is stripped from market capitalization and net income is cleansed of the cash effect) will be more reliable than cash versions. This will also mean that the time honored way of estimating PE, i.e., dividing the market price today by the earnings per share, will have to be replaced by an approach where we use use aggregated market value, cash and earnings, rather than per share numbers. 

    Spreadsheets

    1. Intrinsic value of cash and operating assets (to back up example in post)
    2. PE Cleanser (to compute non-cash PE for a company)

    Datasets

    1. Cash and non-cash PE ratios by year: All US companies
    2. Cash and non-cash PE ratios by sector in 2014






    No Light at the end of the Tunnel: Investing in Bad Businesses

    I am a cynic when it comes to both CEOs and equity research analysts. I think that many CEOs are political animals, bereft of vision and masters at using strategic double-speak to say absolutely nothing. I also believe that many equity research analysts are creatures of mood and momentum, more market followers than leaders. Once in while, though, my cynicism is upended by a thoughtful CEO or a well-done equity research report and even more infrequently by both happening at the same time, as was the case in this recent interplay between Sergio Marchionne, Fiat Chrysler's CEO, and Max Warburton, the auto analyst at Sanford Bernstein.

    The CEO/Analyst Exchange on Fiat Chrysler
    Sergio Marchionne is an unusual chief executive, a man who is not afraid to talk the language of investors and is open about the problems confronting not only his company, but also the entire automobile business. While he has been arguing that case for a while, sometimes in public and sometimes with other auto company executives, he crystallized it in a presentation he made in an analyst conference call, titled "Confessions of a Capital Junkie". In the presentation, he argues that the auto business has not generated its return on capital over its last cycle and that without significant structural changes, it will continue to under perform. He then diagnoses the reason for the under performance as over investment in R&D and capital costs, with companies duplicating each other's efforts. He concludes with the remedy of consolidation, where with mergers and joint ventures, companies could co-operate and reduce their capital costs, and asks analysts and investors in auto companies to apply pressure for change. Mr. Marchionne's pitch was unusual was two reasons.  First, how many CEOs admit that their businesses have gone bad and that fundamental change is needed in how they are run? Second, it is unusual for a CEO to ask investors to become more activist and push for change, since most CEOs prefer a pliant and forgiving shareholder base.

    Max Warburton, Bernstein's auto analyst who was at the conference, responded by asking "“Do you think the German [car manufacturers] have any interest in what we say?', arguing that investors and analysts were powerless to push for change. In an extended analyst report, Mr. Warburton went further, making the point that shareholders are way down the list of priorities for the typical auto company, and especially so in Europe and Asia. 

    As I said at the start, this is the type of exchange between CEOs and analysts that you hope to see more of, and I agree with both Mr. Marchionne and Mr. Warburton on some aspects and disagree on others. I agree with both men that the auto business has been in trouble for a while and I made this point earlier in my post on GM buybacks. However, I don't think that the problem is one of duplication of expenses and that the answer is the consolidation of companies, as argued by Mr. Marchionne, and here is why. For consolidation to generate higher profits at auto companies, they will have to ensure that they don't  pass the cost savings on to customers by cutting car prices, and nothing in the behavior of the auto industry in the last decade leads me to believe that they are capable of this concerted action. I agree with Mr. Warburton that the auto business is not shareholder-focused and that institutional forces (governments, unions) will make it difficult for investors to be heard. While there are investors in the market who will continue to supply capital at favorable terms to this business, sensible investors are under no obligation to play this game. Abandoning the auto business is not feasible if you are the auto analyst at Sanford Bernstein, but it is a viable option for the rest of us, at least until prices reflect the quality of these businesses. This debate also raises interesting fundamental questions that I hope to examine in the rest of the post, including how we categorize businesses into good and bad ones, why businesses become bad, why companies continue to operate and sometime expand in bad businesses and why investors may still seek to put their money in these companies.

    What is a bad business?
    If Mr. Marchionne's point is that the automobile business is a bad one, it is worth starting this discussion with the question of what it is that make a business a bad one. At an extremely simplistic level, you can argue that a bad business is one where many or most companies lose money, but that definition would encompass young sectors (social media, biotechnology) that tend to lose money early in the life cycle. It also would imply that any sector that collectively makes profits is a good one, which would not make sense, if the sector has huge amounts of capital invested in it. Thus, any good definition of business quality has to look at not only how much money a company makes but how much it needs to make, given its risk and the capital invested in that business. In corporate finance, we try, to capture this by looking at both sides of the equation:


    While there are some business (banks, investment banks and other financial service companies), where the equity comparison is more useful, in most businesses, it is the comparison on a overall capital basis that carries more weight. If you accept the proposition that the return on invested capital measures the quality of a company’s investment and the cost of capital is the hurdle rate that you need to earn, given its risk, the spread between the two becomes a snapshot of the capacity of the company to generate value.

    Why a snapshot? If the return on invested capital is estimated, as it usually is, using the operating income that the company generated in the most recent time period and the cost of capital reflects the expected return, given the risk free rate and equity risk premium in that period, it is also possible that looking at a single period can give you a misleading sense of whether the company in question is generating value. With cyclical and commodity companies, in particular, where earnings tend to move through cycles, a good case can be made that we should be looking at earnings over a cycle and not just the most recent year. Finally, the return on invested capital is an accounting number and is hence handicapped by all the limitations of accounting principles & rules, a point I made in this long, torturous examination of accounting returnsIf you bring the two strands of discussion together, there are two levels at which a sector has to fail to be called a “bad” business.
    1. Collective, weighted under performance: Most companies in the sector should be earning returns on their invested capital that are less than the cost of capital, not just a few, and the aggregate return on capital earned by a sector has to lag the cost of capital.
    2. Consistent under performance: These excess returns (return on capital minus cost of capital) should be negative over many time periods.
    3. No delayed payoff: There are some infrastructure businesses that require extended periods of large investment and negative excess returns, before they pay off in profitability.
    In my post on GM, I made the case that the automobile business was a bad one, using these two metrics. Collectively, the distribution of returns on capital across global automobile companies in 2014 looked as follows:

    If you look at the return on capital across time for the auto industry, you see the same phenomenon play out.



    It should come as no surprise that I agree with Mr. Marchionne that the auto business is a bad one and with Mr. Warburton that the companies in this business are in denial. The bad news for investors is that the auto business is not alone in this hall of shame. I computed returns on capital, costs of capital and excess returns for all non-financial US companies, by year from 2005 to 2014, and then looked for the sectors that delivered a negative excess return on average during the decade, while also generating in excess returns in at least 5 of the 10 years:
    Raw data from Capital IQ with my estimates of costs of capital by year
    Some of the businesses on this list have a good reason for being on the list and perhaps can be cut some slack. For instance, the green and renewable energy business has delivered negative excess returns both in the aggregate and in every year for the last decade, but in its defense, it may be a business that needs time to mature. The real estate sector is well represented on this list, with REITs, homebuilding, building materials and real estate operations & development all making the list with negative excess returns. An optimist may argue that the last decade created the perfect storm for real estate, unlikely to be repeated in the near future, and that these businesses will return to adding value in the future. There are some surprises, with entertainment software, wireless telecom and broadcasting all making the list, suggesting that you can have bad businesses that are growing. Finally, there were 169 companies that were classified as diversified, and their excess returns were negative every year for the entire decade, making a strong argument that many of these companies would be better off broken up into constituent parts. It is true that the returns on capital in this table were computed using standard accounting measures of operating income and debt, and I recomputed them, with leases capitalized as debt to derive the following table:
    Operating Income and Invested Capital, adjusted for leases treated as debt
    The list looks almost identical to the unadjusted excess return rankings, though the excess returns for restaurants, retailers and other larger lessees became much smaller with the adjustment and airlines make the worst business list, once you consider leases as debt.

    How do businesses go bad?
    So, why do businesses go bad? There are a number of reasons that can be pointed to, some rooted in sector aging, some in competition, some in business disruption and some in delusions about growth and profitability.
    1. The Life Cycle: I have used the corporate life cycle repeatedly in my posts as an anchor in trying to explains shifts in capital structure, dividend policy and valuation challenges. It is a useful device for explaining why some sectors fail to deliver returns that meet their costs of capital. In particular, as sectors age, their returns seem to drift down and if the sector goes into decline, with revenues stagnant or falling, companies are hard pressed to generate their costs of capital. At the other end of the life cycle, young sectors that require large infrastructure investments often deliver extended periods of negative excess returns.
    2. Competitive Changes: A business can be changed fundamentally if the competitive landscape changes. This can happen in many ways. A legal barrier to competition (patents, exclusive licenses) can be removed, opening up existing companies to price competition and lower margins. Globalization has played a role as well, as companies that used to generate excess returns with little effort in protected domestic markets find themselves at a disadvantage, relative to foreign competitors. 
    3. Disruption: Disruption is the catchword in strategy and in Silicon Valley, and while it is often hyped and over used, technology has disrupted established businesses. Uber and its counterparts are laying to waste the taxi business in many cities and Amazon has changed the retail business beyond recognition, driving many of its brick and mortar competitors out of business.
    4. Macro Delusion: While all of the above can be used to explain why an old business can become a bad one, there are new businesses that sometimes never make it off the ground, even though they are launched in markets with significant growth potential. One reason is what I have termed the macro delusion, where the sum of the dreams and forecasts of individual companies
    Why do companies stay in bad businesses?
    If you are a company that finds itself in a  bad business, there are four options to consider. The first is to exit the business, extracting as much of your capital you can to invest in other businesses or return to the suppliers of capital. While this may seem like the most logical choice (at least from a capital allocation standpoint), there is a catch. It is unlikely that you will be able to get your original capital back on exit, because buyers will have reassessed the value of your assets, based on their diminished earnings power. Consider, for instance, a company that generates a 3% return on capital on invested capital of $1 billion and assume that its cost of capital is 6%. If a sale of the assets or business will deliver less than $500 million, the best option for the company is to continue to operate in the bad business. The second is to retrench or shrink the business, by not reinvesting back into the business and returning cash from operations back to stockholders (as dividends or buybacks). That was the rationale that I used in supporting the GM buyback. The third is to continue to run the business the way you used to when the business was a good one, hoping (and praying) that things turn around. That seems to be the response of most in the auto business and explains the cold shoulder that they gave to Mr. Marchionne's prescription (of consolidation). The last is to aggressively attack a bad business, with the intent of changing its characteristics, to make it a good one. This is a strategy, with the potential for high returns if you do succeed, but with low odds of success. Not surprisingly, it is the strategy that appeals the most to CEOs who want to burnish their reputations and it one reason that I posited that my returns on my Yahoo! investment would be inversely proportional to Marissa Mayer's ambitions.

    Of the four strategies, the one that is least defensible is to the third one (doing nothing), but that seems to be most common strategy adopted by companies in bad businesses and I can think of four reasons why it continues to dominate. The first is inertia, where managers are unwilling or unable to change their learned behavior, with the resistance become greater, if they have long tenure in the business. The second is poor corporate governance, where those who run firms view shareholders as just another stakeholder group and view costs of capital as abstractions rather than as opportunity costs. The third are institutional factors which can conspire to preserve the status quo, because there are benefits derived by others (labor unions, governments) from that status quo.  The final factor is behavioral, where the easiest path for managers, when faced with fundamental changes in their businesses, is to do nothing and hope that the problem resolves itself. 

    Why do investors invest in these companies?
    If it is difficult to explain why companies choose to stay and sometimes grow in bad businesses, it is far easier to explain why investors may invest in these companies. At the right price, any company, no matter how bad its business, is a good investment, just as at the wrong price, any company, no matter how good its business, is a bad investment. To decide whether to invest in a company in a bad business, investors have to value these companies and there are challenges. The first is that with these companies, growth is almost always more likely to destroy value than to increase it. Consequently, the value of these companies is maximized as they minimize reinvestment, shrink their businesses and liquidate themselves over time. The second problem is that while designing a valuation model that allows for a shrinking company is easy enough to do, the value that you get is operational only if management in the company does not undercut you, by aggressively seeking out growth with expensive reinvestment. I present responses to these problems in this paper.

    As a passive investor, you have to accept your powerlessness over management and build, into your expectations, what you believe that the management will do in terms of investment, financing and dividend policy, no matter how irrational or value destroying those actions may be. As an activist investor, though, you may be able to force managers to reassess the way they run the company. It should come as no surprise that the classic targets of activist investors tend to be companies in bad business that are run by managers in denial. Finally, while the debate about corporate governance has atrophied into one about director independence, corporate governance scores and CEO pay, the real costs of poor corporate governance are felt most intensely in companies that operate in bad businesses, where without the threat of shareholder activism, managers often behave in irrational, value-destructive ways.

    Closing Thoughts
    As I look at the excess returns generated by companies in different sectors, I am struck by how little margin for error there seem to in many businesses, with excess returns hovering around zero. If we attach large values to the disruptors of existing businesses, consistency requires us to reassess the values of the disrupted companies. Thus, if we are bidding up the values of Tesla,  Uber and Google (driverless cars) because they might disrupt the automotive business, does it not stand to reason that we should be bidding down (at least collectively) the values of Volkswagen, Ford and Toyota? More generally, we seem to be more willing to anoint the winners from disruption than we are in identifying and repricing the losers.

    Datasets
    1. Industry averages excess returns, by year: 2005-2014
    2. Industry average costs of capital: US
    3. Industry average cost of capital: Global
    Papers



    Billion-dollar Tech Babies: A Blessing of Unicorns or a Parcel of Hogs?

    A unicorn is a magical beast, a horse-like, horned creature that is so rare, that even in mythology, you almost never run into a blessing of unicorns (which, I have learned is what a group of unicorns is called). It was perhaps the rarity (and magic) of private businesses with billion-dollar valuations that led Aileen Lee, founder of Cowboy Ventures, to call them unicorns, in 2013, but as their numbers increase by the month, it may be time to rename them after a species that is more common and less magical.  While there are several provocative questions that surround the rise of unicorns, this post is dedicated to a very specific question of how the investor protections that are offered to venture capitalists at the time of their investments can not only affect the measurement of value and make non-unicorns look like unicorns but also skew the behavior of both investors and owners.

    A Blessing of Unicorns
    One of the best visuals that I have seen on the rise of Unicorns is in this Wall Street Journal article, and it not only allowed you to see the rise of individual companies but compare the numbers over time. In June 2015, there were 97 companies that had values that exceeded a billion, with Xaomi and Uber leading the list, with valuations in excess of $40 billion. The breakdown of Unicorns globally is captured in the pie chart below:
    Source: Wall Street Journal
    Not surprisingly, the vast majority of unicorns are US-based, though the number of Asian entrants into the ranks is increasing. Looking at the sectors across which these unicorns are sprinkled, the WSJ article provides the following breakdown:
    Source: Wall Street Journal
    The explosion in the numbers of these companies has also given rise to almost as many explanations for the phenomena, some based on rationality and some on the prevalence of a bubble. The rationality-based explanation for the surge in unicorns is that it has become easier to remain a private business, as private capital markets broaden and become more liquid, while it has become more costly to become a public company, with increased disclosure requirements and pressure from investors/analysts. The less benign argument is that investors are being driven by greed to push up the prices of young companies and that this has all the makings of a bubble. I think there is truth in both arguments and that you can have both good reasons for the increased number of large value private businesses and momentum driven froth in the market. However, I will leave that discussion to those who know more about these young companies than I do, and are more confident in their capacity to detect bubbles than I am.

    Breaking the Unicorn barrier
    If the conventional definition of a unicorn is a private business with a valuation that exceeds a billion, how do you arrive at the valuation of such a business? While you have no share prices or market capitalizations for these companies, you can extrapolate to the values of private businesses, when they raise fresh capital from venture capitalists or private investors. Thus, if a venture capitalist invests $100 million in a company and gets 10% of the ownership in the company in return, we estimate a value of $1 billion for that company, making it a Unicorn. There are, however, two problems that get in the way of a good estimation. One is that the capital infusion changes the value of the company, creating a distinction between pre-money and post-money values. The other is that the investor's equity investment generally comes with bells and whistles, designed to protect the investor from downside risk and these protections can skew the value estimate.

    1. Pre versus Post Money
    In an earlier post on the offers and counter offers that you see on Shark Tank, the show where entrepreneurs pitch business ideas and ask competing venture capitalists for money, I drew the distinction between pre and post money valuations. If the capital raised in an offering is held by the company, rather than used to pay down debt or owners's cashing out, the value of the company increases by the amount of the new capital raised, leading to the following distinction between pre-money and post-money values.
    • Post-money valuation = Investor's capital infusion/ Percentage ownership received in exchange
    • Pre-money valuation = Post-money valuation - Investor capital infusion
    In the example above (where an investor invests $100 million for 10% of a firm), the post-money value is $1 billion but the pre-money value is only $900 million. Thus, companies that are smaller than a billion can make themselves look like billion dollar companies, if they are willing to give up enough ownership in the company and can find investors with deep pockets.
    While it is unlikely that you will be able to find an investor to offer $950 million in capital for a business with a $50 million valuation, it does illustrate why post money valuations may not always be comparable across businesses.

    2. Investor Optionality
    While the difference between pre and post money valuations is easy to handle, there is another aspect of venture capital investing that is more messy. Many venture capital investors  are offered protection against downside risk on their investments, though the degree of protection can vary across deals. What type of protection? Consider the investor who invested $100 million to get 10% of the company in the example above. That investor's biggest risk is that the value of the business will drop and that investors in subsequent rounds of capital raising or in an initial public offering will be able to get much better deals for their investments. To protect against this loss, the investor may seek (and get) a provision that allows his or her ownership stake to be adjusted for the lower value. With full protection, for instance, if the value of the business drops to $500 million on a subsequent capital event, the original investor's ownership stake will be adjusted up to 20% (reflecting the lower value). This is termed a full ratchet. Alternatively, in the weighted-average approach, the original investor will receive partial protection, resulting in an ownership stake between 10% and 20% if the value drops to $500 million, depending on how the weighted average ownership stake is computed. The key, though, is that this provision is protection against a value drop, but only if the company seeks out capital, and is thus contingent on a capital event occurring.

    The protection is usually stated in terms of price per share, where the price per share of the investor's original investment is adjusted to reflect the price per share in the new round of capital, but it is effectively a protection of your original dollar investment and it is easiest to think of this protection as a put option on your investment. In the full ratchet case, assuming a capital event occurs, you are effectively protecting your initial dollar  investment, at least until the value of the business hits $100 million (at which point you would be entitled to 100% of the business). Once the value of the business drops below $100 million, the protection can no longer be complete and the pay off diagram for this investment, as a function of the value of the business, is below:

    Note that the protection works fully when the value of the business is between $100 million and $ 1 billion and only if there is a capital event to trigger it. To value this option, you need three more pieces of information:
    1. Probability of capital event: Since a capital event is the trigger for the protection, there will be no protection if no capital event occurs, a scenario that will unfold if the business unravels quickly. Put differently, the protection is useless if the business never raises any additional capital. (Since the probability of accessing new capital will decrease as the value of the business drops, especially if the drop occurs quickly, the option value is likely to be overstated.
    2. Expected time to capital event: The timing of the capital event may not be known with certainty, but to the extent that it can be forecast, you need an expected value. If the protection covers multiple capital events, it is the expected time to the last one.
    3. Degree of protection: Depending on how it is structured, the protection offered an investor can range from 100% (with full protection) of the dollar capital invested to less (with weighted average).
    Assume, for instance, that the investor in the example above (who invested $100 million for 10% of the business) if offered complete protection in an anticipated IPO of the company and assume further that there is a 90% chance of the IPO occurring in one year. For the standard deviation, I used the industry average standard deviation of 72.48%, derived from publicly traded stocks in the online software business. The expected value (allowing for the 90% chance of a capital event) that I estimate for the protection option, in this spreadsheet, is $25.116 million and the effects on the pre-money and post money valuations are captured below:
    • Unadjusted value of protection = Value of put option = $27.98 million
    • Value of protection = Value of put option * Probability of capital event = $27.98 * 0.90 = $25.116 million
    • Investment made = Capital injected - Value of protection = $100 mil - $25.116 mil = $74.884 mil
    • Ownership stake received = 10%
    • Post-money valuation = Investment made/Ownership Stake = $ 74.884/.10 = $748.84 million
    • Pre-money valuation = Pre-money valuation - Capital Infused = $748.84 - $100 million = $648.84 million
    Thus, the capital increase pushed up the value by $100 million and the investor protection clause served to inflate the unadjusted post-money valuation from $748.84 million to $ 1 billion. The greater the investor protection offered and the larger the amount of capital raised, the greater will be the disparity between the true value of the business and its perceived value (based on the transaction details). In the table below, I list out the percentage difference between the true value and the perceived value as a function of investor protection and business risk (captured in standard deviation).

    For a $100 million investment for 10% of a company, with a 90% chance of a capital event.
    Thus, if investors get 95% protection in a business where equity values have an annualized standard deviation of 70%, the true value of the business will be 21.54% lower than the perceived value (which is $ 1 billion, based on the $100 million investment for 10% of the firm).

    I know that I have simplified the complex world of venture capital deal-making in this example, and that allowing for more sophisticated protection mechanisms and multiple capital rounds will make it more difficult to estimate the protection value. However, this example delivers the general message that the more protections that are offered to investors at the time that they invest in young start-ups, the less dependable are the simple extrapolations of value (from capital invested and ownership stakes received).

    No free lunches
    As an outsider with an interest in valuation, I find venture capital deals to be jaw-droppingly complex and not always intuitive, and I am not sure whether this is by design, or by accident. When it comes to investor protection, the stories that I read for the most part are framed as warnings to owners about "vulture capital" investors who will use these protection clauses to strip founders of their ownership rights. I think the story is a far more complex one, where both investors and owners see benefits in these arrangements, and where both can expose themselves to dangers, if they over reach.

    Private Company Investors
    It is easy to see why private company investors like protections against downside risk, especially when investing in young start-ups, where valuation is difficult to do. However, there are three consideration that investors need to keep in mind, when deciding how much protection to seek.
    1. At a fair price, protection adds no value: In investing, you can, for the most part, buy protection agains the downside (in the form of insurance or put options), if you are willing to pay the right price. At a fair price, the protection delivers peace of mind but no additional value. In the example above, the prices that I computed for downside protection were fair prices and neither the investor nor the owner lose at that price. Thus, an investor can either invest $100 million, with no downside protection, and ask for 13.35% of the post-money value of $748.84 million, or get full downside protection and settle for 10.00% of the artificially inflated post-money value of $1 billion.
    2. Paper Protection:  When investing in young start-ups with uncertain futures, the protection clauses in agreements often deliver far less than they promise. The anti-dilution provisions fail if the business you invest in never seeks out additional capital and the liquidation preferences that many investors add to their investments will not provide much respite when these young businesses are forced to liquidated, since their valuations tend to be heavily tilted towards human and idea capital. It should therefore come as no surprise that a significant portion of venture capital investments, promise and protection notwithstanding, yield little or nothing for investors. At the risk of offending some of my readers, I would argue that the protection clauses in most venture capital investments have more in common with the rhythm approach for birth control, a hit-or-miss system that delivers big surprises, than with full-fledged contraception.
    3. Abdication of valuation responsibilities: Venture capitalists who view building in protection against the downside as an alternative to making valuation judgments are seeking false security. As an investor, if I were asked to choose between investing with a venture capitalist who makes good valuation judgments but is not adept at building in downside protection or with a venture capitalist who is superb at building in downside protection but haphazard about valuation judgments, I would pick the venture capitalist who makes good valuation judgments every single time. 
    There is also the very real concern is that some venture capitalists who believe that they are protected from downside risk (even if that belief is misplaced) may be inclined to take reckless risks in investing.
    Founders/Entrepreneurs
    There are three benefits to founders and entrepreneurs from granting protection to investors. The first is that they allow them to raise capital in circumstances where its might not otherwise have been feasible. The second is that granting these protections may give the founders/owners more freedom to run the businesses as they see fit, without constant investor oversight. The third is that it allows for inflated valuations, as illustrated in the example above, that can then yield either bragging rights or access to more capital.

    The costs are equally clear. If owners give away too much of the firm for bragging rights, they will be worse off. In the example above, for instance, where we estimated the value of protection to be approximately $25.12 million, giving the investors more than 10% of the unadjusted post-money value of the business in return for $100 million in capital invested would be giving up too much. This cost is exacerbated by a behavioral quirk, which is that the founder owners of a business often tend to be far more confident about its future success than the facts merit. The same over confidence and faith that makes them successful entrepreneurs also will lead you to under price the investor protections that they are giving away in return for capital.

    Public Market Investors
    While public market investors may view these arrangements between venture capital investors and founder owners as an inside-VC game, they can be sucked into the game in one of two ways. The first is when public market investors are drawn to invest in private businesses, drawn by the allure of high returns (and not wanting to be left out). The second is when private businesses go public and investors are trying to estimate a fair price to pay for the offered shares.

    In both cases, it is natural to look at the post-money valuations that emerge from prior capital rounds and use those values as anchors in determining fair prices to pay. After all, not only are these real transactions (rather than abstract valuations), but the assumption is that the venture capitalists who were able to invest in these rounds must be smarter and better-informed than the rest of us. I think that both assumptions are shaky, the first because the structuring of the transaction (with investor protection and capital infusion) affecting the observed post-money valuations and the second because any investor group (no matter how savvy it might be) is capable of becoming irrationally exuberant. Investors can take the first steps in protecting themselves by doing their homework. A private company that is planning on going public has to reveal the details of protective clauses and other carry overs from prior capital rounds in its prospectus.

    Some unsolicited suggestions
    There is nothing wrong with investors seeking protection from downside risk, just as there it is perfectly natural for owners to seek to pump up post-money valuations to make themselves more attractive to new capital providers. The damage occurs when one or both groups let these desires dominate its investing and business decisions. At the risk of sounding presumptuous, I would suggest the following:

    1. Be real: Both sides would be well served by reality checks. Investors have to be recognize that the protection they are getting is porous and contingent on capital raising events and owners have to realize that offering these protections may alter how and when they raise additional capital, perhaps to the detriment of their businesses.
    2. Keep it simple: The only people who gain from complexity are lawyers, accountants and consultants. I may be missing the historical context here, but I think that there are far simpler ways of building in protection than the standards that exist today.  For instance, rather than continuing with the practice of adjusting price per share for dilution, which is the practice today, I think it would be far simpler to write the protection in terms of dollar capital invested.
    3. Check the price of protection: At the right price, protection creates value for neither investors nor founder owners. If the protection is priced too high, with the investor settling for a far smaller percentage of the unadjusted value than he or she should, it is not worth it. If the protection is priced too low, founder owners are giving up too much of their businesses in return for the capital raised.
    4. Don't forget your fundamentals: While the presence or absence of protection may make a difference in marginal investments, it should not fundamental change the businesses you invest in, if you are investor, or how you run your business, if you are an owner. Thus, if investors  use the presence of downside protection as a reason for investing in over valued businesses, they will lose out in the end. (And making that investment convertible and calling it preferred will not make it a good investment.)  By the same token, founders who give away much larger percentages of their businesses than they should, to pump up post-money valuations, will regret that decision in good times, and even more so in bad times. 


    Attachments
    1. Valuing Investor Protection



    Cash, Debt and PE Ratios: Cash is an upper and debt is a downer!

    In my last post, I looked at the leavening effect that large cash balances have on PE ratios, especially in a low-interest rate environment. In making that assessment, I used a company with no debt to isolate the effect of cash, but many of the comments on that post raised interesting points/questions about debt. The first point is that while cash acts as an upper for PE, debt can act as a downer, with increases in debt reducing the PE ratio, and that if we are going to control for cash differences in the market across time, we should also be looking at debt variations over the years. The second is the question of which effect on PE dominates for firms that borrow money, with the intent of holding on to the cash. In this post, I will start by looking at debt in isolation but then move to consider the cross effects of cash and debt on PE.

    Debt and PE: A simple illustration
    To examine the relationship between PE and debt, I went back to the hypothetical software firm that I used to evaluate the effect of cash on PE. Initially, I assume that the firm has no cash and no debt and is expected to generate $120 million in pre-tax operating income next year, expected to grow at 2% a year in perpetuity. Assuming that the cost of equity (and capital) for this firm is 10%, that the tax rate is 40% and that its return on equity (and capital) on new investments is 36%, the company's income statement and intrinsic value balance sheet are as follows:

    Now, assume that this firm chooses to move to a 40% debt ratio with a pre-tax cost of borrowing of 4%. The effects of the debt on the are traced through in the picture below:

    Note that the value of the business has increased from $850 million to $988.37 million, with the bulk of the value increase coming from the tax subsidies generated by debt

    The effects of borrowing show up everywhere, with almost almost every number shifting, and the effects at first sight seem to be contradictory. Higher debt raises the cost of equity but lowers the cost of capital, reduces net income but increases earnings per share and results in a lower PE ratio, while increasing the value per share. The intuition, though, is simple. Borrowing money to fund the business increases both the expected returns to equity investors (captured in the EPS increase) and the riskiness in those equity returns (pushing the PE ratio down) and at least at a 40% debt ratio, the benefits outweigh the costs. In fact, if you are able to continue to borrow money at 4% at higher debt ratios, the PE ratio will continue to drop and the value per share continue to increase as the debt ratio increases.


    Note that at a 90% debt to capital ratio, the PE ratio drops to 2.75 but the value per share increases to $11.41. If it is sounds too good to be true, it is, because there are two forces that will start to work against debt, especially as the debt ratio increases. The first is that the rate at which you borrow will increase as you borrow more, reflecting the higher default risk in the company. The second is that at a high enough debt level, with high interest rates, the interest expenses may start to exceed your operating income, eliminating the tax benefits of debt. In the table below, I highlight the effects on PE and value per share of different borrowing rates:
    Numbers in red are declines in value/share
    The breakeven cost of borrowing, at least in this example, is around 8.6%; if the company borrows at a rate that exceeds 8.6%, debt reduces the value per share. The effect on PE, though, is unambiguous. As you borrow more money, the PE ratio decreases and it does so at a greater rate, if the borrowing rate is high.

    Debt, Cash and PE: Bringing it all together
    Now that we have opened to the door to cash and debt separately, let's bring them together into the same company. A measure that incorporates both cash and debt is the net debt, which is the difference between the cash and debt balances of the company.
    Net Debt = Total Debt - Cash and Marketable Securities
    This number will be negative when cash balances exceed total debt, zero, when they offset each other, and positive, when debt exceeds cash. In the table below, I have estimated the PE ratio for the company with different combinations of debt ratios (from 0% to 50%) with cash ratios (from 0% to 50%), with debt borrowed at 4% and cash invested at 2%:
    Numbers in red are declines in value/share
    Note that both the cash effect, which pushes up PE ratios, and the debt effect, which pushes down PE ratios, is visible in this table. Interesting, a zero net debt ratio (which occurs across the diagonal of the table) does not have a neutral effect on PE, with PE rising when both debt and cash are at higher values; thus the PE when you have no cash and no debt is 11.81, but it is 12.66 when you have 40% debt and 40% cash. Before you view this as a license to embark on a borrow-and-buy treasury bills scheme, note that the value per share effect of borrowing money and holding it as cash is negative; the value per share declines $0.22/share when you move from a net debt ratio of zero (with no debt and no cash) to a net debt ratio of zero (with 40% debt and 40% cash).  Again, there is no mystery as to why. If you borrow money at 4% and invest that money at 2%, which is effectively what you are doing when cash offsets debt, you are worse off than you would have been if you had no cash and no debt. In fact, the only scenario where the value effect of borrowing money and buying T.Bills is neutral is when you can borrow money at the risk free rate but even in that scenario, the PE ratio still increases. In short, the cash effect dominates the debt effect and you can check it out for yourself by downloading the spreadsheet that I used for my computations.

    Cash and Debt Effects on PE: US Stocks from 1962 to 2014
    In my last post, I noted the difficulty with dealing with cash balances at financial service firms, where the cash serves a very different purpose than it does at non-financial service firms. That statement is even more applicable when it comes to debt, since debt to a financial service firm is less a source of capital and more raw material. Hence, I will focus entirely on non-financial service firms for this section. The first set of statistics that I will estimate relate to debt and cash. In the graph below, I look at cash as a percent of firm value (estimated as market capitalization plus total debt), total debt as a percent of that same value and the net debt ratio (the difference between total debt and cash, as a percent of value) for non-financial service firms in the US from 1962 to 2014.
    Raw data from Compustat: All money-making, non-financial service firms
    Note the median values for cash and debt are highlighted on the graph. In 2014, the cash holdings at non-financial service companies in the US amounted to 7.30%, higher than the median value of 7.23% for that statistic from 1962 to 2014, and the total debt was 24.20% of value, lower than the median value of 28.39 for that ratio from 1962 to 2014. Since cash pushes up PE ratios and debt pushes down PE ratios, the 2014 levels for both variables are biasing PE ratios upwards, relative to history.

    Unlike the cash effect, which I was able to measure with relative ease by netting cash out of the market capitalization and the income from cash from the net income, the debt effect is messier to isolate. If you assume that cash is the only non-operating asset (i.e., that companies do not have cross holdings and other non-operating investments), the debt effect can be computed approximately. First, if cash and debt is zero for a company, and there are no other non-operating assets, the net income for that company will be its after-tax operating income (EBIT (1-tax rate)). Second, the value of the company, if it it had no cash and debt, can be approximated with its enterprise value, leading to the EV/EBIT(1-t) providing an approximate measure of what the earnings multiple would have looked like with no cash and no debt. (The enterprise value does include the value effect of debt and is hence not a clean measure of what the value would have been, if the firm had no debt and no cash.)
    Debt Effect = EV/ EBIT (1-t)  - Non-cash PE
    To estimate these numbers for my sample, I used the average effective tax rate each to compute the after-tax operating income in that year, in recognition of the reality that US companies would not be paying the marginal tax rate on taxable income, even if they had no interest expenses. The graph below summarizes the cash and debt effects on stocks from 1962 through 2014:
    Source: Compustat; All money-making, non-financial service US firms
    At the end of 2014, the PE ratio was 17.73, the non-cash PE was 16.05 and the EV/EBIT(1-t) was 19.44. So, what do these numbers mean? All three measures are higher than the median values over the last 55 years, which would be ammunition you could use to argue that stocks are overvalued. However, as I noted in my post on PE ratios last year, the treasury bond rate, at 2%, is also much lower than the historic norm, and if you don't buy into the bubble story, could be used to explain the higher multiples. I don't this post is the forum for examining the heft of these arguments, but I did try to provide my views in this post last year on bubbles.

    PE Ratios: Three Rules for the road
    Like most investors, I like the simplicity and intuitive feel of PE ratios, but they are blunt instruments that can get us into trouble, when used casually. A low PE ratio can be indicative of cheapness, but it can also be the result of high debt ratios and low or no cash holdings. Conversely, a high PE ratio can point to over priced stocks, but it can be caused by high cash balances and low debt ratios. Based on the last two posts, I would suggest three simple rules for the use of PE ratios.
    1. When comparing PE ratios across companies, don't ignore cash holdings and debt. As the diversity of companies within sectors increases, the old notion of picking the lowest PE stock as the winner is increasingly questionable, since you may be choosing most highly levered company in the sector.  
    2. When comparing PE ratios across time, don't ignore cash holdings and debt. In these last two posts, I have noted the ebbs and flows in both cash as a percent of firm value and debt as a percent of value across time, sometimes due to shifts in the numerator (cash and debt values changing) and sometimes due to shifts in the denominator (market value of equity changing). Whatever the reasons, these shifts can affect the PE ratios for the market, making it look expensive when cash balances are high and debt ratios are low. 
    3. Any corporate action that changes the cash or debt as a percent of value will change the PE ratio. Consider a company that has a large cash balance and is planning on using that cash to buy back stock. Even if nothing else changes, the PE ratio for the company should decrease after the buyback, as (high PE) cash leaves the company. Thus, the practice of forecasting earnings per share after buybacks and multiplying those earnings per share by a constant PE will overstate value. This effect will be even more pronounced, if the company borrows some or all of the money to fund the buyback, since a higher debt ratio will also push down the PE even further.

    Finally, if you are at the receiving end of an investing pitch (that a stock or market is cheap or expensive), based just on PE ratios, you should  be skeptical, no matter how credentialed the person making the pitch may be, and do your own due diligence.

    Spreadsheets





    Decoding Currency Risk: Pictures of Global Risk - Part IV

    In my last three posts, I have looked at country risk, starting with measures of that risk and then moving on to valuing and pricing that risk. You may find it strange that I have not mentioned currency risk in any of these posts on country risk, but in this one, I hope to finish this series by looking first at how currency choices affect value and then at the dynamics of currency risk.  

    Currency Consistency
    A fundamental tenet in valuation is that you have to match the currency in which you estimate your cash flows with the currency that you estimate the discount rate that you use to discount those cash flows. Stripped down to basics, the only reason that the currency in which you choose to do your analysis matters is that different currencies have different expected inflation rates embedded in them. Those differences in expected inflation affect both our estimates of expected cash flows and discount rates. When working with a high inflation currency, we should therefore expect to see higher discount rates and higher cash flows and with a lower inflation currency, both discount rates and cash flows will be lower. In fact, we could choose to remove inflation entirely out of the process by using real cash flows and a real discount rate. 

    Currencies and Discount Rates
    There are two ways in which you can incorporate the expected inflation in a currency into the discount rate that you estimate in that currency. The first is through the risk free rate that you use for the currency, since higher expected inflation should result in a higher risk free rate. The second is by converting the discount rate that you estimate in a base currency into a discount rate in an alternate currency, using the differential inflation between the currencies.

    a. Risk free rate
    A risk free rate is more than just a number that you look up to estimate discount rates. In a functioning market, investors should set the risk free rate in a currency high enough to cover not only expected inflation in that currency but also to earn a sufficient real interest rate to compensate for deferring consumption.
    Risk free rate in a currency = Expected inflation in that currency + Real interest rate
    The risk free rate should therefore be higher in a high-inflation currency than using that higher rate should bring inflation into your discount rate.

    But how do we get risk free rates in different currencies? While most textbooks would suggest using the rate on a government bond, denominated in the currency in question, that presumes that governments are default free and that the government bond rate is a market-determined rate. However, governments are not always default free (even with local currency borrowings) and the rate may not be market-set. In July 2015, I started with the government bond rates in 42 currencies and cleansed them of default risk by subtracting out the sovereign default spreads (based on local currency sovereign ratings) from them to arrive at risk free rates in these currencies, which you can find in the table below:

    Risk free rates in July 2015
    Note that the default spread is set to zero for all Aaa rated governments, and the government bond rate becomes the risk free rate in the currency. Thus, the risk free rates in US dollars is 2.47% and in Swiss Francs is 0.16%. To compute the risk free rate in $R (Brazilian Reais), I subtract out my estimate of the default spread for Brazil (1.90%, based on its Baa2 rating) from the government bond rate of 12.58% to arrive at a risk free rate of 10.68%. To estimate a cost of equity in nominal $R for an average risk company with all of its operations in Brazil, you would use the 10.68% risk free rate in $R and the equity risk premium of 8.82% that I reported in my last post to arrive at a cost of equity of 19.50% in $R. That number would be higher for above-average risk companies, with a beta operating as your scaling mechanism.

    b. Differential inflation
    There are two problems with the risk free rate approach. The first is that it not only requires that you be able to find a government bond rate in the currency that you are working with, but also that the rate be a market-determined number. It remains true that in much of the world, government bond rates are either artificially set by governments or actively manipulated to yield unrealistic values. The second is that you are adding equity risk premiums that are computed in dollar-based markets (since the default spreads that they are built upon are from dollar-based bond or CDS markets) to risk free rates in other currencies. You could legitimately argue that the equity risk premium that you add on to a $R risk free rate of 10.68% should be higher than the 8.82% that you added to a US $ riskfree rate of 2.25% in July 2015.

    If the differences between currencies lies in the fact that there are different expectations of inflation embedded in them, you should be able to use that differential inflation to adjust discount rates in one currency to another. Thus, if the cost of capital is computed in US dollars and you intend to convert it into a nominal $R cost of capital, you could do so with the following equation:

    To illustrate, if you assume that the expected inflation rate in $R is 9.5% and in US $ is 1.5%, you could compute the cost of equity in US$ and then adjust for the differential inflation to arrive at a cost of equity in $R:
    Cost of equity for average risk Brazilian company in US $ = 2.25% + 8.66% = 10.91%

    The cost of equity of 19.65% that we derive from this approach is higher than the 19.50% that we obtained from the risk free rate approach and is perhaps a better measure of cost of equity in $R.

    This approach rests on being able to estimate expected inflation in different currencies, a task that is easier in some than others. For instance, getting an expected inflation rate in US dollars is simple, since you can use the difference between the 10-year T.Bond rate and the TIPs (inflation-indexed) 10-year bond rate as a proxy. In other currencies, it can be more difficult, and you often only have past inflation rates to go with, numbers that are prone to government meddling and imperfect measurement mechanisms. Notwithstanding these problems, I report inflation rates in different countries, using the average inflation rate from 2010-2014 for each country.



    I also report the inflation rate in 2014 and the IMF expectations for inflation (though I remain dubious about their quality) for each country.

    Currencies and Cash Flows
    Following the currency consistency principle is often easier with discount rates, where your inflation assumptions are generally either explicit or easily monitored, than it is with cash flows, where these same assumptions are implicit or borrowed from others. If you add in accounting efforts to adjust for inflation and inconsistencies in dealing with it to the mix, it should come as no surprise that in many valuations, it is not clear what inflation rate is embedded in the cash flows.

    a. Inflation in your growth rates
    In most valuations, you start with base year accounting numbers on revenues, earnings and cash flows and then attach growth rates to one or more of these numbers to get to expected cash flows in the future. At the risk of stating the obvious, the expected inflation rate embedded in this growth rate has to be the same inflation rate that you are incorporating in your discount rate. This simple proposition is put to the test, though, by the ways in which we estimate these expected growth rates, which is to use history, trust management/analyst projections for the future or base it on fundamentals (how much the company is reinvesting and how well it is reinvesting):
    1. Past Growth: With historical growth, where you estimate growth by looking at the past, your biggest exposure to mismatches occur in currencies where inflation rates have shifted significantly over time. For instance, assume that you are valuing your company in Indian rupees in July 2015 and that the average inflation rate in India, which was 8% between 2010 and 2014 is expected to decline to 4% in the future. If you use historical growth rates in earnings, between 2010 and 2014, for an Indian company, you are likely to over value the company because its past growth rate will reflect past inflation (8%) but your discount rates, computed using expected inflation or current risk free rates in rupees, will reflect a much lower inflation rate. 
    2. Management/Analyst Forecasts: With management or analyst forecasts, the problem is a different one, since the expected inflation rates that individuals use in their forecasts can vary widely. While there is no reason to believe that your estimate of expected inflation is better than theirs, it is undeniably inconsistent to use management estimates of expected inflation for growth rates and your own or the market's estimates of inflation, when estimating discount rates.
    3. Fundamental or Sustainable Growth: I believe that the best way to keep your valuations internally consistent is to tie growth to how much a company is reinvesting and how well it is reinvesting. The measures we use to measure reinvestment and the quality of investment are accounting numbers and inflation mismatches can enter insidiously into valuations. Assume, for instance, that you are estimating reinvestment rates and returns on capital for a Brazilian company, using its Brazilian financial statements. Since Brazilian accounting allows for inflation adjustments to assets, the return on capital that you compute is closer to a real return on capital (with no or low inflation embedded in it) than to a nominal $R return on capital, if inflation accounting works as advertised. In countries like the United States, where assets are not adjusted for inflation, you can argue that the return on capital is a nominal number, but one that reflects past inflation, not expected future inflation.  In either case, the growth rate that you compute from these numbers will be skewed.
    b. Expected Exchange Rates
    It is common practice, in some valuation practices, to forecast cash flows in a base currency (even if it is not the currency that you plan to use to estimate your discount rate) and then convert into your desired currency, using expected exchange rates. Thus, a Brazilian analyst who wants to value a Brazilian company in US dollars may estimate expected cash flows in nominal $R first and then convert these cash flow into US $, using an $R/US $ exchange rate.  The big estimation question then becomes how best to estimate expected exchange rates and there are three choices. 
    1. Use the currency exchange rate: The first one, especially in the absence of futures or forward markets, is to use the current exchange rate to convert all future cash flows. This will result in an erroneous value for a simple reason: it creates an inflation mismatch. If, for instance, the expected inflation rate in $R in 9.5% and in US$ is 1.5%, you will significantly over value your company with this approach, because you have effectively built into a 9.5% inflation rate into your cash flows (by using a constant exchange rate) and a 1.5% inflation rate into your discount rate (since you are estimating it in US dollars).
    2. Use futures and forward market exchange rates: This is more defensible but only if you then extract risk free rates from these same futures/forward market prices. (This will require that you assume interest rate parity in exchange rates and derive the interest rate in $R from the $R/US$ forward rate). In addition, in many emerging market currencies, the forward and futures markets tend to be operational only at the short end of the maturity spectrum, i.e., you can get 1-year forward rates but not 10-year rates.
    3. Use purchasing power parity: With purchasing power parity, the expected exchange rates are driven by differential inflation in the currencies in question. Thus, if purchasing power parity holds and the inflation rates are 9.5% in $R and 1.5% in US$, the $R will depreciate roughly 8% every year. While I am sure that you can find substantial evidence of deviation from purchasing power parity for short or even extended periods, here is why I continue to stick with it in valuation. By bringing in the differential inflation into both your cash flows and the discount rate, it cancels out its effect and thus makes it less critical that you get the inflation numbers right. Put differently, you can under or over estimate inflation in $R (or US $) and it will have no effect on your value.
    Currencies and Value
    If you can make it through the minefields to estimate cash flows and discount rates consistently, i.e., have the same expected inflation rate in both inputs, the value of a company or a capital investment should be currency invariant. In other words, if you value Tata Motors in Indian rupees, you should get the same value for the company, if you value it entirely in US dollars. If you don't get the same value, I would argue that the difference comes from one or two sources:
    • Inflation inconsistencies: It is stemming from inconsistencies in the way that you have dealt with inflation in different currencies, since a company's value should come from its fundamentals and not from which currency you chose to evaluate it in. 
    • Currency views: You have built in a currency view into your company valuation. Thus, if you assume that the $R will strengthen against the US dollar in the next 5 years,  when estimating cash flows, notwithstanding the higher inflation rate, you will find your company to be under valued, when you value it in $R. If that is the case, my suggestion to you would be to just buy currency futures or options, since you are making a bet on the currency, not the company.
    The bottom line is that your currency choice should neither make nor break your valuation. A well-run company that takes good investments should stay valuable, whether I value it in US dollars, Euros, Yen or Rubles, just as a badly run or risky company will have a low value, no matter what currency I value it in.

    Currency Risk
    When working with cash flows in a foreign currency, it is understandable that analysts worry about currency risk, though their measurement of and prescriptions for that risk are often misplaced. First, it is not the fact that exchange rates change over time that creates risk, it is that they change in unexpected ways. Thus, if the Brazilian Reai depreciates over the next five years in line with the expectations, based upon differential inflation, there is no risk, but if it depreciates less or more, that is risk. Second, even allowing for the fact that there is currency risk in investments in foreign markets, it is not clear that analysts should be adjusting value for that risk, especially if exchange rate risk is diversifiable to investors in the companies making these investments. If this is the case, you are best served forecasting expected cash flows (using expected exchange rates) and not adjusting discount rates for additional currency risk. 

    It is true that currency and country risk tend to be correlated and that countries with high country risk also tend to have the most volatile currencies. If so, the discount rates will be higher for investments in these countries but that augmentation is attributable to the country risk, not currency risk.

    Currency Rules for the Road
    It is easy to get entangled in the web of currency effects and lose sight of your quest for value, but here are few rules that I think may help you avoid distractions.
    1. Currencies are measurement mechanisms, not value driversAs I write this post, it is a hot day in New York, with temperatures hitting 95 degrees in fahrenheit. Restating that temperature as 35 degrees celsius may make it seem cooler (it is after all a lower number) but does not alter the reality that I will be sweating the minute that I step out of my office. In the same vein, if I value an Argentine company in a risky business, converting its cash flows from Argentine pesos to US dollars will not make it less risky or less exposed to Argentine country risk.
    2. Pick a currency and stick with it: The good news is that if your valuations are currency invariant, all you have to do is pick one currency (preferably one that you are comfortable with) and stick with it through your entire analysis. 
    3. Make your inflation assumptions explicit: While this may cost you some time and effort along the way, it is best to be explicit about what inflation you are assuming, especially when you estimate cash flows or exchange rates, to make sure that it matches the inflation assumptions that you may be building into your discount rates,
    4. Separate your currency views from your company valuations: It is perfectly reasonable to have views on currency movements in the future but you should separate your currency views from your company valuations. If you do not, it will be impossible for those using your valuations to  determine whether your judgments about valuation are based upon what you think about the company or what you feel about the currency. It is this separation argument that is my rationale for sticking with much maligned purchasing power parity in estimating future exchange rates.
    5. You can run, but you cannot hide: If inflation is high and volatile in your local currency, it is easy to see why you may prefer working with a different, more stable currency. It is the reason why so much valuation and investment analysis in Latin America was done in US dollars. The bad news, though, is that while switching to US dollars may help you avoid dealing with inflation in your discount rate, you will have to deal with it in your cash flows (where you will be called upon to forecast exchange rates). 



    Pricing Country Risk - Pictures of Global Risk - Part III


    In my last two posts, I looked at country risk, starting with an examination of measures of country risk in this one and how to incorporate that risk into value in the following post. In this post, I want to look at an alternative way of dealing with country risk, especially in investing, which is to let the market price of country risk govern decisions.

    Pricing Country Risk
    If you are not a believer in discounted cash flow valuations, I understand, but you still have to consider differences in country risk in your investing strategies. If you use pricing multiples (PE, Price to Book, EV to EBITDA) to determine how much you will pay for companies, you could assume that the levels of these multiples in a country already incorporate country risk. Thus, you are assuming that the PE ratios (or any other multiple) will be lower in riskier countries than in safer ones. 

    It is easy to illustrate the impact of risk on any pricing multiple, with a basic discounted cash flow model and simple algebra. To illustrate, note that you can use a stable growth dividend discount model to back into an intrinsic PE:
    Dividing both sides of this equation by earnings, we derive an intrinsic PE ratio:
    The PE ratio that you should expect to observe in a country will be a function of the efficiency with which firms generate earnings (measured by the payout ratio), the expected growth in these earnings (g) and the risk in these earnings (captured by the cost of equity). Holding the growth and earnings efficiency constant, then, you should expect to see lower PE ratios in countries with higher risk and higher PE ratios in safer countries. You can use the same process to extract the determinants of price to book ratios or enterprise value multiples and you will arrive at the same conclusion.

    Equity Multiples
    To see how well this pricing paradigm works, I started by looking at PE ratios by country in July 2015. To estimate the PE ratio for a country, I tried three variants. In the first, I compute the PE ratio for each company in the country (where it was computable) and then average across these PE ratios. To the extent that there are small companies with outlandish PE ratios in the sample (and there are many), these ratios will be skewed upwards. In the second, I compute a weighted average PE ratio across companies, with the weights based upon net income. This ratio is less affected by outliers, but it excludes money losing firms (since the PE ratio is not meaningful for these companies). In the third, I add up the market values of equity across all companies in the market and divide by aggregated net income for all companies, including money losing companies, i.e., an aggregated PE ratio. This ratio has the advantage of including all listed firms in a market but big money losing firms will push this measure up. The picture below summarizes differences in PE ratios across the world, with the weighted average PE ratio as the primary measure, but with the all three reported for each country.
    As you can see PE ratios are noisy, with some very risky countries (like  Venezuela) trading at high PE ratios and safe countries at lower values, not surprising given how much earnings can shift from year to year. For the most part, the riskiest countries are the ones where stocks trade at the lowest multiple of earnings.

    To get a more stable measure of pricing, I computed price to book values by country, again using the simple and weighted averages across companies and aggregated values and report the weighted average Price to Book in the picture below:
    As with PE ratios, there are outliers and Venezuela still stands out with an absurdly high price to book ratio, incongruous given the risk in that country. For the most part, though, the PBV ratio is correlated with country risk, as you can see in this list of the 28 countries that have price to book ratios that are less than one in July 2015:
    Weighted average PBV ratio in July 2015

    Enterprise Value Multiples
    Both PE and PBV ratios are equity multiples and may reflect not just country risk but also variations in financial leverage across countries. To remedy this problem, I look at EV to EBITDA multiples across countries:

    via chartsbin.com
    Looking at this map, it is quite clear that there is much less correlation between EV/EBITDA multiples and country risk than there is with the equity multiples. While it is true that the lowest EV/EBITDA multiples are found in the riskiest parts of the world (Russia & Eastern Europe, parts of Latin America and Africa), the highest EV/EBITDA multiples are in India and China. 

    There are two ways of looking at these results. The optimistic take is that if you have to pick a multiple to use compare companies that are listed in different markets, you should use an enterprise value multiple, since it is less affected by country risk. The pessimistic take is that you are likely to over value emerging market companies, if you use EV/EBITDA multiples, since they are less likely to incorporate country risk.

    Using these multiples
    The standard approach to pricing a company is to choose a multiple and compare how stocks that you deem “comparable” are being priced based on that multiple. This approach can be extended to deal with country risk, albeit with some limitations, in one of four ways: 
    1. Compare how stocks listed in a country are priced to find “bargains”: You could compare PE ratios across Brazilian companies on the assumption that Brazilian country risk is already incorporated in the pricing and buy (sell) the lowest (highest) PE stocks. The danger with this approach is that you are assuming that all Brazilian companies are equally exposed to Brazilian country risk. 
    2. Compare how stocks within a sector in a country are priced: Rather than compare across all stocks in a market, you could compare stocks within a sector in that market, on the assumption that both country and sector risk are already in the prices. Thus, you could compare the EV/Sales ratios of Brazilian retailers and argue that the retailers that trade at the lowest multiples of revenues are cheapest. The downside is that you may not find enough companies in a country, especially in a smaller market. 
    3. Compare how stocks within a sector are priced globally: A logical outgrowth of globalization is to compare companies within a sector, even if they are listed in different countries. Thus, you could compare Vale to other mining companies listed globally and Coca Cola to beverage companies across countries. The benefit is that you have more comparable firms but the danger is that you are ignoring country risk. 
    4. Compare stocks within a sector are priced globally, but control for country risk: In this last approach, you look at the pricing of companies across a sector but try to control for country risk by looking at differences between how the market is pricing companies in developed markets and emerging markets. 
    No matter which approach you use, you have the pluses and minuses of pricing. The plus is that you will always be able to find "cheap" stocks, because you are making relative judgments and it is simple to get the data. The minus is that if stocks are collectively over priced, either at a country or sector level, a pricing comparison will just yield the least over priced stock in the country or sector.
    Valuing and Pricing: Final Thoughts
    In my last post, I looked at ways in which you can try to incorporate country risk into the values of companies. In this one, I looked at how price these companies, based upon how the market is pricing other companies in risky countries. As I have argued in my posts on price versus value, the two approaches can yield divergent numbers and conclusions. Thus, you could value a company with all its operations in China, using an appropriate equity risk premium for China, and conclude that the stock is over valued. You could then compare the PE ratio for the same company to the PE ratio for the Chinese market and decide that it is cheap, because it trades at a lower multiple of earnings than a typical Chinese company.

    I tend to go with the first approach, since I have more faith in my valuation abilities than in my pricing abilities, i.e., I am more investor than trader. However, I am not quick to dismiss those who use pricing metrics to pick investments, since a nimble trader can play the pricing game very profitably. If you are unsure about where you fall in this process, I would suggest that you both value and price companies and buy only when both signal that the stock is a bargain.





    Valuing Country Risk: Pictures of Global Risk - Part II

    In my last post, I looked at the determinants of country risk and attempts to measure that risk, by risk measurement services, ratings agencies and by markets. In this post, I would first like to focus on how investors and business people can incorporate that risk into their decision-making. In the process, I will argue that while it is easy to show that risk varies across countries, significant questions remain on how best to deal with that risk when making investment and valuation judgments.

    Valuing Country Risk
    If the value of an asset is the risk-adjusted present value of its expected cash flows, it stands to reason that cash flow claims in riskier countries should be worth less than otherwise cash flow claims in safer parts of the world. This common-sense principle, though, can be complicated in practice, because there are two ways in which country risk can flow through into value. 
    1. Adjust expected cash flows: The first is to adjust the expected cash flows for the risk, bringing in the probability of an adverse event occurring and computing the resulting effect on cash flows. In effect, the expected cash flows on an investment will be lower in riskier countries than an otherwise similar investment in safer countries, though the mechanics of how we lower the cash flows has to be made explicit. 
    2. Modify required return: The second is to augment the required return on your investment to reflect additional country risk. Thus, the discount rate you use for cash flows from an investment in Argentina will be higher than the discount rate that you use for cash flows in Germany, even if you compute the discount rate in the same currency (US dollars or Euros, for instance). The question of whether there should be an additional premium for exchange rate risk is surprisingly difficult to answer, though I will give it my best shot later in this post. 
    While both processes are used by analysts, the adjustments made to cash flows and discount rates are often arbitrary and risk is all too often double counted. The questions of which types of risks to bring into the expected cash flows and which ones into discount rates but also how to do so remain open and I will lay out my perspective in this post.

    Adjust Cash Flows
    If there is a probability that your business can be adversely impacted by risk in a country, it stands to reason that you should incorporate this effect into your expected cash flow. There are three ways that you can make this adjustment.
    1. Probabilistic adjustment: The first is to estimate the likelihood that a risky event will occur, the consequences for value and cash flow if it does and to compute an expected value. This is the best route to follow for discrete, country-specific risks that can have large or catastrophic effects on your business value, since discount rates don't lend themselves easily to discrete risk adjustment and the fact that the risk is country-specific suggests that globally diversified investors may be able to diversify away some or much of the risk. A good example would be nationalization risk in a country prone to expropriating private businesses, where bringing in its likelihood will lower expected earnings in future periods and cash flows. 
    2. Build in the cost of protection: The second approach is to estimate the cost of buying protection against the country risk in question and bring in that cost into your expected cash flows. Thus, if you could buy insurance against nationalization, you could reduce your expected earnings by that insurance cost and use those earnings as a basis for estimating cash flows. This approach is best suited to those risks that can be insured against either in the insurance or financial markets. It is also my preferred approach in dealing with corruption risk, which, as I have argued in a prior post, is more akin to an unofficial tax imposed on the company.
    3. Cash flow hair cuts: The third way to adjust for country risk is to lower expected cash flows in risky countries 10%, 20% or more, with the adjustment varying across countries (with bigger hair cuts for riskier countries) and analysts (with more risk averse analysts making larger cuts). The perils of this approach are numerous. The first is that it is not only arbitrary but it is also specific to the individual making it, causing it to vary from investment decision to decision and from analyst to analyst. The second is that, once made, the adjustment is hidden or implicit and subsequent decision makers may not be aware that it has already been made, resulting in multiple risk adjustments at different levels of the decision-making process.
    A key distinction between the first approach (probabilistic) and the other two (building in cost of insuring risk or haircutting cash flows) is that taking into account the probability that your business could be adversely impacted by an event and adjusting the expected cash flows for the impact does not "risk adjust" the cash flows. You will attach the same value to a risky business as you would to a safe business with the same expected cash flows.

    Adjust Required Returns
    The second approach to dealing with country risk is to adjust discount rates, pushing up the required returns (and discount rates) for investments made in riskier countries. Those higher rates will push down value, thus accomplishing the same end result as lowering expected cash flows.

    Fixed Cash Flow Claims (Fixed Income)
    With fixed income claims (bonds, financial guarantees), this is easy enough to do, requiring an additional default spread (for country risk) in the desired interest rate, which, in turn, will lower value. In my last post on country risk, I looked at measures of sovereign default risk including sovereign ratings and credit default swaps. If you have a fixed cash flow claim against a sovereign, you could use these default risk measures to calculate the value of these claims. Thus, if the sovereign CDS spread for Brazil is 2.91% and the risk free rate in US dollars is 2.47%, you would price Brazilian dollar denominated bonds or fixed obligations to earn you 5.38%. 

    But what if your claim is against a company or business in a risky country? There are two ways in which you could estimate the default spread that you would use to value this claim:
    1. Company Rating: Just as ratings agencies and CDS markets estimate default risk in sovereigns, they also estimate default risk in some companies, especially larger ones. If your fixed cash flow claim is against a company where one or both of these are available, you can use them to compute an expected return (and discount your fixed claims at that rate). To illustrate, Vale, a Brazilian mining company, has a bond rating of Baa2 from Moody's in July 2015, and the default spread for a Baa2 rated bond rated bond is 1.75%. Since ratings agencies already incorporate (at least in theory) the fact that Vale is a Brazilian company into the bond rating, there is no need to consider country risk.
    US dollar cost of debt for Vale = US $ Risk free rate + Default Spread based on rating = 2.25%+1.75%  = 4.00%
    2. Country Default Spread + Company Default Spread: For many companies in emerging markets, the first approach will be a non-starter, and for these companies, you will have to approach the cost of debt estimation in two steps. In the first step, you will have to assess the default risk of the company, using its financial statements; I use an interest coverage ratio to estimate a synthetic bond rating and a default spread. In the second, you have to estimate the default spread for the country in which the company is incorporated. For smaller companies that have no way of avoiding the country risk, the US dollar cost of debt becomes:
    US dollar cost of debt for company = Risk free rate + Company Default Spread + Country Default Spread
    To illustrate, I estimated a synthetic rating of AAA for Bajaj Auto, an Indian auto manufacturer. To get Bajaj Auto’s cost of debt in US dollars, I would add the default spread based on this rating (0.40%) and the default spread for India (2.20%) to the US dollar risk free rate (2.25%), yielding a composite value of 4.65%. For larger companies with some or a great deal of global exposure, it is possible that only a portion of the country default spread will apply.

    Residual Cash Flow Claims (Equity)
    When valuing equity claims, the process of adjusting for country risk becomes more complicated. First, since equity claim holders don't get paid until the fixed cash flow claims have been met, they face more risk and should demand higher rewards for bearing that risk. Second, since equity investors can diversify away some risks, it is possible for a global investor to be exposed to these risks at the country level and still not demand a higher required return for these risks. Thus, if you are augmenting your required returns for country risk, you are arguing that some country risk is not diversifiable to the investors pricing the company exposed to that risk either because they don't have the capacity to diversify away that risk (by holding a globally diversified portfolio) or because there is correlation across countries that results in even globally diversified portfolios continuing to be exposed to country risk. Third, a multinational company is exposed to risky in many countries and not just to the risk of the country in which it is incorporated. Consequently, you have to separate the estimating of risk premiums for countries from that of risk premiums for companies.

    Equity Risk Premiums
    In earlier posts on this topic, I describe the process by which I estimate equity risk premiums for countries. Briefly summarizing, I start with a premium that I estimate for the S&P 500 at the start of every month as my "mature market premium" and add to that premium an additional country risk premium for riskier countries. I use either the sovereign rating or CDS spread as my measure of country risk, treating all countries with ratings of Aaa (AAA) or sovereign CDS spreads close to the US CDS spread as mature markets and estimating the equity risk premium for other markets as follows:
    To illustrate, my estimate of the equity risk premium for the S&P 500 at the start of July 2015 was 5.81%, and my estimate of the equity risk premium for Brazil (with its Baa2 sovereign rating and 1.90% default spread at the start of July) is 8.82%:

    The standard deviations of the Bovespa (20.25%) and the Brazilian government bond (12.76%) are used to scale up the default spread to yield an equity risk premium of 8.82%.

    Using this approach and extrapolating across countries, I obtained updated equity risk premiums for 169 countries in July and the results are contained in this data set. The global picture of equity risk, at least as I see it, is in below:
    Company Exposure to Equity Risk
    The standard practice in valuation is to look at a company's country of incorporation and assign an equity risk premium to it, based on that choice, a practice that has its roots in simpler times when much or all of most companies' revenues came from domestic markets and where multinationals were the exception, rather than the rule.

    That practice is indefensible in today's markets where most companies, including many small firms, derive their revenues from across the globe and often have their production spread over many countries. It makes far more sense to take a weighted average of equity risk premiums across these many markets to get to a company equity risk premium. The equity risk premiums themselves can be weighted on any of the following:
    1. Revenues: To the extent that your revenue stream is dependent upon the economic health of the country from which it is derived, you could argue that it is revenue that you should be focusing on. 
    2. EBITDA or Earnings: Since value is a function of cash flows (and not revenues), you may be inclined to use the EBITDA, by region, to weight equity risk premiums. There are three concerns you should have, though. The first is that many companies don't break down EBITDA, by region, while most break down revenues globally. The second is that accounting judgments come into play when assessing earnings by region, since expenses have to be allocated across regions. Much as we would like to believe that these allocations are driven by economic fundamentals, it is undeniable that tax considerations play a role. Third, unlike revenues which are always positive, the EBITDA for a region can be negative and it is not clear how you deal with negative weights.
    3. Assets: If you are an asset-based company (real estate or hospitality), your primary exposure to country risk may be at the asset level, and your most logical basis for computing an equity risk premium is to weight it based on assets. As with earnings, companies are not always forthcoming breaking down assets and even when broken down, the reported values tend to be book values (rather than market values).
    4. Production: In some cases, your primary exposure to risk may be to your operations rather than your revenue streams. In other words, if country risk leads you to shut down your factories, refineries or mines, it does not matter where you generate your revenues. Thus, with natural resource companies and companies that require significant infrastructure investments, you may choose to weight based upon where your production is centered. This is rarely reported in full in most company financials, though you may be able to guess, if you are familiar with the company.
    To illustrate, Coca Cola, while headquartered in the United States, has revenues across much of the globe and its 2014 annual report breaks revenues down into geographical regions. Using that revenue breakdown with the weighted ERP of each region from the last section, we estimate an equity risk premium of 6.90% for Coca Cola.
    Coca Cola Revenue Breakdown (2014)
    Consider Vale, a commodity company, instead. Its revenue breakdown on 2014 is below, with a weighted equity risk premium of 7.39%  for the company.
    Vale Revenue Breakdown (2014)
    As you can see, Vale is more exposed to Chinese country risk than Brazilian country risk, at least based on revenues. As a commodity company, you could argue that some of Vale's risks come from where its iron ore/mining reserves lie and that the equity risk premium should reflect that at as well. I agree, but Vale is still surprisingly opaque when it comes to the geographical breakdown of its operations.

    Bringing it together
    Since country risk can take many different forms and the way you should deal with it varies widely depending on that form, the picture below is designed to capture how best (at least from my perspective) to incorporate risk into value.


    There are three keys to dealing with country risk.
    1. Look at country risk through the eyes of investors in your company: Many businesses, when looking at country risk, tend to look at how exposed they are to the risk, when they should be looking at risk exposure through the eyes of their investors. 
    2. Make your risk adjustment(s) transparent: Whatever adjustment you make for country risk, it should be transparent. Put differently, if you adjust discount rates for country risk, your country risk adjustment should be visible to others who may look at your valuation. In far too many valuations, the adjustments for country risk are implicit, thus making it impossible for others to understand the adjustments or take issue with them.
    3. Do not double count or triple count risk: In a surprisingly large number of valuations, risk is double counted. Thus, it is not uncommon to see government bond rates that are not risk free being used as risk free rates, multiple hair cuts to the same cash flows and the same risk being adjusted for in both the cash flows and discount rate.
    One of the key requirements in operating a business globally is understanding how risk varies across countries and incorporating those risk assessments into whether and where you invest your (or your business) money. In these last two posts, I have tried to provide my perspective on both measuring risk differences across countries and how I think this risk should enter your investment decisions. It is true that both posts have avoided the questions of how the market prices these risks and of how currency risk enter the process, which you may view as glaring omissions, I will deal with the pricing question in my next post and look at decoding the currency puzzle in my last one.

    Papers to read

    1. My paper on country risk (July 2015)

    Data attachments



    Groundhog day in Greece, Hijinks in Brazil and Market Chaos in China: Pictures of Global Risk - Part I


    It’s been an eventful few weeks. Greece’s extended dance with default has left even seasoned players of the European game exhausted and hoping for a resolution one way or the other. In Latin America, Brazil’s political and business elite are in the spotlight as the mess at Petrobras spreads its poisonous vapors. On the other side of the world, the Chinese government, which finds markets useful only when they serve its purposes, is trying to stop a full fledged rout of its equity markets. For investors everywhere, the events across the world, discomfiting though they might be, are reminders of two realities. The first is that globalization, while bringing significant benefits, has created connections across markets that make any country's problem a global one. The second is that notwithstanding this globalization, some parts of the world are more prone to generate political and economic surprises than others. As companies and investors are forced to look outside their borders, I thought it would be a good time to examine how and why risk varies across countries and at updated measures of that risk.

    The Sources of Country Risk

    There is risk in every market for investors and businesses, but some countries are more exposed to risk than others. While there are few people who would contest this notion, I think it is still worth examining the drivers of country risk as a prelude to measuring it. Broadly speaking, these drivers can be broken down into political, legal and economic groupings.

    I. Economic Risk
    1. Stage in Development Life Cycle: When looking at companies, it is generally true that companies early in their life cycles, with evolving markets and business models, will be more volatile and risky than companies that are further alone in the life cycle. The same concept can be extended to countries, with emerging market economies, exhibiting higher growth and more uncertainty than more mature economies.
    2. Economic concentration: Countries that are dependent upon one or a few commodities or industries for growth will have more economic volatility than countries with diversified economies. In particular, smaller countries (and economies) are more likely to face this problem since their small sizes require them to find niches in the global economy and specialize. In the map below, I report concentration measures for countries estimated by UNCTAD to capture this dependence, with high values correlating to more concentrated economies (and higher risk) and lower values to more diversified economies.
      via chartsbin.com
    II. Political Risk

    1. Continuous versus Discontinuous Change: The debate about whether risk is higher or lower in democracies or autocracies is an old one and one that is sure to evoke a heated response. On the one hand, democracies create more continuous change, where newly elected governments often feel few qualms about replacing policies that were put into place by prior governments, than autocracies, where governments can promise and deliver stability.  However, change in an autocracy, while less common, is also more likely to be wrenching and difficult to plan for.
    2. Corruption and Side Costs: In an earlier post on the topic, I argued that corruption and bribery create side costs for businesses akin to taxes and make it more difficult to operate. Operating a business in a corrupt environment generally exposes you to more risk, since the costs are unpredictable and rules are unwritten. In the map below, I use a corruption measure from Transparency International to compare countries across the globe:
    via chartsbin.com

    3. Physical Violence: Operating a business exposes you not only to economic risk but physical risk in some countries, as war, violence and terrorism all wreak havoc. The extent of this danger varies across the world and the map below reports on a violence measure developed by the Institute forPeace and Economics.
    4. Nationalization/Expropriation Risk: While less prevalent than it was a few decades ago, it is still the case that businesses in some countries are more exposed to the risk of being nationalized or having assets expropriated by the government, acting in the “national” interest. 
    III. Legal Risk
    Investors and businesses are dependent upon legal systems enforcing their ownership rights. If you operate in a country where ownership rights are not respected or where the legal system enforcing it is either ineffective or unreliable, it is riskier to start and operate a business in that country. The International Property Rights Index tries to measure the degree of protection, by country, and the summary results, by country, are reported below:


    The Measurement of Country Risk
    Given that economic, political and legal risk can vary across countries, it is no surprise that investors and businesses seem out measures of country risk that they can use in decision making. We look at three variants of these measures below. 

    1. Risk Scores 
    With country risk scores, a service weights (subjectively) the importance of each of the many determinants and comes up with a score for country risk. While there are many services that attempt to do this, the picture below uses the scores from Political Risk Services (PRS) to map out hot spots in the globe. 
    Euromoney, The World Bank and the Economist also have country risk scores but the problem with these scores is three fold. The first is that many of them are intended for general use, rather than for businesses. The second is that there is no standardization in the process; thus, a high score is a reflection of low risk in the PRS system but of high risk in the Economist. Finally, the scores themselves are more rankings than true scores; thus a country with a PRS risk score of 80 is not twice as safe as a country with a PRS risk score of 40. 

    2. Default Risk 
    The most widely used measures of country risk are those that try to capture the risk that the country’s government will default on its obligations. While this is undoubtedly a much narrower measure than the political/economic risk scores described in the last section, it is more focused and easily usable in businesses. 
    a. Sovereign Ratings: Ratings agencies such as Standard and Poor’s, Moody’s and Fitch have long rated sovereign debt, assigning ratings to countries for both their foreign currency and local currency borrowings. In July 2015, Moody’s provided sovereign ratings for 129 countries and the map below summarizes these ratings: 
    While ratings are easy to get (and costless for the most part) and can be easily converted into default spreads that can be utilized as risk premiums, ratings measure only default risk, can be erroneous and often reflect risk changes with a lag. 
    b. Credit Default Swaps (CDS): In the last decade, the credit default swap market, which I described in this post, has provided updated, market-driven estimates of default risk. In July 2015, there were 62 countries with default risk measures available on them and the map below provides those market judgments. 
    Credit default swaps are more likely to reflect real world concerns in a timely fashion, but as with any market-driven numbers can also be volatile and prone to over reaction. 

    Conclusion 
    It is a cliché to state that the world is full of risk and that risk exposure varies across countries and time, but it is critical that investors and businesses make their best efforts to measure these risks and bring them into their decisions. In the next post, I will look at bringing the risk measures (country risk scores, ratings and CDS spreads) into investment and valuation decisions and also at how the market is pricing these risk measures in equity markets today. If you are interested in exploring this topic in more detail, you are welcome to download and read my paper on country risk.

    Attachments




    Big Markets, Over Confidence and the Macro Delusion!

    In early October of 2013, I was sitting in CNBC, waiting to talk about Twitter, which had just filed its prospectus (for its initial public offering). I was sharing the room with an analyst who was very bullish on the company, and he asked me what I thought Twitter was worth. When I replied that I had not had a chance to value the company yet, he suggested that I should save myself the trouble, and that the stock was worth at least $60 a share. Curious, I asked him why, and he said that Twitter would use its large user base to make money in the "huge" online advertising market. When I questioned him on how huge the market was, his answer was that he did not have a number, but he just knew that it was "really big". I am thankful to him, since he framed how I started my valuation of Twitter, which is with an assessment of the size of the online advertising market globally. Since I talked to that analyst, I have also become more more aware of the big market argument, and I have seen it used over and over in other markets, often as the primary and sometimes the only reason for assigning high values to companies in these markets. These analysts may very well be right about these markets being very big, but I think that suggesting that a company will be assured growth and profits, just because it targets these markets, not only misses several intermediate steps, but also exposes investors and business-owners to the macro delusion.

    Big Markets! Really, Really Big Markets!
    Would I rather that my company operate in a big market than a small one? Of course. Increasing market potential, holding all else constant, is good for value, but for that value to be generated, a whole host of other pieces have to fall into place. First, the company has to be able to capture a reasonable market share of that big market, a task that can be made difficult if the market is splintered, localized or intensely competitive. Second, the company has to be able to generate profits in that big market and create value from growth, also a function of the firm's competitive advantages and market pricing constraints. Third, once profitable, the company has to be able to keep new entrants out, easier in some sectors than in others.

    It is therefore dangerous to base your argument for investing in a company and assigning it high value entirely on the size of the market that it serves, but that danger does not seem stop analysts and investors from doing so. Here are four examples:

    China: A billion-plus people makes any market large, and if you add rapid economic growth and a
    burgeoning middle class to the mix, you have the makings of a marketing wet dream. Visions of millions of cell phones, refrigerators and cars being sold were enough to justify attaching large premiums to companies that had even a peripheral connection to China. The events of the last few weeks have made the China story a little shakier, but it will undoubtedly return, once things settle down.
    Online Advertising: It is undeniable that more and more of business advertising is moving online, and this shift has not only pushed Google, Facebook and Alibaba to the front lines of large market cap companies but has been the impetus behind Twitter, Yelp, Linkedin and a host of other social media companies capturing market capitalizations that seem outsized, relative to their operating metrics.


    The Sharing Economy: Even as private businesses, Uber and Airbnb have not only captured the attention of investors, with multi-billion dollar valuations, but have also disrupted conventional approaches to doing business. In the process, they have opened up the sharing paradigm, where private property (car, house) owners can put excess capacity in what they own to profitable use. 


    The Cloud: This is a recent entrant to the "big" market parade, as both technology titans such as Intel, Google and Amazon and new entrants such as Box vie to put our music, video, data and even our computing capabilities on large shared computers. Bessemer Venture Partners, which tracks companies that generate revenues from cloud computing, estimated a collective market capitalization of $170 billion for these companies in August 2015.

    I am sure that you will find more examples add to the list. For example, just a couple of weeks ago, Morgan Stanley issued a strong buy recommendation on Tesla and based it entirely on its potential growth in the "mobility services" market. It took me two readings of the report for me to figure out that the mobility service market was a hybrid of the car sharing and driverless car markets, a potentially huge market, that would have become even enormous, if you were able to slap ads on the cars and put them in China.

    The Macro Delusion: Individual Rationality, Collective Irrationality
    When you label a market as a bubble, you take the easy way out, since a market bubble suggests that the investors who push prices to unsustainably high levels are being irrational, crazy and perhaps even stupid. It is for that reason that I have used the word guardedly (and when I have, regretted it), and taken issue with "market bubblers" in earlier posts. Even if you believe that assets (real estate, stocks, bonds) are being over priced, you will almost always be better served assuming that investors setting these prices have their own reasons for doing so, and understanding those reasons (even if you disagree with them).

    To see how (almost) rational and (mostly) smart individuals can be fooled by big market potential into being collectively irrational, assume that you are an entrepreneur who has come up with a product that you see as having a large potential market and that, based on that assessment, you are able to convince venture capitalists to fund your business.

    Note that everyone in this picture is behaving sensibly. The entrepreneur has created a product that he sees as fulfilling a large market need and the venture capitalists backing the entrepreneur see the potential for profit from the product.

    Now assume that six other entrepreneurs see the same big market potential at about the same time you do, and create their own products to fulfill that market need, and that each finds venture capitalists to back his or her product and vision. 

    To make the game interesting, let's make each of these entrepreneurs bright and knowledgeable about their products, and let's make the VCs also smart and business savvy. If this were a rational market place, each entrepreneur and his/her VC backers should be valuing his/her business, based on assessments of market potential and success, and the existence of current and future competitors.

    Let's now add the twist that causes the deviation from rationality and make both the entrepreneurs and VCs over confident, the former in the superiority of their products over the competition, and the latter in their capacity to pick winners. This is neither an original assumption, nor a particularly radical one, since there is substantial evidence already that both groups (entrepreneurs and venture capitalists) attract over confident individuals.  The game now changes, since each business cluster (the entrepreneur  and the venture capitalists that back his or her business) will now over estimate its capacity to succeed and its probability of success, resulting in the following. First, the businesses that are targeting the big market will be collectively over valued. Second, the market place will become more crowded and competitive over time, especially with new entrants being drawn in because of the over valuation. Thus, while revenue growth in the aggregate may very well match expectations of the market being big, the revenue growth at firms will fall below collective expectations and operating margins will be lower than expected. Third, the aggregate valuation of the sector will eventually decline and some of the entrants will fold, but there will be a few winners, where the entrepreneurs and VCs will be well rewarded for their investments.

    The collective over valuation of the companies in the big market will bear resemblance to a bubble, and the correction will lead to the usual hand wringing about bubbles and market excesses, but the culprit is over confidence, a characteristic that is almost a prerequisite for successful entrepreneurship and venture capital investing. That is one reason that I feel no need to inveigh against bubbles in the social media space, since this is a feature of investing in young, start-up businesses in big markets, not a bug. That said, the extent of the over pricing will vary, depending upon the following:
    1. The Degree of Over Confidence: The greater the over confidence exhibited by entrepreneurs and investors in their own products and investment abilities, the greater will be the over pricing. While both groups are predisposed to over confidence, that over confidence tends to increase with success in the market. Not surprisingly, therefore, the longer a market boom lasts in a business space, the larger the over pricing will tend to get in that space. If fact, you can make a reasonable argument that the over pricing will be greater in markets where you have more experienced venture capitalists and serial entrepreneurs.
    2. The Size of the Market: As the target market gets bigger, it is far more likely that it will attract more entrants, and if you add in the over confidence they bring to the game, the collective over pricing will increase.
    3. Uncertainty: The more uncertainty there is about business models and the capacity to convert them into end revenues, the more over confidence will skew the numbers, leading to greater over pricing in the market. 
    4. Winner-take-all markets: The over pricing will be much greater in markets, where there are global networking benefits (i.e., growth feeds on itself) and winners can walk away with dominant market shares. Since the payoffs to success is greater in these markets, misestimating the probability of success will have a much bigger effect on value.
    The Online Ad Market and Social Media Company Valuations
    The market that best lends itself to run this experiment today is the online advertising market, with the influx of social media companies into the marketplace in the last few years. To run my experiment, I took the market capitalization of each company in the online advertising space and backed out of the expected revenues ten years from now. To do this, I had to make assumptions about the rest of the variables in my valuation (the cost of capital, target operating margin and sales to capital ratio) and hold them fixed, while I varied my revenue growth rate until I arrived at the current market capitalization. 

    The figure below illustrates this process using Facebook with the enterprise value of $245,662 million from August 25, 2015, base revenues of $14,640 million  (trailing 12 months) and a cost of capital of 9%. Leaving the existing margins unchanged at 32.42%, we can solve for the imputed revenue in year 10:
    Spreadsheet
    I assume that Facebook's current proportion of revenues from advertising (91%) will remain unchanged over the next decade, yielding imputed revenues from advertising for Facebook of $117,731 million in 2025. The assumption that the advertising proportion will remain unchanged may be questionable, at least with some of the other companies on the list below, where investors may be pricing in growth in new markets into the value. You undoubtedly will disagree with this and some of my other assumptions, which is why I will let you make your own in the attached spreadsheet and solve for your estimate of future revenues.

    I repeat this process with other publicly traded companies with significant online advertising revenues, using a fixed cost of capital and a target pre-tax operating margin of  either the current margin or 20%, whichever is higher, for every firm. Note that both assumptions are aggressive (the cost of capital may have been set too low and the operating margin is probably too high, given competition) and both will push imputed revenues in year 10 down.
    Numbers & Valuations in US dollars for all companies (Folder with valuations)
    The collective online advertising revenues imputed into the market prices of the publicly traded companies on this list, in August 2015, was $523 billion.  Note that this list is not comprehensive, since it excludes some smaller companies that also generate revenues from online advertising and the not-inconsiderable secondary revenues from online advertising, generated by firms in other businesses (such as Apple). It also does not include the online adverting revenues being imputed into the valuations of private businesses like Snapchat, that are waiting in the wings. Consequently, I am understating the imputed online advertising revenue that is being priced into the market right now.

    To gauge whether these imputed revenues are viable, I looked at both the total advertising market globally and the online advertising portion of it. In 2014, the total advertising market globally was about $545 billion, with $138 billion from digital (online) advertising (Sources: Zenith Optimedia. eMarketer). The growth rate in overall advertising is likely to reflect the growth in revenues at corporations, but online advertising as a proportion of total advertising will continue to increase. In the table below, I allow for different growth rates in the overall advertising market over the 2015-2025 time period and varying proportions moving to digital advertising to arrive at these estimates of digital/online advertising revenues in 2025:
    Even with optimistic assumptions about the growth in total advertising and the online advertising portion of it climbing to 50% of revenues, the total online advertising market in 2025 is expected to be $466 billion. The imputed revenues from the publicly traded companies on my list is already in excess of that number, and it seems reasonable to conclude that these companies are being over priced, relative to the market (online advertising) that they are expected to profit from.

    As more companies line up to enter this space, this gap between the size of the market that is priced in and the actual market will continue to grow, but investors will continue to fund these companies, even if they are aware of the gap. After all, the nature of over confidence is that founders and investors are convinced that the over pricing is not at their firms, but in the rest of the market. There are two threats to this over confidence and they are inevitable. The first is that as companies in this space continue to report earnings and revenues, you will see more negative surprises (lower revenue growth, shrinking margins and more reinvestment) and some price adjustment. The second is that there is no better deflator of investors over confidence than a market panic, and if the China crisis does not do it, there will be others down the road.

    What now?
    Even if you accept my argument that big markets can create macro delusions and that these delusions can lead to a gap between collective expectations and reality, what you should do, in response, will depend on how you approach investing. If you are a trader, playing the pricing game, you may not care about the gap, since your returns will be based on timing, i.e., entering the market at the right time and exiting before the delusion is laid bare. It is possible that a lot of public investors and venture capitalists in this space are playing this pricing game and some of them will get very rich doing so. 

    If you are a founder/owner or private investor interested in the long term value of your business, you may not be able to do much about your over confidence but there are a few simple steps that you can take to keep it in check. I do know that many in the start-up community view intrinsic valuations (or DCFs) with suspicion, but done right, a DCF is more than a valuation of a company. It provides a template for how you hope to convert products/users/downloads into revenues and profits, how much capital you will need to deliver the growth you so eagerly seek, and how competition will impinge on your best laid plans (by affecting growth and margins).  

    If you are a public market investor, surveying a "big market" group of companies, this post is not a clarion call to abandon the group, but to approach it differently. You can still make money investing in this sector, but only if you are selective about the companies that you invest in (which requires that you grapple with estimating the size of the big market and make your best judgments on winners and losers)  and are cognizant of the price that you are paying, not only when you buy the stock but while your hold it. In fact, your very best investments may come from mis-pricing in this segment.

    No matter which group you belong to, it is time that we stop labeling each other. If you are on the outside (of these big markets) looking in, don't be so quick to categorize players in the market as irrational, shallow and naive. If you are on the inside looking out, stop thinking of anyone who does not buy into your big market thesis as a Luddite, out of touch with technology and stuck in the past. You and I should be able to disagree about the values of Uber, Snapchat and Twitter, without our motives being impugned, our intelligence questioned and our sanity put to the test.

    YouTube Version
    I know that this is a long post and that your attention may have flagged half way through. To remedy that, I decided to make a YouTube video around this post. I hope you enjoy it!

    Attachments
    1. Imputed Online Ad Revenues by Company (with raw data on the companies)
    2. Spreadsheet to compute Imputed Online Ad Revenues
    3. Folder with imputed revenue spreadsheets for companies




    Another Market Crisis? My Survival Manual/Journal!

    I would be lying if I said that I like down markets more than up markets, but I have learned to accept the fact that markets that go up will come down, and that when they do so quickly, you have the makings of a crisis. I find myself getting more popular during these periods, as acquaintances, friends and relatives that I have not heard from in years seem to find me. They are  invariably disappointed by my inability to forecast the future and my unwillingness to tell them what to do next, and I am sure that I move several notches down the Guru scale as a consequence, a development that I welcome. To save myself some repetitions of this already tedious sequence, I think it is best that I pull out my crisis survival journal/manual, a work in progress that I started in the 1980s and that I revisit and rewrite each time markets go into a tailspin. It is more journal than manual, more personal than general, and more about me than it is about markets. So, read on at your own risk!

    The Price of Risk
    For me, the first casualty in a crisis is perspective, as I find myself getting whipsawed with news stories about financial markets, each more urgent and demanding of attention than the previous one. The second casualty is common sense, as my brain shuts down and my primitive impulses take over. Consequently, I find it useful to step back and look at the big picture, hoping to see patterns that help me make sense of the drivers of market chaos.

    It is my view that the key number in understanding any market crisis is the price of risk. In a market crisis, the price of risk increases abruptly, causing the value of all risky assets to drop, with that drop being greater for riskier assets. While the conventional wisdom, prior to 2008, was that the price of risk in mature markets is stable and does not change much over short periods, the last quarter of 2008 changed (or should have changed) that view. I started tracking the price of risk in different markets (equity, bond, real estate) on a monthly basis in September 2008, a practice that I have continued through the present. Getting an a forward-looking, dynamic price of risk in the bond market is simple, since it takes the form of default spreads on bonds, and FRED (the immensely useful Federal Reserve Database) has the market interest rates on a Baa rated (Moody's) bonds going back to 1919, with data available in annual, monthly or daily increments. That default spread is computed by taking the difference between this market interest rate and the US treasury bond rate  on the same date. Getting a forward-looking, dynamic price of risk in the equity markets is more complicated, since the expected cash flows are uncertain (unlike coupons on bonds) and equities don't have a specific maturity date, but I have argued that it can be done, though some may take issue with my approach. Starting with the cumulative cash flow that would have generated by investing in stocks in the most recent twelve months, I estimate expected cash flows (using analysts' top down estimates of earnings growth) and compute the rate of return that is embedded in the current level of the index. That internal rate of return is the expected return on stocks and when the US treasury bond rate is netted out, it yields an implied equity risk premium. The January 2015 equity risk premium is summarized below:
    Implied ERP Spreadsheet (January 2015)
    That premium had not moved much for most of this year, with a low of 5.67% on March 1, and a high of 6.01% in early February, and the ERP at the start of August was 5.90%, close to the start-of-the-year number. Given the market turmoil in the last weeks, I decided to go back and compute the implied equity risk premium each day, starting on August 1.
    ERP By Day
    Note that not much changes until August 17, and that almost all of the movement have been in the days between August 17 and August 245 During those seven trading days, the S&P 500 dropped by more than 11% and if you keep cash flows fixed, the expected return (IRR) for stocks increased by 0.68%. During the same period, the US treasury bond rate dropped by 0.06%, playing its usual "flight to safety" role, and the implied equity risk premium (ERP) jumped by 0.74% to 6.56%. 

    I did use the trailing 12-month cash flows (from buybacks and dividends) as my base year number, in computing these equity risk premiums, and there is a reasonable argument to be made that these cash flows are too high to sustain, partly because earnings are at historic highs and partly because companies are returning more of that cash than ever before. To counter this problem, I assumed that earnings would drop back to a level that reflects the average earnings over the last 10 years, adjusted for inflation (i.e., the denominator in the Shiller CAPE model) and that the payout would revert back to the average payout over the last decade. That results in lower equity risk premiums, but the last few days have pushed that premium up by 0.53% as well.

    My computed increases in ERP, using both trailing and normalized earnings, overstate the true change, because the cash flows and growth were left at what they were at the start of August, a patently unrealistic assumption, since this is also an economic crisis, and any slowing of growth in China will make itself felt on the earnings, cash flows and growth at US companies. That effect will take a while to show up, as corporate earnings, buyback plans and analyst growth estimates are adjusted in the months to come, and I am sure that some of the market drop was caused by changes in fundamentals. The argument that a large portion of the drop comes from the repricing of risk is borne out by the rise in the default spread for bonds, with the Baa default spread widening by 0.17%, and the increase in the perceived riskiness (volatility) of stocks, with the VIX posting its largest weekly jump ever, in percentage terms.

    The Repricing of Risky Assets
    When the price of risk changes, all risky assets will be repriced, but not by the same magnitude. Within mature markets, you should expect to see a bigger drop in stock prices at more risky companies than at safer ones, though how you define risk can affect your conclusions. If you define risk as exposure to the the precipitating factor in the crisis, I would expect the stock prices of  companies that are more dependent on China for their revenues to drop by more than the rest of the market. Since I don't have data on how much revenue individual companies get from China, I will use commodity companies, which have been aided the most by the Chinese growth machine over the last decade and therefore have the most to lose from it slowing down, as my proxy for China exposure. The table below highlights the 20 industry groups (out of 95) that have performed the worst between August 14 and August 24:


    Notice that commodity companies comprise one quarter of the group, with a few cyclical and technology sectors thrown into the mix.

    Looking across markets geographically, changes in the equity risk premium in mature markets will be magnified as you move into riskier countries and thus it is not surprising to see the carnage in emerging markets over the last week has exceeded that in developed markets, with currency declines adding to local stock market drops.

    Percentage Return in US dollar terms
    In the picture below, I capture the percentage change in market capitalizations between August 14, 2015, and August 24, 2015 in U.S. $ terms, with the PE ratios as of August 14 and August 24 highlighted for each country:

    via chartsbin.com
    Note that this phenomenon of emerging markets behaving badly cannot be blamed on China, since it happened in 2008 as well, when it was the banking system in developed markets that triggered the market rout.

    A Premium for Liquidity?
    There is another dimension, where crises come into play, and that is in the demand for liquidity. While investors always prefer more liquid assets to less liquid ones, that preference for liquidity and the price that they are willing to pay for it varies across time and tends to surge during market crisis. To see if this crisis has had the same effect, I looked at the drop in market capitalization, in US $ terms, between August 14 and 24 for companies classified by trading turnover ratios (computed by dividing the annual dollar trading value by the market capitalization of the company):
    Liquidity classes, based on turnover ratio = $ Trading Value/ $ Market Cap
    Surprisingly, it is the most liquid firms that have seen the biggest drop in stock prices, though the numbers may be contaminated by the fact that trading halts are often the reactions to market crises in many countries, that are home to the least liquid stocks. If this is the reason for the return divergence, there is more pain waiting for investors in these stocks as the market drop shows up in lagged returns.

    To the extent that market crises crimp access to capital markets, the desire for liquidity can also reach deeper into corporate balance sheets, creating premiums for companies that have substantial cash on their balance sheets and fewer debt obligations. To test this proposition, I classified firms globally, based upon the net debt as a percent of enterprise value, and looked at the price drop between August 14 and August 24:
    Net Debt/EV = (Total Debt- Cash)/ (Debt + Market Cap - Cash)
    The crisis seems to have spared no group of stocks, with the pain divided almost evenly across the net debt classes, with the largest price decline being in the stocks that have cash balances that exceed their debt. Note, however, that the multiples at which these companies trade at both prior and after the drop, reflect the penalty that the market is attaching to extreme leverage, with the most levered companies trading at a PE ratio of 3.11 (at least across the 15.76% of firms in this group that have positive earnings to report). If your contrarian strategy for this market is to screen for and buy low PE stocks, this table suggests caution, since a large portion of the lowest PE stocks will come with high debt ratios.

    As the public markets drop, the question of how this crisis will affect private company valuations has risen to the surface, especially given the large valuations commanded by some private companies. Since many of these private businesses are young, risky startups and that investments in them are illiquid, I would guess they will be exposed to a correction,  larger than what we observe in the public marketplace. However, given that venture capitalists and public investors in these companies will be self appraising the value of their holdings, the effect of any markdown in value will take the form of fewer high-profile deals (IPO and VC financing).

    What now?
    A market crisis bring out my worst instincts as an investor. First out of the pack is fear pushing me to panic, with the voice yelling "Sell everything, sell it now", getting louder with each bad market day. That is followed quickly by denial, where another voice tells me that if I don't check the damage to my portfolio, perhaps it has been magically unaffected. Then, a combination of greed and hubris kicks in, arguing that the market is filled with naive, uninformed investors and that this is my time to trade my way to quick profits. I cannot make these instincts go away, but I have my own set of rules for managing them. (I am not suggesting that these are rules that you should adopt, just that they work for me..)
    1. Break the feedback loop: Being able to check your portfolio as often as you want and in real time, with our phones, tablets and computers, is a mixed blessing. I did check my portfolio this morning for the damage that the last week has done, but I don't plan to check again until the end of the week. If I find myself breaking this rule, I will consider sabotaging my wifi connection at home, going back to a flip phone or leaving for the Galapagos on vacation.
    2. Turn off the noise: I read the Wall Street Journal and Financial Times each morning, but I generally don't watch financial news channels or visit financial websites. I become religious about this avoidance during market chaos, since much of the advice that I will get is bad, most of the analysis is after-the-fact navel gazing and all of the predictions share only one quality, which is that they will be wrong. 
    3. Rediscover your faith: In my book (and class) on investment philosophies, I argue that there is no "best' investment philosophy that works for all investors but that there is one for you, that best fits what you believe about markets and your personality. My investment philosophy is built on faith in two premises, that every business has a value that I can estimate, and that  the market price will move towards that value over time. During a crisis, I find myself returning to the core of that philosophy, to make sense of what is going on.
    4. Act proactively and consistently: It is natural to want to act in response to a crisis. I am no exception and I did act on Monday, but I tried to do so consistently with my philosophy. I revisited the valuations that I have done over the past year (and you can find most of them on my website, under my valuation class) and put in limit buy orders on a half a dozen stocks (including Apple, Tesla and Facebook), with the limit prices based on my valuations of the companies. If the crisis eases, none of the limit orders may go through, but I would have protected myself from impulsive actions that will cost me more in the long term. If it worsens, all or most of the of the limit buys will be executed, but at prices that I think are reasonable, given the cash flow potential of these companies.
    Will any of these protect me from losing money? Perhaps not, but I did sleep well last night and am more worried about whether the New York Yankees will score some runs tonight than I am about what the Asian markets will do overnight. That, to me, is a sign of health!
    The Silver Linings
    Just as recessions are a market economy's way of cleansing itself of excesses that build up during boom periods, a market crisis is a financial market's mechanism for getting back into balance. I know that is small consolation for you today, if you have lost 10% or more of your portfolio, but there are seedlings of good news, even in the dreary financial news:
    1. Live by momentum, die by itIn trading, momentum is king and investors who play the momentum game make money with ease, but with one caveat. When momentum shifts, the easy profits accumulated over months and years can be wiped out quickly, as commodity and currency traders are discovering.
    2. Deal or no deal? If you share my view that slowing down in M&A deals is bad news for deal makers, but good news for stockholders in the deal-making companies, the fact that this crisis may be imperiling deals is positive news.
    3. Rediscover fundamentals: My belief that first principles and fundamentals ultimately win out and that there are no easy ways to make money is strengthened when I read that carry traders are losing money, that currency pegs do not work when inflation rates deviate, and mismatching the currencies in which you borrow and generate cash flows is a bad idea.    
    4. The Market Guru Handoff: As with prior crises, this one will unmask a lot of economic forecasters and market gurus as fakes, but it will anoint a new group of prognosticators who got the China call right as the new stars of the investment universe. 
    If a market crisis is a crucible that tests both the limits of my investment philosophy and my  faith in it, I am being tested and as with any other test, if I pass it, I will come out stronger for the experience. At least, that is what I tell myself as I look at the withered remains of my investments in Vale and Lukoil!

    Spreadsheets



    My Valuation Class: The Fall 2015 Model Preview

    It is almost September and as the academic clock resets for a new year,  I get ready to teach a new valuation class. With three hundred registered students, it is about as diverse a class as any I have every taught, with a mix of full-time  and part-time MBA students, law and engineering graduate students and a few dozen undergraduates. And with a market meltdown framing discussions, it will be interesting to see how the class plays out. As always, I cannot wait for the class to start and as I have, each semester, for the last few years, I invite you to follow the class, if you are so inclined. 

    Setting the table
    Valuation is an intimidating title for a class, stirring up visions (and nightmares) about spreadsheets, accounting statements and financial theory. This may be the default version of the class and it serves experts in the topic well to preserve this air of mystery and intimidation. I have neither the expertise nor the desire to  teach such a class, and I hope that you will not only take my class, no matter what your background and experience, but that you will also learn to enjoy valuation as much as I do. The best way for me to start describing my class is to tell you what it is not about, rather than what it covers. So, here we go: 
    1. It is not an accounting class: Much of the raw data in my valuations comes from accounting statements, but once I get that raw data, I lose interest in the rest of the accounting details. In fact, one of my first in-practice webcasts (short webcasts about practical issues in valuation) uses the Procter and Gamble 10K to illustrate how little of a typical accounting filing gets used in valuation and how much is irrelevant or useless. I admire people who can forecast our full financial statements (income statements, balance sheets and cash flow statements) decades out, but I have never ever felt the urge to do so and I am not sure that I have the accounting skills to even do so.
    2. It is not a modeling class: As someone who did his first valuation on an old fashioned columned paper sheet with a calculator, I have mixed feelings about spreadsheets, in general, and Microsoft Excel, in particular. I like the time that I save in computational details, but I have to weigh that against the time I lose, playing pointless what-if games with the data that I would never have considered in my calculator days. I admire Excel Ninjas but I have also seen what happens when analysts become the spreadsheet's tools, rather than the other way around. Needless to say, I have never taught a session (let alone a class) built around Excel spreadsheets, though I have no qualms about using one to illustrate fundamental valuation principles.
    3. It is not a financial theory class: To be able to teach this class at a research university, I had to go through the rites of passage of a Finance doctoral student,  traversing the path that finance has followed, starting with Harry Markowitz and modern portfolio theory, moving through its Greek phase (with alphas and betas dominating the conversation first and then leading on to the expropriation of the rest of the Greek alphabet by the options theorists) to the counter-revolutionaries of behavioral finance. Unlike some who make you choose whether you are for financial theory or against it, I view it as a buffet, where I can partake on the portions of the theory that I find useful and leave behind that which I do not. In my valuation class, in particular, I would be surprised if I spent more than 5% of my time on financial theory, and if I do, it is only because I am trying to get to some place more interesting.
    Now that I have established what the class is about, let me lay out the five themes around which this class is built. 
    1. Valuation is a craft, not an art or a science: I start my class with a question, "Is valuation an art or a science?", a trick since the answer, in my view, is neither. Unlike physics and mathematics, indisputably sciences with immutable laws, valuation has principles but none that meet the precision threshold of a science. At the other extreme, valuation is not an art, where your creative instincts can guide you to wherever you want to go and geniuses can make up their own rules. I believe that valuation is a craft, akin to cooking and carpentry, and that you learn what works and what does not by doing it, not by reading or listening to others talk about it. That is the reason that each week during the course of the semester, I post my valuation of a company, with a Google shared spreadsheet for everyone in the class to try their hand at valuing the same company and coming to a very different conclusion than I do.
    2. Valuing an asset is different from pricing it: I will not bore you by repeating this distinction that I drew first in this post but have returned to over and over again. It is my belief that much of what passes for valuation, in practice, is really pricing, sometimes disguised as valuation and sometimes not, but I also think that there is nothing wrong with pricing an asset, if that is what your job entails. Thus, though the bulk of this class is built around intrinsic value and its determinants, a significant portion of the class is dedicated to better pricing techniques, through the judicious use of multiples, comparable assets and statistics.
    3. Anything can be priced and most almost anything can be valued: This may be stubborn side speaking, but I have always believed that you can value any cash-flow generating asset (as I have attempted to, in these posts on valuing tracking stock on a professional athlete, a sports team, a trophy asset and young companies) and that you can price any asset (as I tried to to, in these posts on Gold and Bitcoins). While this class is centered around valuing publicly traded companies, I deviate from that script often enough, that by the end of the class, you should be able to value and price any asset.
    4. Valuation = Story + Numbers: As readers of this blog, you have heard me get on the soapbox often enough, but to me the essence of valuation is connecting stories to numbers. As I noted in this most recent post of mine, this requires me to push people out of their comfort zones, encouraging numbers people to tell more stories and stories people to work more with numbers. No matter how far on either end of the numbers/ story spectrum you are, I think that no one is beyond reach.
    5. Valuation without action is pointless: I have never felt the need to use a case study in my valuation class or value a widget company in my class, because I not only find valuing real companies  in real time more interesting, but I can act on my own valuations and I usually do, though not always with conviction. Investing requires faith in both your capacity to value companies and in markets correcting over time and I try to let people see both the source of my faith and challenges to that faith. 
    I did put together a short (about two minutes) YouTube video of my class that summarize my perspective on this class. 

    So, both number crunchers and story tellers, welcome to the class and we can learn from each other!

    Prepping for the class
    As a realist, there are a few skills that will stand you in good stead in this class and none of these skills are difficult to acquire.
    1. Read financial statements: For better or worse, our raw data comes from accounting statements and you need to be able to navigate your way through these statements. If you have a tough time deciphering the difference between gross, operating and net income, and don't quite understand what goes into book value of equity, you will have a tough time valuing companies. Don't remember your accounting classes? Don't want to go back there? Never fear! I have a primer on accounting that takes you through the absolute basics (which is about all I know anyway) and you can get to it by clicking on this link.
    2. Understand basic statistics: Statistics, I was taught in my first class, is designed to help us make sense of large and contradictory data. Since that is precisely our problem in pricing assets today, i.e., that we have too much data pulling us in too many directions, it may be time to dust off that statistics book (I hope that you did not sell it back or burn it after your last statistics class) and reacquaint yourself with simple statistics. So, start with the averages, medians and standard deviations, move on to correlations and regressions and if you can handle it, to statistical distributions. If you are lost, try this link for my statistics primer.
    3. Get comfortable with rudimentary finance: I have always found it unfair that to take some classes, you have to take the equivalent of a lifetime in pre-requisites. While having taken a corporate finance class eases the way in valuation, it is not required, nor is any other finance course. That said, your life will be easier if you have nailed down the basics of time value of money and computing present value, as well as understand the roots of modern portfolio theory, even if you don 't quite get the specifics. This link has my time value of money primer.
    Getting down to Specifics
    It's taken me a while to get to specifics, but the class starts on September 2, 2015 and classes are every Monday and Wednesday from 10.30 am -11.50 am (with Sept 7, 14 and 23 being holidays) until December 14. The calendar for the class is available at this link.  The class content will follow a familiar path, starting with a big picture perspective on valuing/pricing, followed by intrinsic valuation (DCF), relative valuation (pricing and multiples), asset-based valuation (accounting, liquidation & sum of the parts) and it will end with real options. There will be two add-on sessions on acquisition valuation and value enhancement.

    If you are one of the 300 registered in the class, I hope to see you in class. If not, the classes will be recorded and webcast, usually by the end of each session day, and there are three forums you can use to follow the class:
    1. My website: Everything I do in this class will be accessible on this page for the class. As you will notice on the page, you can not only access the webcasts for the lectures, but you can download the lecture notes, try your hand at the valuations of the week and even take quizzes/exams (though you have to grade them yourself). If you want, you can read the emails that I send to the class at this link
    2. iTunes U: This has become one of my favorite platforms for delivering my class and it works flawlessly, if you have an Apple device, with an iPad providing a much better experience than an iPhone. (You have to download the iTunes U app, but it is free and the learning curve is barely uphill.)  However, you can tweak it to work on an Android, with an add-on app. This semester's version will be available at this link.
    3. YouTube: This was my add-on platform last semester and while it was never intended for delivering full classes, it worked surprisingly well. The webcasts come naturally to it, though the 80 minutes is a stretch, but I will add on the presentation material and the post-class tests to the webcasts to supplement them. This semester, the lectures and supporting material will be found at this channel.
    Alternate Pathways
    This is not the first time that I have put my classes online and this may not be the first time that you have thought about taking this particular class. As with other online classes, I know that life gets in the way, with family and work commitments taking priority, as they should, over an online valuation class that provides no credit or certification. You can follow one of the following four paths, each requiring more time and brain commitment than the prior one:
    1. Watch an occasional lecture or lectures: Rather than watch all 26 lectures, you can pick and choose a few on the topics that interest you the most. This strategy works best for those who cannot commit the time and/or are already experienced enough in valuation that they need just a brushing up of skill sets. 
    2. Watch every lecture, do post class tests/solutions: You could watch every lecture, a significant time commitment at 80 minutes apiece, and do just the post-class tests (designed to take about 5-10 minutes). Remember that you don't have to take this in real time, since the course will stay online for at least a year.
    3. Watch lectures and take quizzes/exam: In addition to watching the lectures, you can put your knowledge to the test and take the quizzes and final exam. I will post my solutions with a grading template and you can grade yourself (My advice: Be an easy grader!). Since the exams are all open-book, open-notes all you have to do is honor the time constraint (30 minutes for quizzes, 2 hours for the final).
    4. Watch lectures, take quizzes exam & value a company: In addition to doing all of the tasks in the prior path, you also pick a company to value (just as everyone else in my class will be) and try to apply what you learn in the class in that valuation. Unfortunately, there is little chance that I can offer you the feedback that I offer to those in my class, but I will try to answer a question or two, if you are stuck, and will provide my feedback template, when the time comes due.
    If all of these pathways all sound like too much work/time commitment and/or watching 80 minute videos of valuation lectures on your phone or tablet is not your idea of fun, I do have an alternative. Try my online valuation class, where the sessions are about 10-15 minutes apiece, on my website, YouTube or iTunes U
    Pass on it or pass it on!
    If you try the class and don't like it, I will not be offended and I am sure that you will find a better use for  your time. If you try the class and you like it, I would like something in return. Please pass on a bit of what you know or have learned to at least one other person, and perhaps more. Knowledge is one of the few things in life that we can share, without being left poorer for the sharing, and while the return on this investment will be not be financial, the emotional dividends will make it worthwhile. 

    Attachments



    Beijing Blunders: Bull in a China Shop!

    I have generally steered from using my blog as a vehicle for rants, not because I don't have my share of targets, but because I know that while ranting makes me feel better, it almost always creates more costs than benefits. It is true that I have had tantrums (mini-rants) about the practice of adding back stock-based compensation to EBITDA or expensing R&D to get to earnings, but the targets of those tend to be harmless. After all, what can sell-side  equity research analysts or accountants collectively do to retaliate? Refuse to send me their buy and sell recommendations? Threaten me with gang-audits?

    This post is an exception, because the target of the rant is China, a much bigger and more powerful  adversary than those in my mini-rants, and it is only fair that I let you know my priors before you read this post. First, I am hopelessly biased against the Chinese government. I believe that its reputation for efficiency and economic stewardship is inflated and that its thirst for power and money is soft-pedaled. Second, I know very little about the Chinese economy or its markets, how they operate and what makes them tick. It it true that some of my ignorance stems from the absence of trustworthy information about the economy but a great deal of it comes from not spending any time on the ground in China. So, if you disagree with this post, you have good reason to dismiss it as the rant born of ignorance and bias. If you agree with it, you should be wary for the same reasons.

    The Chinese Economic Miracle: Real or Fake?
    For the last two decades, the China story has been front and center in global economics, and with good reason. In the graph below, you can see the explosive growth in Chinese GDP, measured in Chinese Yuan and US dollars:


    The Chinese economy grew from being the eighth largest in the world in 1994 to the second largest in the world in 2014. It is true that many of the statistics that we use for China come from the Chinese government and there are is reason to question its reliability. In fact, there are some with conspiratorial inclinations who wonder whether the Chinese miracle is a Potemkin village, designed for show. Much as my bias would lead me down this path, there are some realities on the ground that are impossible to ignore:
    1. The China growth story is real: Any one who has visited China will tell you that the signs of real growth are around you, especially in urban China. It is not just the physical infrastructure of brand new airports, highways and high-speed trains, but the signs of prosperity among (at least some of) its people. I did my own experiment yesterday that confirmed the reality of Chinese growth. After I woke up to the alarm on my China-made iPhone, I put on my Nike exercise clothes, manufactured in China, slipped on my Asics running shoes, also from China. As I went through the day, it was easier for me to keep track of the things that were not made in China than those that were. Based just on that very unscientific sampling, I am willing to believe that China is the world's manufacturing hub.
    2. It has a Beijing puppet-master: To those who celebrate the growth of the Chinese economy as a triumph of free markets, I have to demur. The winners and losers in the Chinese economy are not always its best or most efficient players and investment choices are made by policy makers (or politicians) in Beijing, not by the market. There are those who distrust markets who would view this as good, since markets, at least in their view, are short term, but trusting a group of experts to determine how an economy should evolve can be even more dangerous.
    3. It is driven by infrastructure investment, not innovation: The Chinese economy is skilled at copying innovations in other parts of the world, but not particularly imaginative in coming up with its own. It is revealing that the current vision of innovation in China is to have a CEO dress up like Steve Jobs and make an Android phone that looks like the iPhone. Note that this should not be taken as a reflection of the Chinese capacity to be innovative but a direct consequence of centralized policy (see prior point). 
    4. The China story is now part of every business: In just the last month and a half, I have been in the US, Brazil and India, and can attest to the fact that the China story is now embedded in companies across the globe. In the US, I saw Apple report good earnings and lose $100 billion in market capitalization, with some attributing the drop to disappointing results from China. In Brazil, my Vale valuation rests heavily on how China does in the future, because China accounts for 37% of Vale's revenues and the surge in iron ore prices in the last decade came primarily from Chinese infrastructure investment. In India, I valued Tata Motors, whose acquisition of Jaguar , has made them more of a Chinese company than an Indian one, dependent on the Chinese buying oversized Land Rovers for a significant portion of their profits. 
    5. It is also a weapon of mass distraction: In a post from a few months ago, I talked about weapons of mass distraction, words that analysts use to induce you to pay premiums  for companies and to distract you from specifics. In that post, I highlighted "China" as the ultimate wild card, with mention of exposure to the country operating as an excuse for pushing up the stock price. The problems with wild cards though is that they are unpredictable, and it is entirely possible that the China card may soon become a reason to discount value, as the handwringing about earnings effects and corporate exposures of the China crisis begins.  
    The Chinese Markets: All Pricing, all the time!
    If you have been reading the news for the last few months, which have been about the epic collapse of Chinese stocks, I would not blame you for feeling sorry for investors in the Chinese market. I would suggest that you save your sympathy for more deserving causes, because as with everything else in markets, it depends on your time perspective. In the chart below, I look at three charts that look at the Shanghai Composite over time:
    Shanghai Composite
    It is undeniable that markets have been melting down since June, with the Shanghai Composite down 32% from its peak on June 12. However, if you had invested in Chinese stock at the start of this year, you have no reason to complain, with a return of 8.44% for the year to date, among the best-performing markets globally.  Stepping even further back, if you had invested in Chinese stocks in 2005, you would have earned close to 13$ as an annual return each year, with all the ups and downs in between.

    In earlier posts, I have drawn a contrast between valuation and pricing and why a healthy market need both investors (who buy or sell businesses based on their perceptions of the values of these businesses) and traders (who buy and sell assets based on what they think others will pay for them). A market dominated mostly by investors will quickly become illiquid and boring, and ironically reduce the incentives to collect information and value companies. A market dominated by traders will be volatile, with price movements driven by mood, momentum and incremental information, and will be subject to booms and busts. I would characterize the Chinese stock market as a pricing market, where traders rule and investors have long since fled or have been pushed out. While there are some who will attribute this to China being a young financial market, and others to cultural factors, I believe that it is a direct consequence of self-inflicted wounds.
    1. Investor restrictions: There is perhaps no more complicated market to trade in than the Chinese markets, with most Chinese companies having multiple classes of shares: Class A shares,  and traded primarily on the mainland, denominated in Yuan, Class B shares, denominated in US $, traded on the mainland and Class H shares, traded in Hong Kong, denominated in HK$. The Chinese government imposes tight restrictions on both domestic investors (who can buy and sell class A shares and class B shares, but only if they have legal foreign currency accounts, but cannot trade in class H shares) and foreign investors (who can buy and sell only class B and class H shares). As a consequence of these restrictions, investors are forced into silos, where shares of different classes in the same company can trade at different prices and governments can keep a tight rein on where investors put their money. Note also that the highest profile technology companies in China, like Baidu and Alibaba, create shell entities (variable interest entities or VIEs) and list themselves on the NASDAQ, making them effectively off-limits to domestic investors.
    2. Opaque financials and poor corporate governance: While China has moved towards adopting international accounting standards, Chinese companies are not doyens of disclosure, often holding back key information from investors. It is therefore not surprising that almost 10% of all securities class action litigation in the US between 2009 and 2013 was against Chinese companies listed in the US, that variable interest entities hold back key information and that non-Chinese companies like Caterpillar and Lixil have had to write off significant portions of their Chinese investments, as a result of fraud. This non-disclosure problem is twinned with corporate governance concerns at Chinese companies, where shareholders are viewed more as suppliers of capital than as part-owners of the company.
    3. Markets as morality plays: The nature of markets is that they go up and down and it is that unpredictability that keeps the balance between investors and traders. In China, the response to up and down markets is asymmetric. Up markets are treated as virtuous and traders who push up stock prices (often based on rumor and greased with leverage) are viewed as "good" investors. Down markets are viewed as an affront to Chinese national interests and not only are there draconian restrictions on bearish investors (restrictions on short selling, trading stops) but investors who sell stock are called traitors, malicious market manipulators or worse. Thus, the same Chinese government that sat on its hands as stock prices surged 60% from January to June has suddenly discovered the dangers of volatility in the last few weeks as markets have given up much of that gain.   
    The bottom line is that the Chinese government neither understands nor trusts markets, but it needs them and wants to control them. By restricting where investors can put their money, treating short sellers as criminals and market drops as calamities, the Chinese government has created a monster, perhaps the first one that does not respond to its dictates. The current attempt to stop the market collapse, including buying with sovereign funds, putting pressure on portfolio managers, name calling and sloganeering may very well succeed in stopping the bleeding, but the damage has been done.

    Moneyball in China
    The best cure for bias and ignorance is data and I decided that the first step in ridding myself of my China-phobia would be a look at how Chinese stocks are being priced in the market today. The essence of value investing is that at the right price, any company (including a Chinese company with opaque financials and non-existent corporate governance) can be a good investment and it is possible that the drop in stock prices in the last few months has made Chinese stocks attractive enough for the rest of us.

    To make these comparisons, I used the market price data as of August 19, 2015, to estimate market capitalization and enterprise values. For the accounting data, I used the numbers from the trailing 12 months, generally the 12 months ending mid-year 2015, for most companies. The first comparison was on pricing multiples:

    I compared China with India, Brazil and Russia, the three other countries that have been lumped together (awkwardly, in my view) as the BRIC,  as well as with the rest of the emerging markets. For comparisons, I also looked at the US and the rest of the developed markets (where I included Japan, Western Europe, Australia, Canada and New Zealand). In spite of the drop in stock prices in the last few months, Chinese stocks are collectively more expensive than stocks anywhere else in the world.

    To measure the profitability of Chinese companies, I looked at three measures of margin (EBITDA, Operating Income and Net Income) and three measures of return (Return on Equity and Return on Invested Capital):

    Chinese companies lag the rest of the world, when it comes to EBITDA and operating margins, but do better than other emerging market companies on net margins. On returns on equity and invested capital, Chinese companies are more profitable than Brazilian companies (reflecting the economic downturn in Brazil in the last year) but are pretty much on par with the rest of the world.

    One reason for the superior net margins at Chinese companies is that they tend to borrow less than companies elsewhere in the world, perhaps the only bright light in these comparisons.


    That may be at odds with some of what you may be reading about leverage in China, but it looks like the debt in China is either more in the hands of local governments or is off balance sheet.

    Finally, if the straw that you are grasping for is higher growth in China, there is some backing for it when you compare growth rates across companies, but only in analyst expectations, rather than in growth delivered:

    It is true that this market-level look at China may be missing bargains at the sector level and to remedy that, I looked at PE ratios and EV/EBITDA multiples regionally, by industry grouping. The industry-average values, classified by region, can be downloaded here, but across the ninety five industry groupings, Chinese companies have the highest PE ratios in the world in fifty and the highest EV/EBITDA multiples in fifty eight. You could dig even deeper and look at company-level data and you are welcome to do so, using the complete dataset here.

    Overall, I am hard pressed to make a case for investing in Chinese stocks, if you have a choice of investing in other markets, even after the market drop of the last few months. If you are a domestic investor in China, your choices are more restricted, and you may very well be forced to stay in this market. It is interesting that India and China, two markets that restrict domestic investors from investing outside the country, are the two most richly priced.

    Conclusion
    As I confessed up front, I am not a China hand and don't claim any macro or market forecasting skills, but my experience with company valuation and pricing lead me to make the following predictions for China.
    1. Slower real growth: If I were a betting man, I would be willing to take a wager that the expected real growth rate in the Chinese economy will be closer to 5% a year for the next decade than to the double-digit growth that we have been programmed to expect. That may strike you as pessimistic, after the growth of the last two decades, but just as size eventually catches up with companies, the Chinese economy is getting too big to grow at the rates of yesteryear. The question, for me, is not whether this will happen but how the Chinese government will deal with the lower growth. While the sensible option is to accept reality and plan for lower real growth, I fear that the need to maintain appearances will lead to a cooking of the economic books, in which case we will have an number-fixing scandal of monumental proportions.
    2. More pricing ahead: I don't see much hope that investors will be welcomed back into Chinese markets any time soon. So, even if this market shakeup drives some of traders out of the game, investors motivated by value will be reluctant to step in, if the government continues to make markets into morality plays. As long as the market continues to be a pricing game, the price moves in the market will have little do with fundamentals. As a consequence, I would suggest that you ignore almost all attempts by market experts to explain what is happening in Chinese markets with economic stories. 
    3. Buyer beware: If you are drawn to Chinese markets (like moths to a flame), here is my advice for what it is worth. If you are an investor, you need to look past the hype and value companies, opacity and complexity notwithstanding, and be a realist when it comes to corporate governance. If you are a trader, this is a momentum game and if you can get ahead of momentum shifts, you will make money. If your bet is on the downside, just be ready to be maligned, abused or worse.
    I understand why corporate chieftains and heads of government are unwilling to speak openly about the Chinese government, given how much of their own economic prosperity rests on maintaining good relations. Financial markets don't have such qualms and they are delivering their message to Beijing clearly and decisively. Let's hope someone is listening!
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    Storied Asset Sales: Valuing and Pricing "Trophy" Assets

    Pearson PLC, the British publishing/education company, has been busy this summer, shedding itself of its ownership in two iconic media investments, the Financial Times and the Economist. On July 23, 2015, it sold its stake in the Financial Times for $1.3 billion to Nikkei, the Japanese media company, after flirting with Bloomberg, Reuters and Axel Springer. It followed up by selling its 50% stake in the Economist for $738 million, with 38% going to Exor, the investment vehicle for the Agnelli family, and the remaining 12% being purchased by the Economist Group itself. The motive for the divestitures seems to be a desire on the part of Pearson to stay focused on the education business but what caught my eye was the description of both the Financial Times and the Economist as “trophy” assets, a characterization that almost invariably accompanies an inability on the part of analysts to explain the prices paid by the acquirer, with conventional business metrics (earnings, cash flows, revenues etc.).

    What is a trophy asset?
    My first task in this analysis was to find other cases where the term was used and I found that its use spreads across asset classes. For instance, it seems to be commonplace in real estate transactions like this one, where high-profile properties are being acquired. As in the stories about the Economist and the Financial times, it seems to also be used in the context of media properties that have a long and storied tradition, like the Washington Post and the Boston Globe. In the last few years, sports franchises have increasingly made the list as well, as billionaires bid up their prices for these franchises. I have seen it used in the context of natural resources, with some mines and reserves being categorized as trophy assets for mining companies. While this is a diverse list, here are some of what they share in common:
    1. They are unique or rare: The rarity can be the result of natural scarcity (mining resources or an island in Hawaii), history (a newspaper that has survived a hundred years) or regulation/restriction (professional sports leagues restrict the creation of new franchises). 
    2. They have name recognition: For the most part, trophy assets have name recognition that they acquire either because they have been around for a long time, are in the news or have wide following.
    3. They are cash flow generating businesses or investments: In contrast with collectibles and fine art, trophy assets are generally cash flow generating and can be valued as conventional assets/businesses.
    There is undoubtedly both a subjective and a negative component to the “trophy asset” label. The subjective component lies in how “rare” is defined, since some seem to define it more stringently than others. The negative aspect of labeling an asset as a trophy asset is that the buyer is perceived as paying a premium for the asset. Thus, an asset is more likely to be labeled as a trophy asset, when the buyer is a wealthy individual, driven more by ego and less by business reasons in making that investment.

    Valuing a trophy asset
    Rather than take it as a given that buyers overpay for trophy assets, let us look at the possibility that these assets are being acquired for their value rather than their glamor. We have the full financial statements for the Economist but only partial estimates for the Financial Times, and I have used this information to estimate base values for the two assets:
    Spreadsheet with valuation
    Thus, based on the earnings power in the two assets and low growth rates, reflecting their recent static history, the estimated value for the Economist is about £800 million and the Financial Times is worth £410 million. I will label these values in this table as the status quo estimates, since they reflect the ways in these media names are managed currently. While you could take issue with some of my assumptions about both properties, it seems to me that Nikkei’s acquisition price (£844 million) for the Financial Times represents a much larger premium over value than Exor's acquisition of the Economist Group for £952 million.  Does that imply that Nikkei is paying a trophy asset premium for the Financial Times? Perhaps, but there are three other value possibilities that have to be considered.
    1. Inefficiently utilized: If a trophy asset is under utilized or inefficiently run, a buyer who can use the asset to its full potential will pay a premium over the value estimated using status quo numbers. That is difficult to see in the acquisition of the Economist stake, at least to the Agnellis, since the interest is a non-controlling one (with voting rights restricted to 20%), suggesting that the acquirer of the stake cannot change the way the Economist is run. With the Financial Times, the possibilities are greater, since there are some who believe that the Pearson Group has not invested as much as it could have to increase the paper's US presence. 
    2. Synergy benefits to another business: If the buyer of the trophy asset is another business, it is possible that the trophy asset can be utilized to increase cash flows and value at the acquiring business. The value of those incremental cash flows, which can be labeled synergy, can be the basis for a premium over the status quo value. With the Nikkei acquisition of the Financial Times, this is a possibility, especially if growth in Asia is being targeted. With the Agnelli acquisition of the Economist, it is difficult to see this as a rationale since Exor is an investment holding company, not an operating business.
    3. Optionality: There is a third possibility and it relates to other aspects of the business that currently may not be generating earnings but could, if technology or markets change. With both the Economist and the Financial Times, the digital versions of the publications in conjunction with large, rich and loyal reader bases offer tantalizing possibilities for future revenues. That option value may justify paying a premium over intrinsic value. In fact, at the risk of playing the pricing game, note that you are acquiring the Economist at roughly the same price that investors paid for Buzzfeed, a purely digital property with a fraction of its history and content. 
    With the Financial Times, adding these factors into the equation reinforces the point that the price paid by Nikkei can be justified with conventional value measures. With the Economist, and especially with the Exor acquisition, it does look like the buyers are paying a premium over value.

    Pricing a trophy asset
    As many of you who read my blog know, I have a fetish when it comes to differentiating between the value of an asset and its price. If value is a function of the cash flows from, growth in and risk of a business (estimated using intrinsic valuation models), price is determined by demand and supply and driven often by mood and momentum. If “trophy assets” are sought after by buyers just because they are rare and have name recognition, it is entirely possible that the pricing process can yield a number (price) very different from that delivered by the value process. In particular, the more sought after the trophy asset, the greater will be the premium that buyers are willing to pay (price) over value.

    In June 2014, when Steve Ballmer bid $2 billion to buy the Los Angeles Clippers, I tried first explaining his bid by valuing the Clippers as a business. Even my most optimistic estimates of earnings and cash flows at the franchise generated a value of $1.2 billion for the franchise, leading me to conclude that Ballmer was paying the excess amount ($800 million) for an expensive play toy. While it is possible that the same motivations may be driving John Elkann, the scion of the Agnelli family and chairs Exor, in his acquisition of the Economist, I hope that Nikkei, a privately held business, is not paying for an expensive toy.

    I am not arguing that paying this price premium is irrational or foolish. Far from it! First, it is possible that the emotional dividends that you receive from owning a trophy asset make up for the higher price up front. After all, Steve Ballmer’s friends are likely to be much more excited about being invited to have a ring side view of a Clippers game than watch Microsoft introduce Windows 10. Second, paying a premium over value does not preclude you from generating nosebleed returns from your investment, if you can find other buyers who are willing to pay even bigger premiums to take these trophy assets of your hands. In fact, many sports franchise buyers in the last decade who were viewed as paying nosebleed prices for their acquisitions have been able to sell them to new buyers for even higher prices. 

    Implications
    I tend to be skeptical of when an assets is casually labeled as a trophy asset, since it the labeling allows us to categorize its buyers as driven by non-financial considerations, without having to back up that contention. While both the Economist and the Financial Times have been labeled trophy assets, I think we have to hold back on that judgment, especially with the latter, to see what Nikkei has in mind for its new addition. After all, people were quick to label the acquisition of the Washington Post by Jeff Bezos as a trophy buy, but news stories suggests that there have been major changes at the Post since the deal was completed, which may be laying the foundations for delivering value.

    If an asset class becomes a repository for trophy assets, it will attract buyers who will pay for non-economic benefits and the pricing of assets will lose connection to fundamentals. At the MIT Sloan Sports Conference this year, I was on a panel about the “valuation” of sports franchises and I made the argument that wealthy buyers in search of glamorous toys were increasingly changing these markets into pricing markets. In fact, as long as the number of sports franchises is static and the number of billionaires keeps increasing, I see no reason for this trend to stop. So, if the New York Yankees or Real Madrid go on the auction block, be prepared for some jaw-dropping prices for these franchises.

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    No Mas, No Mas! The Vale Chronicles (Continued)!

    Some of my Brazilian readers seem to be upset that I used "No Mas", Spanish words, rather than Portuguese ones, in the title. To be honest I was not thinking about language, but instead about a boxing match from decades ago, where Roberto Duran used these words to give up in his bout with Sugar Ray Leonard

    I have used Vale as an illustrative example in my applied corporate finance book, and as a global mining company, with Brazilian roots, it allows me to talk about how financial decisions (on where to invest, how much to borrow and how dividend payout) are affected by the ups and downs of the commodity business and the government’s presence as the governance table. In November 2014, I used it as one of two companies (Lukoil was the other one) that were trapped in a risk trifecta, with commodity, currency and country risk all spiraling out of control. In that post, I made a judgment that Vale looked significantly under valued and followed through on that judgment by buying its shares at $8.53/share. I revisited the company in April 2015, with the stock down to $6.15, revalued it, and concluded that while the value had dropped, it looked under valued at its prevailing price. The months since that post have not been good ones for the investment, either, and with the stock down to about $5.05, I think it is time to reassess the company again.

    Vale: A Valuation Retrospective
    In November 2014, in a post titled “Go where it is darkest”, I repeated a theme that has become a mantra in my valuation classes. While it easiest to value mature, money-making companies in stable markets, I argue that the payoff to doing valuation is greatest when uncertainty is most intense, whether that uncertainty comes from the company being a young, start-up without a business model or from macroeconomic forces. The argument is based on the simple premise that your payoff is determined not by how precisely you value a company but how precisely you value it, relative to other people valuing the same company. When faced with boatloads of uncertainty, investors shrink from even trying to do valuation, and even an imprecise valuation is better than none at all.

    It is to illustrate this point that I chose Vale and Lukoil as my candidates of doom, assaulted by dropping commodity prices (oil for Lukoil and iron ore prices for Vale), surging country risk (Russia for Lukoil and Brazil for Vale) and plummeting currencies (Rubles for Lukoil and Reais for Vale). I valued both companies, but it is the valuation of Vale that is the focus of this post and it yielded a value of $19.40/share for a stock, that was trading at $8.53 on that day. The narrative that drovemy valuation was a simple one, i.e., that iron ore prices and country risk would stabilize at November 2014 levels, that the earnings over the last twelve months (leading into November 2014), which were down 40% from the previous year’s numbers, incorporated the drop in iron ore prices that had happened and that eventually Vale would be able to continue generating the mild excess returns it had as a mature mining company.
    I did buy Vale shares after this analysis, arguing that there was a buffer built into earnings for further commodity price decline.

    In April 2015, I revisited my valuations, as the stock prices of both companies dropped from the November 2014 levels, and I labeled the post “In search of Investment Serenity”. The post reflected the turmoil that I felt watching the market deliver a negative judgment on my initial thesis, and I wanted to check to see if the substantial changes on the ground (in commodity prices, country risk and currency levels) had not changed unalterably changed my thesis. Updating my Vale valuation, the big shifts were two fold. First, the trailing 12-month earnings that formed the basis for my expected value dropped a third from their already depressed levels six months earlier. Second, the implosion in Petrobras, the other large Brazilian commodity company, caused by a toxic combination of poor investments, large debt load and unsustainable dividends, raised my concern that Vale, a company that shares some of the same characteristics, might be Petrobrased. Again, I made the assumption that the trailing 12-month numbers reflected updated iron ore prices and revalued the company, this time removing the excess returns that I assumed in perpetuity in my earlier valuation, to arrive at a value per share of $10.71. 
    I concluded, with a nod towards the possibility that my conclusions were driven by my desire for confirmation bias (confirming my earlier judgment on Vale being under valued), that while I might not have been inclined to buy Vale in April 2015, I would continue to hold the stock.

    Vale: The September 2015 Version
    The months since my last valuation (in April 2015) have not been good for Vale, on any of the macro dimensions. The price of iron ore has continued to decline, albeit at a slower rate, over the last few months. That commodity price decline has been partially driven by the turmoil in China, a country whose massive infrastructure investments have been responsible for elevating iron ore prices over the last decade.  The political risk in Brazil not only shows no signs of abating, but is feeding into concerns about economic growth and the capacity of the country to repay its debt. The run-up that we saw in Brazilian sovereign CDS prices in April 2015 has continued, with the sovereign CDS spread rising above 4.50% this week. 

    Source: Bloomberg
    The ratings agencies, as always late to the party, have woken up (finally) to reassess the sovereign ratings for Brazil and have downgraded the country, Moody’s from Baa2 to Baa3 and S&P from BBB to BB+, on both a foreign and local currency basis. While both ratings changes represent only a notch in the ratings scale, the significance is that Brazil has been downgraded from investment grade status by both agencies.

    Finally, Vale has updated its earnings yet again, and there seems to be no bottom in sight, with operating income dropping to $2.9 billion, a drop of more than 50% from the prior estimates.  While it is true that some of the write offs that have lowered earnings are reflections of iron ore prices in the past, it is undeniable that the earnings effect of the iron ore price effect has been much larger than I estimated to be in November 2014 or April 2015. Updating my numbers, and using the sovereign CDS spread as my measure of the country default spread (since the ratings are not only in flux but don’t seem to reflect the assessment of the country today), the value per share that I get is $4.29.
    I was taken aback at the changes in value over the three valuations, separated by less than a year, and attempted to look at the drivers of these changes in the chart below:

    The biggest reason for the shift in value from November 2014 to April 2015 was the reassessment of earnings (accounting for 81% of my value drop), but looking at the difference between my April 2015 and September 2015 valuations, the primary culprit is the uptick in country risk, accounting for almost 61% of my loss in value.

    Vale: Time to Move on?
    If I stay true to my investment philosophy of investing in an asset, only if its price is less than its value, the line of no return has been passed with Vale. I am selling the stock, but I do have to tell you that it was not a decision that I made easily or without fighting through my biases. In particular, I was sorely tempted by two games:
    1. The “if only” game: My first instinct is to play the blame game and look for excuses for my losses. If only the Brazilian government had behaved more rationally, if only China had not collapsed, if only Vale’s earnings had been more resilient to iron ore prices, my thesis would have been right. Not only is this game completely pointless, but it eliminates any lessons that I might be extract from this fiasco.
    2. The “what if” game: As I worked through my valuation, I had to constantly fight the urge to pick numbers that would let me stay with my original thesis and continue to hold the stock. For instance, if I continue to use the rating to assess default spreads for Brazil, as I did in my first two valuations, the value that I get for the company is $6.65. I could have then covered up this choice with the argument that CDS markets are notorious for over reacting and that using a normalized value (either a rating-based approach or an average CDS spread over time) gives me a better estimate.
    After wrestling with my own biases for an extended period, I concluded that the assumptions that I would need to make to justify continuing to hold Vale would have to be assumptions about the macro environment: that iron ore prices would stop falling and/or that the market has over reacted to Brazil’s risk woes and will correct itself. If there is anything that I have learned already from my experiences with commodity companies and country risk, it is that my macro forecasting skills are woeful and making a bet on them magically improving is wishful thinking. In fact, if I truly want to make a bet on these macro movements, there are far simpler, more direct and more lucrative ways for me to exploit these views that buying Vale; I could buy iron ore future or sell the Brazil sovereign CDS. I like Vale's management but I think that they have been dealt a bad hand at this stage, and I am not sure that they can do much about the crosswinds that are pummeling them. If you have more faith in your macro forecasting skills than I do, it is entirely possible that Vale could be the play you want to make, if you believe that iron ore prices will recover and that the Brazil's risk will revert back to historic norms. In fact, given my abject failure to get these right over the last few months, you may want to view me as a contrary indicator and buy Vale now.

    Investing Lessons
    It is said that you can learn more from your losses than from your wins, but the people who like to dish out this advice have either never lost or don’t usually follow their own advice. Learning from my mistakes is hard to do, but let looking back at my Vale valuations, here is what I see:
    1. The dangers of implicit normalization: While I was careful to avoid explicit normalization, where I assumed that earnings would return to the average level over the last five or ten years or that iron ore prices would rebound, I implicitly built in an expectation of normalization by taking the last twelve-month earnings as indicative of iron ore prices during that period. At least with Vale, there seems to be a lag between the drop in iron ore prices and the earnings effect, perhaps reflecting pre-contracted prices or accounting lethargy. By the same token, using the default spread based on the sovereign rating provided a false sense of stability, especially when the market's reaction to events on the ground in Brazil has been much more negative.
    2. The Stickiness of Political Risk: Political problems need political solutions, and politics does not lend itself easily to either rational solutions or speed in resolution. In fact, the Vale lesson for me should be that when political risk is a big component, it is likely to be persistent and can easily multiply, if politicians are left to their own devices. 
    3. The Debt Effect: All of the problems besetting Vale are magnified by its debt load, bloated because of its ambitious growth in the last decade and its large dividend payout (Vale has to pay dividends to its non-voting preferred shareholders). While the threat of default is not looming, Vale's buffer for debt payments has dropped significantly in the last year, with its interest coverage ratio dropping from 10.39 in 2013 to 4.18 in 2015.
    There are two lessons that I had already learned (and that I followed) that helped me get through this experienced, relatively unscathed. 
    1. Spread your bets: The consequences of the Vale misstep for my portfolio were limited because I followed my rule of never investing more than 5% of my money in any new stock, no matter how alluring and attractive it looks, a rule that I adopted  because of the uncertainty that I feel in my valuation judgments and that the market price moving towards my value. In fact, it is the basis for my post on how much diversification is the right amount.
    2. Never take investment risks that are life-style altering (if you fail): Much as I would like to make that life-altering investment, the one whose payoff will release me from ever having to think about investing again, I know it is that search that will lead me to take "bad" risks. Notwithstanding the punishment meted out to me by my Vale investment, I am happy to say that it has not altered my life choices and that I have passed the sleep test with flying colors. (I have not lost any sleep over Vale's travails).
    Closing Thoughts
    If I had known in November 2014 what I know now, I would obviously have not bought Vale, but since I don’t have that type of hindsight , that is an empty statement. I don’t like losing money any more than any one else, but I have no regrets about my Vale losses. I made the best judgments that I could, with the data that I had available in my earlier valuations. If you disagreed with me at the time of my initial valuation of Vale, you have earned the right to say "I told you so", and if you went along with my assessment, we will have to commiserate with each other.

    This is not the first time that I have lost money on an investment, and it will not be the last, and I will continue to go where it is darkest, value companies where uncertainty abounds and hope that my next excursion into that space delivers better results than this one.

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    Previous Blog Posts

    1. Go where it is darkest (November 2014)
    2. In search of Investment Serenity (September 2015)
    Vale Valuations

    1. Valuation of Vale (November 2014)
    2. Valuation of Vale (April 2015)
    3. Valuation of Vale (September 2015)



    What's in a name? Of Umlauts, The Alphabet and World Peace!

    As the title should forewarn you, this is a post that will meander from eating spots to basketball players to corporate name changes. So, if you get lost easily, you may want skip reading it. It is triggered by two events that occurred this summer. One is Google's widely publicized decision to rename itself Alphabet and to reorganize itself as a holding company. The other is the much less public news that the eating place across the street from the building where I teach will be reopening with a new name "Bröd Kitchen", a new menu, and (probably) higher prices.

    Coffee Shop to Eatery to Bröd Kitchen

    In my post on my valuation class, I noted that this is my 30th year at New York University and I have seen the neighborhood around the school transition over time. When I started in 1986, I had my office and did the bulk of my teaching in the graduate school campus, which was downtown, but I lived near and still taught some classes at the undergraduate school. Right across the school was the Campus Coffee Shop (Yes! This is exactly what it looked like!) and it was exactly what its name suggested, an unpretentious coffee shop. The menu was primarily breakfast food, served all through the day, and the coffee came in one flavor (bitter), one texture (sludge) with only two add-ons (cream & sugar). The waiters and waitresses were all crotchety and old, viewed service as a foreign concept and I can only pity the poor person who tried to order a cappuccino or latte. To compensate, the coffee was only 50 cents, the egg sandwich about a dollar and you got what you paid for.



    About 15 years into my stint at Stern, the building's landlord (a brutally oppressive tyrant named New York University) decided that the campus coffee shop was too downscale and it was replaced by the Campus Eatery. This place offered fewer seats, a wider menu with paninis replacing sandwiches (as if putting a bad sandwich in a hot press can make it a  good one) and machine-made cappuccinos that had neither milk nor espresso in them. Not surprisingly, the prices went up to reflect the name change from coffee shop to eatery, though the only edible items on the menu remained the breakfast items, albeit at twice the price you paid at the coffee shop.



    At the start of this summer, I noticed that the Campus Eatery had closed and that the space was being renovated for a new restaurant. The restaurant has not opened yet (at least as of last Thursday, which was the last day I was in the city) but the name went up a few weeks ago and when I saw that it was Bröd, the umlaut made me suspicious. My trusted Google search engine found another eating place with the same name in New York, and I was able to find the company's website. It looks like a bakery with a Scandinavian tilt and Northern European prices, but the only consolation price is that it could have been worse. This could have become a Le Pain Quotidien, a New York based food chain with a pretentious French name and prices to match. (A reader points out to me that it is in Brussels, but according to the company's website, it is a New York based company with branches all over the world!)
    Update: I did a trial run this morning, since Bröd opened. Bought an iced coffee and a Cherry Danish (in keeping with the Scandinavian theme). Cost me $9.53 and it tasted just like the iced coffee and Danish that I get from the street cart that I usually go to.. and pay $2.50 for.. So, lesson learned!

    While these are three different businesses, with three different owners, they have all occupied the same space and I tend to think of them as the same eating place with three different names. That started me ruminating about why people and businesses change names and whether those name changes can affect the values that you attach to the entities involved. 

    Reasons for Name Changes
    I must confess that I have changed my name, though the change was more the result of happenstance than design. I grew up in South India in a period where caste names had been abandoned, but family names were not in vogue yet, and went through much of my school and college years known only by my first name (Aswath) and without a last name. It was as I was filling out my I-94 form on the my flight into the United States that I faced the question of what to use as my family name, and I used my father's first name, Damodaran, as the filler. Since then, I have seen friends and acquaintances change their names, mostly as a result of marriages, and businesses change names, with mergers being the most common trigger. However, there are other, more interesting reasons for name changes, though, and here are a few of them:
    1. To decontaminate or escape: In some cases, a name may get contaminated to the point that changing it is the only way to escape the taint. When Philip Morris changed its name to Altria in 2001, it was partly an attempt to remove the taint of tobacco (and its associated lawsuits) from its then food and beverage subsidiaries (Kraft and Miller Brewing). While there may have been other reasons for Tyco Electronics to rename itself TE Connectivity in 2010, one reason may have been to disassociate itself from the accounting scandals at its parent company
    2. To change: Changing your name can sometime make it easier for you to change yourself, as a person or how you operate, as a business. In this context, corporate name changes can cover the spectrum. Some  name changes reflect changes that have already happened, as was the case when Apple Computer became Apple in 2007, a concession to the reality that it was deriving more of its revenues and profits from its smartphones, tablets and retail than from its computer business. It can sometimes be a precursor of changes to come, as was the hope at International Harvester, when it sold off its agricultural division to Tenneco, renamed itself Navistar in 1986, and worked to make a name for itself in the diesel engine and truck chassis markets.  Finally, there is an escapist component to the some name change, where the firm is trying to  get away from troubles and hopes that changing its name will help it in the endeavor. When Research in Motion changed its name to Blackberry in 2013, it was in an attempt to divert attention from declining sales and a business in trouble. 
    3. To market: To make money, you have to sell your products and services, and not surprisingly, companies are drawn to names that they perceive will make it easier for them to market. In some cases, this may require simplifying your name to make it easier for customers to relate to; Tokyo Tsushin Kogyo did the right thing in 1958, when it renamed itself Sony. In still others, it may be designed to have a name that better fits your product or service; we should all be thankful that Larry Page and Sergey Brin changed their search engine's name from Backrub to Google a year into development. Finally, the name change may be to something more exotic, in the  hope that this will give you pricing power; the only surprising thing about L’Oréal renaming of its US subsidiary, Cosmair,  to L’Oréal USA was that it took so long to happen. After all, it must be a marketing maxim that having an accent in your name (the é in L’Oréal), in an Anglo-Saxon setting and that adding a apostrophe can only add to your cachet.
    4. To fool: In one of the more publicized frauds of the last century, a German named Christian Gerhartsreiter managed to fool East Court elite (both society and business) into thinking that he was Clark Rockefeller, using the last name to open doors to country clubs and financial opportunities. Corporations have played their own version of this game, incorporating the hot businesses of the moment to their names, whether it be dot.com in the 1990s, oil in the last decade or social media today. 
    There are two points to note. The first is that these reasons are not mutually exclusive and more than one may apply for a given name change. The other is that the lines of separation between the reasons can also be fuzzy, with the one separating marketing and fooling investors being perhaps the most difficult one to delineate.
    Valuing and Pricing Name Changes
    Can changing your name change your value as a business or you as an individual? You may scoff, but I do believe that there are pathways to changing behavior or increasing value that begin with a name change. You will not find them if the name change is purely cosmetic or if your reason is to fool customers or investors, but you may, with any of the other reasons. Thus, if your rationale for the name change is to remove the taint of an old name or to market your product more easily,  it should show up as higher revenues and profits, if you are right. If the name change is the first step in changing the way you run as a business, it should be manifested in your investing, financing and dividend decisions, and consequently in value. The proof, though, is in the results and it is true that the benefits are either transient or illusory in many cases.

    It is much easier to see a price effect from a name change, and especially so, if your end game is fooling investors. The highest profile studies of this phenomenon have centered around the dot com era, when the renaming was visible for all to see (adding a .com to an existing name or removing it), and the evidence was striking. The first study looked at companies that added dot.com to their names in the late 1990s and found that stock prices surged by astonishingly large amounts on the news, often with no accompanying change in operating focus or business practices. The second study looked at companies that removed dot.com from their names after the dot.com bust in 2000 and 2001 and uncovered an equally unsetting market reaction, i.e., that stock prices surged on the removal, again with no really accompanying shift in fundamentals. The results from both studies are graphed below:


    To back up the proposition that this is not just a phenomenon in technology stocks are unique to that time period in market history, a study looked at US and Canadian companies that added "oil" or "petroleum" to their names between 2000 and 2007, a period when oil prices are booming, and found that stock prices reacted positively to the addition, with US investors greeting the name change more effusively than Canadian investors. If history is any guide, these companies will now gain by removing "oil" from their names today, with oil prices at historic lows.

    What are the lessons from these studies? The first is that names do matter in markets and that companies sometimes choose names to please markets. The perils, as you can see even from the limited evidence that I have presented, is that investors are fickle and can change their minds and that a name that is value additive today can become value destructive in a while. 

    Google's Alphabet Soup
    A few weeks ago, Google shook up markets with its announcement that it was revamping the structure of the company, creating a holding company (Alphabet), with the core products of Google including Search, Ads, Maps, Apps, Android and YouTube, in one subsidiary (Google) and its experimental ventures in new businesses in other subsidiaries (though we will have to wait on the specifics). The immediate market reaction was positive, but as we noted in the last section, that effect can fade quickly. The longer term questions are two fold. Why did Google change its corporate name? Will the name change work?

    On the first question, it is my view that three of the reasons listed earlier can be ruled out almost immediately. Given how successful Google has been as a company, in terms of generating earnings and value for its investors, it is implausible that the company would want to disassociate itself from on of the most recognized brand names in the world. From a marketing perspective, it seems inconceivable to me that it will be easier to sell an "Alphabet" product than a "Google" product, and I don't think that there are very many investors out there who see lots of money making potential in the alphabet. Thus, the only motive that we are left with is that the name change is designed to  change the way the company operates. 

    If change is the rationale, the timing seems odd, given that Google just reported exceptional results in its last earnings report, triggering a 16% increase in market capitalization on the news. It is true, though, that Google is still a single-business company, deriving almost all of their revenues from advertising, and that all of its attempts to diversify its business mix have generated more publicity than profits. It is possible that the renaming and reorganization are designed to fix this problem, but will it work? I am skeptical, partly because there is talk that Page and Brin were using Berkshire Hathaway as a model, which makes no sense to me, since the two organizations have very little in common (other than large market capitalization). As I see it, Berkshire Hathway is a closed-end mutual fund, funded with insurance capital, and run by the best stock picker(s) in history, and its holding structure is consistent with that description, where Buffet and Munger have historically picked up under valued, well managed companies as investments, and left the managers in these companies alone. Google, in contrast, is composed of one monstrously successful online advertising business (composed of Google search, YouTube and add ons) and several start-ups that so far have been more adept at spending money than generating earnings.

    If this name change is designed to alter that reality, it has to attack what I see as Google's two big problems. The first is what I term the Sugar Daddy Syndrome, where the earnings power and cash flow generating capacity of Google's advertising business has made its start ups too sloppy in their investments, secure in the knowledge that they have access to an endless source of additional capital.  (Update: Those who are more knowledgeable about Google's ways have pointed out to me that it is quick to lop of projects that don't work, which then makes its new product failures an even bigger mystery. Perhaps, this is a case of a Sugar Daddy with Attention Deficit Disorder!) The second is that Google, for better or worse, has been run as a Benevolent Dictatorship, with Larry Page and Sergey Brin calling the shots at every turn. The fact that Sundar Pichai, the new CEO of the Google portion of the Alphabet, is little known can be viewed as a sign of his modesty and self-effacing nature, but it is also a reflection of the outsized profiles that Page and Brin have had at Google.  So, for this name change to work, it has to solve both problems, and here are the signs that will indicate that it is working. First, I would like to see Google refuse to invest in one or more of its start-ups, on the grounds of non-performance and invest in or acquire a competing start-up in the same business.   Alphabet's new ventures become more like good start-ups, lean, mean and looking for pathways to make money, and Google Advertising behave more like a seasoned VC, looking for the best place to invest its money, inside or outside the company. (For those in the tech business who schooled me on Google's ways, thank you! I have much to learn!) Second, I would also like to see Mr. Pichai deny capital to a project that is prized by Page and Brin, and have them not over rule that decision. Given the history of Google's founders, the likelihood of these events happening is low, but I give Google better odds than I did Ron Artest, an NBA player with anger management issues, when he changed his name to Metta World Peace in 2011.

    What's in a name?
    If value is driven by substance (cash flows, growth and risk), it seems absurd that name changes can affect your value, but I have learned not to dismiss them as non-events. Name changes can lead to shifts in investment, financing and dividend policy that can affect value, but more important, they can have substantial price effects. That may seem irrational, but it is ironic that academics in finance would be so quick to make the judgment that what you name something cannot alter its value or significance. After all, these same academics have learned that attaching letters from the Greek alphabet to their measures of risk (beta) or performance (alpha) provide these measures with a power that they would never possess otherwise. So, who knows? These name changes may all work: Bröd Kitchen might deliver delicious and cheap food, Page and Brin may actually be willing to give up control at Google and Ron Artest could become a Buddhist monk!

    YouTube Webcast




    The Fed, Interest Rates and Stock Prices: Fighting the Fear Factor

    If it feels like you are reading last year’s business stories in today's paper, there is a simple reason. The Federal Reserve's Open Markets Committee (FOMC) meeting date is approaching, and in a replay of what we have seen ahead of previous meetings, we are being told that this is the one where the Fed will lower the boom on stock markets, by raising interest rates. While this navel gazing may keep market oracles, Fed watchers and CNBC pundits occupied, I think that the Fed’s role in setting interest rates is vastly overstated, and that this fiction is maintained because it is convenient both for the Fed and for the rest of us. I think that there are multiple myths about the Fed’s powers that have taken hold of our collective consciousness, and led us into an investing netherworld. So at the risk of provoking the wrath of Fed watchers everywhere, and repeating what I have said in earlier posts, here are my top four myths about central banks.

    1. The Fed sets interest rates
    Myth: The Federal Reserve (or the Central Bank of whichever country you are in) sets interest rates, short term as well as long term. In my last post on this topic, I mentioned my tour of the Federal Reserve Building, with my wife and children, and how sorely tempted I was to ask the tour guide whether I could see the interest rate room, the one where Janet Yellen sits, with levers that she can move up or down to change our mortgage rates, the rate at which companies borrow from banks and the market and the rates on US treasuries. 
    Reality: There is only one rate that the Federal Reserve sets, and it is the Fed Funds rate. It is the rate at which banks trade funds, that they hold at the Federal Reserve, with each other. Needless to say, not only is this an overnight rate, but it is of little relevance to most of us who don't have access to the Fed windows. While there is a tenuous link of Fed Funds rate to short term market interest rates,  that link becomes much weaker when we look at long term rates and their derivatives.
    Why preserve the myth: Giving the Fed the power to set interest rates gives us all a false sense of control over our economic destinies. Thus, if rates are high, we assume that the Fed can lower them by edict and if rates are too low, it can raise it by dictate. If only..

    2. Low interest rates are the Fed’s doing
    Myth: Interest rates are at historic lows not just in the United States but in much of the developed world, and it is central banking policy that has kept them there, through a policy of quantitative easing The myth acquires additional sheen when accompanied by acronyms such as QE1 and QE2, which bring ocean liners to my mind and a nagging fear that the next Fed move will be titled the Titanic!
    Reality: The Fed has had a bond-buying program that is unprecedented and large, but only relative to the Fed's own history. Relative to the size of the US treasury bond market (about $500 billion a day in 2014), the Fed bond-buying (about $60-$85 billion a month) is modest and unlikely to have the influence on interest rates that is attributed to it. So, what has kept rates low? At the risk of rehashing a graph that I have used multiple times, it is far simpler and more fundamental, and it lies in the Fisher equation, which decomposes the nominal interest rate into its expected inflation and real interest rate components:
    Nominal Interest Rate = Expected Inflation + Expected Real Interest Rate
    If you make the assumption that in the long term, the real interest rate in an economy converges on real growth rate, you have an equation for what I call an intrinsic risk free rate.  In the graph below, I graph out the actual US 10-year treasury bond rate against this intrinsic risk free rate and you can make your own judgment on why rates have been low for the last five years.'

    To me, the answer seems self evident. Interest rates in the US (and Europe) have been low because inflation has been non-existent and real growth has been anemic, and it is my guess that rates would have been low, with or without the Fed’s exertions. In fact, the cumulative effect of the Fed's exertions can be measured as the difference between the intrinsic risk free rate and the US treasury bond rate, and during the entire quantitative easing period of 2008-2014, it amounted to about 0.13%. It is true that the jump in US GDP in the most recent quarter  has widened the difference between the treasury bond rate and the intrinsic interest rate, but it remains to be seen whether this increase is a precursor to more healthy growth in the future, or just an one-quarter aberration. 
    Why preserve the myth: I think it is much more comforting for developed market investors to think of low interest rates as an unmitigated good, pushing up stock and bond prices, rather than as a depressing signal of future growth and low inflation (perhaps even deflation) in much of the developed world. That problem will not be fixed by Fed meetings and is symptomatic of shifts in global economic power and a re-apportioning of the world economic pie.

    3. The reason stock prices are so high is because rates are low
    Myth: Stock prices are high today because interest rates are at historic lows. If interest rates revert back to normal levels, stock prices will collapse. 
    Reality: Low interest rates have been a mixed blessing for stocks. The low rates, by themselves, make stocks more attractive relative to the alternative of investing in bonds. But if the low rates are symptomatic of low inflation and low real growth, they do have effects on the cash flows that can partially or completely offset the effect of low rates. One way to decompose the effects is to compute forward-looking expected returns on stocks, given stock prices today and expected cash flows from dividends and buybacks in the future to see how much of the stock price effect is fueled by interest rates and how much by cash flow changes. If this bull market has been entirely or mostly driven by the drop in interest rates, the expected return on stocks should have declined in line with the drop in interest rates. In my most recent update on this number at close of trading on August 31, 2015, I estimated an expected return of 8.50%, almost unchanged from the level in 2009 and higher than the expected return in 2007. 
    At least based on my estimates, the primary driver of stock prices has been the extraordinary fountain of cash that companies have been able to return in the last few years, combined with a capacity to grow earnings over the same period. By the same token, if you are concerned about cash flows, it should be with the sustainability of these cash flows, for two reasons. The first is that earnings will be under pressure, given the strength of the dollar and the weakness in China, and this is starting to show up already, with 2015 earnings about 5-10% below 2014 levels.  The second is that companies will not be able to keep returning as much as they are in cash flows; in 2015, the cash returned to stockholders stood at 91% of earnings, a number well above historic norms. In the table below, I check to see how much the index, which was at 1951.13 at the close of trading on September 3, would be affected by an increase in interest rates (increasing the US 10-year T.Bond rate from the 2.27% on September 3, to 5%) as contrasted with a drop in cash flows (with a maximum drop of 25%, coming from a combination of earnings decline and reduced cash payout):
    Base: S&P 500 on September 3= 1951.13, T.Bond rate = 2.27%; ERP = 6.34%, g=6.30%
    If you hold cash flows constant, an increase in interest rates has a relatively small effect on stock prices, with stock prices dropping 8.76%, even if the US T.Bond rate rises to 5%.  In contrast, if cash flows drop, the index drops proportionately, even if interest rates remain unchanged. You are welcome to make your own "bad news" assumptions and check out the effect on value in this spreadsheet.
    Why preserve the myth: For perpetual bears, wrong time and again in the last five years about stocks, the Fed (and low interest rates) have become a convenient bogeyman for why their market bets have gone wrong. If only the Fed had behaved sensibly and if only interest rates were at normal levels (though normal is theirs to define), they bemoan, their market timing forecasts would have been vindicated. 

    4. The biggest danger to the Fed is that the market will react violently to a change in its interest rate policy
    Myth: The biggest danger to the Fed is that, if it reverses its policy of zero interest rates and stops its bond buying, stock and bond markets will drop dramatically.
    Reality: While no central bank wants to be blamed for a market meltdown, the bigger danger, in my view, is that the Fed does what it has been promising to for so long, and nothing happens. That is a good thing, you might say, and while I agree with you in the short term, the long-term consequences for Fed credibility are damaging and here is why. The best analogy that I can offer for the Fed and its role on interest rates is the story of Chanticleer, a rooster that is the strutting master of the barnyard that he lives in, revered by the other farm animals because he is the one who causes the sun to rise every morning with his crowing (or so they think). In the story, Chanticleer’s hubris leads him to abandon his post one morning, and when the sun comes up anyway, the rooster loses his exalted standing. Given the build up we have had over the last few years to the momentous decision to change interest rate policy, think of how much our perceptions of Fed power will change, if stock and bond markets respond with yawns to an interest rate policy shift.
    Why we hold on to the myth: If you buy into the first three myths, this one follows. After all, if you believe that the Fed sets interest rates, that it has deliberately kept interest rates low for the last five years and that stock prices are high because interest rates are low, you should fear a change in that policy. Coupled with China, you have the excuses for your underperformance this year, thus absolving yourself of all responsibility for your choices. How convenient?

    What next?
    Over the last five years, we have developed an unhealthy obsession with the Federal Reserve, in particular, and central banks, in general, and I think that there is plenty of blame to go around. Investors have abdicated their responsibilities for assessing growth, cash flows and value, and taken to watching the Fed and wondering what it is going to do next, as if that were the primary driver of stock prices. The Fed has happily accepted the role of market puppet master, with Federal Bank governors seeking celebrity status, and piping up about inflation, the level of stock prices and interest rate policy. Market watchers, journalists and economists have found stories about the Fed to be great fillers that they can use to fill financial TV shows, newspaper and opinion columns.

    I don't know what will happen at the FOMC meeting, but I hope that it announces an end to it's "interest rate magic show". I think that there is enough pent up fear in markets that the initial reaction will be negative, but I am hoping that investors move on to healthier, and more real, concerns about economic growth and earnings sustainability. If the Fed does make its move, the best news will be that we will not have to go through more rounds of obsessive Fed watching, second-guessing and punditry.

    YouTube Video

    1. The Fed did it!
    2. Slides to accompany video

    Past Posts
    1. The Fed and Interest Rates: Lessons from Oz (June 21, 2013)
    2. Dealing with Low Interest Rates: Investing and Corporate Finance Lessons (April 2015)
    Data
    1. Interest Rates, Stock Prices and Expected Returns
    Spreadsheets



    Winning at a Loser's Game? Control, Synergy and the ABInBev/SABMiller Merger!

    I have been a long time investor in ABInBev, though I became one indirectly and accidentally, through a stake I took a long time ago in Brahma, a Brazilian beverage company . That company became Ambev in 1999, which in turn was merged with Interbrew, the Belgian brewer, in 2004, and expanded to include Anheuser Busch, the US beer maker, in 2008 to become the largest beer manufacturer in the world.  I made the bulk of my money early in my holding life, but Amber has remained in my portfolio, a place holder that provides me exposure to both the beverage business and Latin America, while delivering mostly positive returns. It was thus with trepidation that I read the news report in mid-September that ABInBev (which owns 62% of Ambev) had approached SABMiller about a takeover at a still-to-be-specified premium over the the latter's market value. While it is entirely possible to create value from acquisitions, I have argued that creating growth through acquisitions is difficult to do, and doubly so when the acquisition is of a large public company. Since ABInBev's control rests with 3G Capital, a group that I respect for its investment acumen, it would be unfair to prejudge this deal without looking at the numbers. So, here we go!

    The Fog of Deal Making: Breaking down an acquisition
    The first casualty in deal making is good sense, as the fog of the deal, created by bankers, managers, consultants and journalists, clouds the numbers. Not only do you see "control" and "synergy", two words that I include in my weapons of mass distraction, thrown around casually to justify billions of dollars in premiums, but you also see them used interchangeably. When you acquire a company, there are three (and only three possible) motives that are consistent with intrinsic value
    1. Undervaluation: You buy a target company because you believe that the market is mispricing the company and that you can buy it for less than its "fair" value. In effect, you are behaving like any value investor would in the market and there is no need for you to either change the way the target company is run or look for synergy benefits. 
    2. Control: You buy a company that you believe is badly managed, with the intent of changing the way it is run. If you are right on the first count and can make the necessary changes, the value of the firm should increase under your management. If you can pay less than the "changed" value, you can claim the difference for yourself (and your stockholders). 
    3. Synergy: You buy a company that you believe, when combined with a business (or resource) that you already own, will be able to do things that you could not have done as separate entities. Broadly speaking, you can break synergy down into "offensive synergies" (where you are able to grow faster in existing or new markets than you would have as standalone businesses and/or charge higher prices for your products), "defensive synergies" (where you are able to reduce costs or slow down/prevent decline in your businesees) and "tax synergies" (where you directly take advantage of tax clauses or indirectly by being able to borrow more money). 
    The key distinction between synergy and control is that control does not require another entity or even a change in managers. It can be accomplished by the target company's management, if they put their minds to it and perhaps hire some help. Synergy requires two entities coming together and stems from the combined entity's capacity to do something that the individual entities would not have been able to deliver. Note that these motives can co-exist in the same acquisition and are not mutually exclusive.  To assess whether these motives apply (or make sense), there are four numbers that you need to track: 
    1. Acquisition Price: This is the price at which you can acquire the target company. If it is a private business, it will be negotiated and probably based on what others are paying for similar businesses. If it is a public company, it will be at a premium over the market price, with the premium a function of the state of the M&A market and whether you have other potential bidders. 
    2. Status Quo Value: This is the value of the target company, run by existing management and based on existing investing, financing and dividend policies. 
    3. Restructured Value: This is the value of the target company, with changes to investing, financing and dividend policies. 
    4. Synergy value: This can be estimated by valuing the combined company (with the synergy benefits built in) and subtracting out the value of the acquiring company, as a stand alone entity, and the restructured value of the target company. 
    Connecting these numbers to the motives, here are the conditions you would need for each motive to make sense (by itself).

    MotiveTest
    UndervaluationAcquisition Price < Status Quo Value
    ControlAcquisition Price < Restructured Value (Status Quo Value + Value of Control
    SynergyAcquisition Price < Restructured Value + (Value of Combined company with synergy - Value of Combined company without synergy)

    Which of these motives, if any, is driving ABInBev's acquisition of SABMiller, and whatever the motive or motives, is the premium being paid justified? To make that assessment, I will compute each of the four numbers for this deal.

    Setting up the ABInBev Deal
    The first news stories on ABInBev’s intent to buy SABMiller came out on September 15, 2015, though there may have been inklings among some who are more connected than I am. While no price was specified, the market’s initial reaction was positive, with both ABInBev and SABMiller’s stock prices increasing on the story. The picture below captures the key details of the deal, including both possible rationale and consequences:



    There were two key reasons provided to rationalize the potential deal. The first is geographic complementarity, since these two companies overlap in surprisingly few parts of the world, given their size. ABInBev is the largest player in Latin America, with Brazil at its center, and SABMiller is the biggest brewer in Africa. SABMiller’s Latin American operations are outside of Brazil, for the most part and while ABInBev has significant North American operations, SABMiller's North American exposure is entirely through its Coors Joint Venture. While no specifics are provided, the basis for synergy seems to be that after this deal, ABInBev will be able to expand sales in the fastest growing market in the world (Africa) and that SABMiller will be able to increase its revenues in the most profitable market in the world (Latin America). The second is consolidation, a vastly over used term that often means nothing, but  if it tied to specifics, relates to potential costs savings and economies of scale. While the absence of geographic overlap may reduce the potential for cost cutting, ABInBev can use the template that it has used so successfully on prior deals (especially the Grupo Modelo acquisition) to cut costs in this acquisition as well.

    There are also negative consequences that follow from this deal. The first is that when anti trust regulators in different parts of the world will be paying close attention to this deal, and it seems likely that SABMiller will be forced to sell its 58% stake in MillerCoors and that Molson Coors, the other JV partner, will be the beneficiary. The second, and this adds to the pressure, ABInBev has agreed to pay $3 billion to SABMiller if the deal falls through.  In summary, though, the challenge is a simple one. ABInBev is paying a $29 billion premium to acquire SABMiller. Is there enough value added to ABInBev's stockholders that they will be able to walk away as winners?

    The Players in the Deal
    To make a value judgment of this deal, we have to begin by looking at ABInBev and SABMiller, as stand alone companies, prior to this deal. In the picture below, I start with a snapshot of ABInBev:

    Capital MixOperating MetricsGeographical Mix
    Interest-bearing Debt$51,504Revenues$45,762Latin America$18,849.00 42.03%
    Lease Debt$1,511Operating Income (EBIT)$14,772Africa$- 0.00%
    Market Capitalization$173,760Operating Margin32.28%Asia Pacific$5,040.00 11.24%
    Debt to Equity ratio30.51%Effective tax rate18.00%Europe$4,865.00 10.85%
    Debt to Capital ratio23.38%After-tax return on capital12.10%North America$16,093.00 35.88%
    Bond RatingA2Reinvestment Rate =50.99%Total$44,847.00 100.00%
    Looking past the numbers, it is worth noting that not only does ABInBev has a history of growing successfully through acquisitions but that its lead stockholder, 3G Capital, is considered a shrewd allocator and steward of capital.

    On the other other side of the deal stands SABMiller, and the picture below provides a sense of the company's standing at the time of the deal:

    Capital MixOperating MetricsGeographical Mix
    Interest-bearing Debt$12,550Revenues$22,130Latin America$7,81235.30%
    Lease Debt$368Operating Income (EBIT)$4,420Africa$6,85330.97%
    Market Capitalization$75,116Operating Margin19.97%Asia Pacific$3,13614.17%
    Debt to Equity ratio17.20%Effective tax rate26.40%Europe$4,18618.92%
    Debt to Capital ratio14.67%After-tax return on capital10.32%North America$1430.65%
    Bond RatingA3Reinvestment Rate =16.02%Total$22,130100.00%

    This table, though, misses SAB's holdings in the MillerCoors JV and its other minority holdings in associates around the world, and the numbers for SAB's shares of these are summarized below:
    SAB Share of Other Associates
    Operating MetricsGeographical Mix
    Revenues$6,099.00Latin America$- 0.00%
    Operating Income (EBIT)$654.00Africa (mostly South Africa)$2,221 36.42%
    Operating Margin10.72%Asia Pacific$2,203 36.12%
    Effective tax rate25.00%Europe$1,675 27.46%
    After-tax return on capital11.00%North America$- 0.00%
    Invested Capital$4,459Total$6,099100.00%
    SAB Share of MillerCoors JV
    Operating MetricsGeographical Mix
    Revenues$5,201.00Latin America$- 0.00%
    Operating Income (EBIT)$800.00Africa (mostly South Africa)$- 0.00%
    Operating Margin15.38%Asia Pacific$- 0.00%
    Effective tax rate25.00%Europe$- 0.00%
    After-tax return on capital11.05%North America$5,201 100.00%
    Invested Capital$5,428Total$5,201100.00%
    The numbers reinforce my earlier point about geographic complementarity at least at the parent company level, with ABInBev getting a large percent of its Latin American sales in Brazil and SABMiller getting most of its Latin American sales from countries other than Brazil.

    Is SABMiller a bargain?
    The first step in this analysis to a valuation of SABMiller, as a stand alone company and with its existing management in place. Based on the numbers, this is a conservatively run company (both in terms of use of debt and reinvestment for growth) and the valuation reflects that:

    SAB Miller+ 58% of Coors JV+ Share of AssociatesSAB Miller Consolidated
    Revenues$22,130.00$5,201.00$6,099.00
    Operating Margin19.97%15.38%10.72%
    Operating Income (EBIT)$4,420.00$800.00$654.00
    Invested Capital$31,526.00$5,428.00$4,459.00
    Beta0.79770.68720.6872
    ERP8.90%6.00%7.90%
    Cost of Equity =9.10%6.12%7.43%
    After-tax cost of debt =2.24%2.08%2.24%
    Debt to Capital Ratio14.67%0.00%0.00%
    Cost of capital =8.09%6.12%7.43%
    After-tax return on capital =10.33%11.05%11.00%
    Reinvestment Rate =16.02%40.00%40.00%
    Expected growth rate=1.65%4.42%4.40%
    Number of years of growth555
    Value of firm
    PV of FCFF in high growth =$11,411.72$1,715.25$1,351.68
    Terminal value =$47,711.04$15,094.36$9,354.28
    Value of operating assets today =$43,747.24$12,929.46$7,889.56$64,566.26
    + Cash$1,027.00
    - Debt$12,918.00
    - Minority Interests$1,183.00
    Value of equity$51,492.26
     I am adding in my estimated values for SAB's share of the Coor's JV and other associates to arrive at the total value of the operating assets. In valuing each piece, I have estimated equity risk premiums that reflect where each one operates, using a 6% mature market premium for the Coors JV, since it generates most of its revenues in North America, and much higher premiums for the other two parts. At least based on my estimates, the value of equity is $51.5 billion, well below the market capitalization of $75 billion on September 15. (This may be cynical of me, but if used (wrongly in my view) a 6% equity risk premium for SABMiller, based on its UK incorporation, I get a value of $76 billion for its equity.)
    Bottom line: To me, SABMiller does not look like it is priced to be a bargain, even at the pre-deal price, and definitely not at the deal price.

    The Value of Control
    Is SABMiller ripe for a restructuring? It is tough to tell from the outside but one way to measure room for improvement is to compare the company on key corporate finance measures against both the acquirer (InBev) and the rest of the alcholic beverage sector:
    SABMillerABInBevGlobal Alcoholic Beverage Sector
    Pre-tax Operating Margin19.97%32.28%19.23%
    Effective Tax Rate26.36%18.00%22.00%
    Pre-tax ROIC14.02%14.76%17.16%
    ROIC10.33%12.10%13.38%
    Reinvestment Rate16.02%50.99%33.29%
    Debt to Capital14.67%23.38%18.82%
    This comparison may be simplistic, but it looks like SABMiller lags the sector is in its reinvestment rate and return on capital, and that it earns a profit margin that match up to the sector. It also has a debt ratio that is not far off from the sector average. ABInBev has a much higher profit margin than the rest of the sector and pays a lower tax rate. I revalued SABMiller with the return on capital, debt ratio and reinvestment rate set equal to the industry average. (I considered using ABInBev's operating margin but much of that comes from Brazil and it is unlikely that SABMiller can match it in South Africa or the rest of Latin America.

    Status Quo ValueRestructuredChanges made
    Cost of Equity =9.10%9.37%Increases with debt ratio
    After-tax cost of debt =2.24%2.24%Left unchanged
    Debt to Capital Ratio14.67%18.82%Set to industry average
    Cost of capital =8.09%8.03%Due to debt ratio change
    Pre-tax return on capital14.02%17.16%Set to industry average
    After-tax return on capital =10.33%12.64%Result of pre-tax ROIC change
    Reinvestment Rate =16.02%33.29%Set to industry average
    Expected growth rate=1.65%4.21%Result of reinvestment/ROIC
    Value of firm
    PV of FCFF in high growth =$11,411.72$9,757.08
    Terminal value =$47,711.04$56,935.06
    Value of operating assets today =$43,747.24$48,449.42
    + Cash$1,027.00$1,027.00
    + Minority Holdings$20,819.02$20,819.02
    - Debt$12,918.00$12,918.00
    - Minority Interests$1,183.00$1,183.00Value of Control
    Value of equity$51,492.26$56,194.44$4,702.17
    Bottom line: Changing the way SABMiller is run adds about $4.7 billion to the value, but even with that addition, the equity value of $56.2 billion is still far below what ABInBev paid on October 15. That suggests that control was not the primary rationale either.

    The Value of Synergy
    This leaves us with only one option, synergy, and to value synergy, I valued ABInBev as a standalone company and put it together with the restructured value of SABMiller to get a combined company value, with no synergy. I then assumed that the synergy (from geographic complementarity and consolidation) would manifest itself in a higher operating margin, higher reinvestment and a higher growth rate for the combined company:

    InbevSABMillerCombined firm (no synergy)Combined firm (synergy)Actions
    Cost of Equity =8.93%9.37%9.12%9.12%
    After-tax cost of debt =2.10%2.24%2.10%2.10%
    Cost of capital =7.33%8.03%7.51%7.51%No changes expected
    Operating Margin32.28%19.97%28.27%30.00%Cost cutting & Economies of scale
    After-tax return on capital =12.10%12.64%11.68%12.00%Cost cutting also improves return on capital
    Reinvestment Rate =50.99%33.29%43.58%50.00%More aggressive reinvestment in shared markets
    Expected growth rate=6.17%4.21%5.09%6.00%Higher growth because of reinvestment
    Value of firm
    PV of FCFF in high growth =$28,732.57$9,806.49$38,539.06$39,150.61
    Terminal value =$260,981.86$58,735.57$319,717.43$340,174.63Value of Synergy
    Value of operating assets =$211,952.80$50,065.35$262,018.16$276,609.92$14,591.76
    It is possible that I have been too pessimistic about the potential cost savings or growth possibilities, but given the history of synergy in big deals, I think that I am being optimistic. Based on my estimates at least, the value of synergy in this deal is $14.6 billion (and that is assuming it is delivered instantaneously).
    Bottom line: If synergy is the motive for this deal, a great deal has to go right for ABInBev to break even on this deal, let alone create value.

    The Disconnect
    The history of 3G Capital as successful value creators predisposed me to give them the benefit of the doubt, when I started assessing the deal. After looking at the numbers, though, I don't see the value in this deal that would justify the premium paid. It is possible, perhaps even likely, that there is some aspect of the deal, perhaps taxes or other benefits, that I am not grasping. If so, I would encourage you to use my template, change the numbers that you think need to be changed, make your own assessment and enter them in this shared Google spreadsheet. It is also possible that even the smartest investors in the world can sometimes let over confidence drive them to over react. Time will tell!

    YouTube version


    Data Attachments
    1. ABInBev Annual Report (2014)
    2. SABMiller Annual Report (2015)

    Spreadsheets
    1. SABMiller: Status Quo and Control Value
    2. Value of Synergy 
    3. Google Shared Spreadsheet for Deal Analysis



    The Ride Sharing Business: Playing Pundit

    This is the third and final post in a series of three on the ride sharing business. In the first, I valued Uber and looked at the evolution of its business over the last 18 months. In the second, I valued Lyft and looked at pricing across ride sharing companies. In this one, I look at the future of the ride sharing business from the perspective of an outsider with no expertise in this business.

    In my last two posts, I first valued Uber, with its expansive narrative, and then looked at putting numbers on Lyft's less ambitious storyline. In my Uber post, I argued that the ride sharing market was proving to be bigger, broader and growing faster than I had estimated it would be in June 2014. In the Lyft post, I examined how VCs were pricing ride sharing companies. In this post, I want to complete the story by looking at the current state of the ride sharing market and for scenarios for the market over time, with consequences for investors, car riders and drivers. 

    The Ride Sharing Market: The State of the Game
    In my posts on ride sharing, I noted that the ride sharing market has grown exponentially in the last two years, drawing in new users and redefining the car service business. That growth can be seen  in multiple dimensions:
    1. Anecdotal & Qualitative evidence: I am usually wary about using anecdotal data but I have been keeping tabs on Uber usage in my travels and I have been amazed at the company's global reach. This summer, I did seminars in São Paulo, Moscow and Mumbai, and in each venue, a significant proportion of the attendants had taken Uber to the event. In fact, my children talk about Ubering to destinations unknown, rather than taking a cab, just as xeroxing and googling became synonyms for copying and online searching. 
    2. Operating metrics at ride sharing companies: The operating metrics at the ride sharing companies individually, and in the aggregate, back up the proposition that this is a high growth business.
    3. CompanyRevenues in 2014Revenues (2015)Growth Rate (2015)
      Lyft$125$300140.00%
      Uber$400$2,000400.00%
      Didi Kuaidi$30$4501400.00%
      Ola$50$150200.00%
      GrabTaxi$15$50233.33%
      BlaBlaCar$30$72140.00%
    4. Investor expectations: The increases in the values attached to ride sharing companies indicate that investors are also scaling up expectations of future growth in this business. Using Uber's estimated value of $51 billion in its most recent VC funding to illustrate the process, I estimated imputed revenues of $51.4 billion in 2026, which, if you hold its revenue slice share at 15% (my assumption) yields an imputed gross billing of $342.8 billion in 2026. If I repeat this exercise with the other ride sharing companies, the collective revenues being forecast by investors may exceed attainable revenues, an example of what I termed the big market delusion.
    5. CompanyEstimated Value (Price)Revenue ShareOperating MarginFailure ProbabilityImputed Revenue(2026)Imputed Gross Billing (2026)
      Lyft$2,50015%25%10%$2,800$18,665
      Uber$51,00015%25%0%$51,418$342,787
      Didi Kuaidi$15,00015%20%0%$20,044$133,629
      Ola$2,50015%20%15%$3,927$26,183
      GrabTaxi$1,50010%20%15%$2,392$23,923
      BlaBlaCar$1,60012%20%10%$2,392$19,935
      Total$74,100NANANA$82,974$565,123
    The growth in ride sharing has been accompanied with more intense competition and rising costs, as can be seen in the large and growing operating losses reported by the companies in this business. The reasons for these losses are manifold, as I noted in my Uber post. Some of the costs come from intense competition for drivers and customers, with companies following the Field of Dreams model, that Amazon has used to such effect in the last decade. Some costs come from outside, higher insurance costs and employee expenses, as ride sharing companies go from being fringe players to larger businesses. Some costs flow from legal fights with regulators, licensing agencies and other rule-writers, whose desire to control the business clashes with the market-driven imperatives of ride sharing. The optimistic view is that these costs will become smaller as companies scale up, but will they? As revenues scale up, the number of drivers will increase proportionately, and unless the competition disappears, the costs of fighting for drivers and customers will continue. In brief, the existing ride sharing model looks like a long term money loser, unless something fundamental changes.

     Future Shock
    At the risk of playing market prognosticator in a market where I am a novice, I see four possible scenarios that can unfold in this market, all possible, but perhaps not equally probable.
    1. Winner-takes-all: The big prize in many technology businesses is that there is a tipping point, where the winner ends up capturing much of the market. That is the template that Microsoft used two decades ago with MS Office to capture the business software business and that Google used to scale the heights of online advertising. The payoff to such a strategy is that you not only control the dominant market share but that you get pricing power (and higher profits). It does seem to be the strategy that Uber is following in the ride sharing business, but there remain three road blocks that may get in the way. First, you have to remove your competitors from the playing field and while Uber had the cash buffer and capital raising upper hand last year, that advantage has narrowed as a result of partnerships and new capital flowing into other ride sharing companies. In a perverse way, Uber's best chance of succeeding at this strategy is if there is a hitch or stop in the flow of capital to tech companies, though that may work against its objective of going public in the near future. Second, you have to navigate your way through the anti trust and monopoly questions that will inevitably follow, not an easy or an inexpensive task, as Google and Microsoft have discovered over the last decade. Third, while technology remains a focal point for ride sharing companies, the car service or logistics business needs physical infrastructure, making it more difficult to preserve global networking benefits.
    2. The Losers' Game: While the winner-take-all is alluring, its logical conclusion, if you have multiple players pursuing it, and none winning, is that you can make the business a loser's game, one in which the market grows as promised and companies generate high revenues, but make very little in profits. A big business can sometimes be a bad one, as I noted in this post on bad businesses and why companies in these businesses continue to invest and grow in them.
    3. The Divide and Rule Game: As the old colonial empires discovered a few centuries ago, and the Sicilian crime families realized in the late 1920s in the United States, the most profitable end game, when competition is cut-throat (literally), is to negotiate a truce, where the spoils are divided up and each competitor is given control of a segment. In the ride sharing market, if the business boils down to two or three large players, they may be able carve up the global market and each player will get a free run in their carved up portion . This will be, of course, terrible news for drivers and customers and may attract regulatory or legal scrutiny, but for investors collectively, it will be most value-adding scenario. There are two potential weak links. The first is that this truce, by its very nature, will not be a friendly one and small violations can lead to it unraveling. The second is that it rests on the premise that there is no outside party that is powerful enough to step in and take advantage of the soft spots in the market.
    4. The Game Changer: I believe that the existing ride sharing model is an unstable one. As I argued in my post on Uber, the very strengths of the models (bare bones infrastructure, drivers as independent contracts and no car ownership) makes it unsustainable in the long term, since ride sharing companies have to compete for drivers on a continuous basis, offering them incentives to switch from competitors, and customers, with special deals. It is therefore likely that a new model will emerge, though it remains an open question of whether it will come from one of the players in the game, or from an outsider. Thus, Uber's hiring of robotics engineers may be a precursor of a different ride sharing game, with driverless cars and infrastructure investments, or it may be Google or Tesla who enter the picture with a different way of operating this business. 
    If these scenarios remind you a little little of the prisoner's dilemma, where two rational individuals are given a choice between cooperating and competing, there are parallels. Consider one possible version, where the ride sharing companies globally boil down to two competitors: Uber, as a global ride sharing behemoth, and the Not-Uber, an alliance of  national ride ride sharing companies (Ola+Didi Kuaidi + GrabTaxi + Lyft..). The box below captures the possible outcomes of this game, which will get infinitely more complicated if there is an outsider player lurking on the fringes.

    Based on my very limited knowledge of the companies in this space, I would give the highest odds to the ride sharing business becoming a loser's game, attach about equal probabilities to it becoming a winner-take-all or a game changer emerging, and see the least chance that the ride sharing companies will collude to maximize profits and value. There are others, who know more about this business than I do, who see this game evolving differently over time. Mark Shurtleff at Green Wheels Mobility Solutions, the ride sharing expert that I referenced in my last post thinks that I am being too pessimistic on some counts and perhaps too optimistic on others and feels that there are small start ups that are finding a better business model than the big players. There are some who believe that I am underestimating the pull of the familiar and that ride sharing companies, once established, will be difficult to displace. 

    The Dance of the Disrupted
    In a post from a few months ago, I looked at the the dark side of disruption, i.e., the businesses being disrupted, both with the intent of identifying the businesses most at risk and to look at the stages, at least as I see them, of how the disrupted business deal with the chaos of seeing established business models being upended. Using that five stage process, it seems to me that the taxi cab business is now at an advanced stage:

    Stage of disruptionThe Taxi Cab Business
    1. Denial and DelusionThis is long in the past, but in the first year or two of Uber’s existence, there were many in the conventional car service and taxi cab businesses, who were convinced that not only was this a passing phase, but that no customer in his right mind would want to miss the comfort, convenience and safety of a yellow cab experience. (Irony alert!)
    2. Failure and False HopeWith each misstep by a ride sharing company (and Uber in particular), whether it be an employee with a loose tongue or a assault by an Uber driver, the hope that this misstep will put an end to the ride sharing business rises among taxi operators and regulators. However, only the most delusional among these hold on this hope.
    3. Imitation and Institutional InertiaIn the mistaken belief that all that separates the ride sharing companies from conventional car service is an app, taxi operators have turned to putting apps in the hands of drivers and customers. At the same time, any attempts to introduce flexibility into the existing car service business are fought by politicians, regulators and some of the operators who benefit from the current structure.
    4. Regulation, Rule Rigging and Legal ChallengesThis seems to be the place where car service companies are making their stand, aided and abetted by regulators, courts and politics. By restricting or even banning ride sharing, they are slowing it’s growth but as I see it, the fight is on its way to being lost, since it is the customers who ultimately will determine the winner in this game, and they are voting with their dollars.
    5. Acceptance and AdjustmentIt may be slow in coming, but a portion of the conventional car service business is adjusting to the new reality, sometimes because they realize that it is a fight that is unwinnable and sometimes because the financial hill is getting steeper to climb. This is especially true for cab operators who have borrowed much or most of the money that they used to buy medallions and are discovering that they cannot pay their debt.
    So what does the future hold? Will there be no taxi cabs left on the streets of New York, London and Tokyo in a few years? I think that the taxi cab business will shrink, but not disappear, and that it will retain a portion of its business in those public spaces where regulators have the most say, airports, train stations and public arenas. If this is the future, it is also clear that there is more pain to come and it will take the form of continuing decline in taxi cab revenues and market capitalization at these companies. As for the private car service business, it will either adapt and share revenues with the ride sharing companies  (which still needs cars and drivers) or focus on corporate relationships (offering discounted and on-demand services to companies that do not want their employees using multiple ride sharing services). 

    Coming soon to a business near you?
    As I watch the traditional taxi cab business flailing and ride sharing companies grow at their expense, and am tempted to pass judgment on the inability of those in the business to adapt to the world that they live in, there are two general lessons that come to mind. From the disruptor's standpoint, I think that the success of Uber and its peer group in changing the car service business is a reminder that existing business models can be disrupted in short order by new technologies, but the collective losses reported by these companies are also a reminder that making money on disruption is much more difficult.

    Looking at the same process from the perspective of the disrupted, it is a reminder that the pain inflicted on the car service business could very easily be coming to the business that you are in. If you are in the financial services business,  the entertainment business or the health care business, all of which are deserving of disruption, I wonder whether you would react any more rationally than the London cabdrivers who went on strike to stop Uber, and ended up getting many of their customers to try Uber for the very first time. I operate in the education business, a large and extraordinarily inefficient business, and there is no group more resistant to change and more unprepared to adapt than tenured professors at research university. I cannot wait to see this group, convinced of its intellectual superiority and attached to unreal perks (minuscule teaching loads, research assistants and sabbaticals),  go through the throes of disruption.

    YouTube Version


    Ride Sharing Series (September 2015)



    Dream Big or Stay Focused? Lyft's Counter to Uber!

    This is the second in a series of three posts on the ride sharing business. In my first, published in both TechCrunch and my blog, I valued Uber, trying to incorporate the news that has come out about the company and its competition in the last year. In this one, I first turn to valuing Lyft, which is telling a narrower, more focused story to investors than Uber and also look at how the pricing ladder in ride sharing companies has pushed up prices across the board. In the last post, due out on Wednesday, I will look at the ride sharing market as a business.

    In my last post, I valued Uber and admitted that the company has made its way to my list of obsessions. My focus on Uber, though, has meant that I have not paid any attention to the other ride sharing company in the US,  Lyft, and I don’t think I have been alone in this process. An unscientific analysis of news stories on ride-sharing companies in the last couple of years suggests that Uber has dominated the coverage of this business. Rather than view this as a slight on Lyft, I would argue that this is at least partially by design, and that it is part of both companies' strategies. Uber is viewed as the hands-down winner of this battle right now, but this is just one battle in a long war and investors define winners differently from corporate strategists.

    Valuing Lyft
    To value Lyft, I will employ the same template that I used for Uber, though the choices I will make in terms of total market, market share, operating margins and risk will all be different, reflecting both Lyft’s smaller scale and more limited ambitions (for the moment).

    The Leaked Numbers
    The place to start this assessment is by comparing the ride sharing reach of Lyft with Uber and that comparison is in the table below:
    UberLyft
    Number of cities in US15065
    Number of cities>30065
    Number of countries601
    Number of rides - 2014140NA
    Number of rides (in millions) - 2015ENA90
    Number of rides (in millions) - 2016ENA205
    Gross Billings (in millions $) - 2014$2,000$500
    Gross Billings (in millions $) - 2015E$10,840$1,200
    Gross Billings (in millions $) - 2016$26,000$2,700
    Estimated Growth for 2015442%140%
    Estimated Growth for 2016140%125%
    Operating loss in 2014 (in millions $)-$470-$50

    The key differences can be summarized as follows. First, Uber is clearly going after the global market, uninterested in forming alliances or partnerships with local ride sharing companies. Lyft has made explicit its intention to operate in the US, at least for the moment, and that seems to have been precursor to forming alliances (as evidenced by this news story from two weeks ago) with large ride sharing companies in other markets. Within the US, Uber operates in more than twice as many cities as Lyft does. Second, both companies are growing, though Uber is growing at a faster rate than Lyft, and that is captured in both the number of rides and gross billings at the companies. Third, both companies are losing money and significant amounts at that, as they go for higher revenues. Note that, for both companies, the bulk of the information comes from leaked documents, and should therefore considered with skepticism. In addition, there are some numbers that come from press reports (Lyft's loss in 2014) that are more guesses than estimates.

    The business models of the two companies, at least when it comes to ride sharing, are very similar. Neither owns the cars that are driven under their names and both claim that the drivers are independent contractors. Both companies use the 80:20 split for ride receipts, with 80% staying with the driver and 20% going to the company, but that surface agreement hides the cut throat competition under the surface for both drivers and riders. Both companies offer incentives (think of them as sign-up bonuses) for drivers  to start driving for them or, better still, to switch from the other company. They also offer riders discounts, free rides or other incentives to try them or, better still, to switch from the other ride sharing company. At times, both companies have been accused of stepping over the line in trying to get ahead in this game, and Uber’s higher profile and reputation for ruthlessness has made it the more commonly named culprit. 

    The other big operating difference is that unlike Uber, which is attempting to expand its sharing model into the delivery and moving markets, Lyft, at least for the moment, has stayed much more focused on the ride sharing business, and within that business, it has also been less ambitious in expanding its offerings to new cities and new types of car services than Uber.

    The Narrative Contrast and Valuation
    In my valuation of Lyft, I will try to incorporate the differences that I see (from Uber) into my narrative:
    LyftUber
    Potential MarketUS-centric, ride-sharing company.Global, logistics company
    Growth EffectDouble ride-sharing market in US in next 10 yearsDouble logistics market globally in next 10 years
    Market ShareWeak national networking benefitsWeak global networking benefits
    Competitive AdvantageSemi-strong competitive advantagesSemi-strong competitive advantages
    Expense ProfileDrivers as partial employeeDrivers as partial employees
    Capital IntensityLow capital intensityLow capital intensity, with potential for shift to more capital intense model
    Management CultureAggressive within ride sharing business, Milder with regulators and media.Aggressive with all players (competitors, regulators, media)
    In short, the Lyft narrative is narrower and more focused (on ride sharing and in the US) than the Uber narrative. That puts them at a disadvantage, at least at this stage in the ride sharing market, in terms of both value and pricing, but it could work in their favor as the game unfolds. 

    The adjustments to the Lyft valuation, relative to my Uber valuation, are primarily in the total market numbers, but I do make minor adjustments to the other inputs as well. 
    1. Smaller total market: Rather than use the total global market, as I did for Uber, I focus on just the US portion of these markets. That reduces the total market size substantially. In addition, I assume that, given Lyft’s focus on ride sharing, that its market is constrained to be the US car service market. Notwithstanding these changes in my assumption, the potential market still remains a large one, with my estimate about $150 billion in 2025. 
    2. National networking benefits: Within the US market, I assume that the increased cost of entry into the business that I referenced in my last post on Uber will restrict new competitors and that Lyft will enjoy networking benefits across the country, enabling it to claim a 25% market share of the US market. 
    3. Drivers become partial employees: My assumptions on drivers becoming partial employees and competition driving down the ride sharing company slice of revenues will parallel the ones that I made for Uber, resulting in lower operating margins (25% in steady state) and a smaller slice of revenues (15%). 
    4. Lyft is riskier than Uber: Finally, I will assume that Lyft is riskier than Uber, given its smaller size and lower cash reserves, and set its cost of capital at 12%, in the 90th percentile of US companies, and allow for 10% chance that the company will not make it.
    The value that I derive for Lyft with these assumptions is captured in the picture below:

    Spreadsheet with Lyft Valuation (September 2015)
    The value that I get for Lyft is $3.1 billion, less than one seventh of the value that I estimated for Uber ($23.4 billion) in my last post.


    The biggest danger that I see for investors in Lyft is that the company has to survive the near future, where the pressure from Uber and the nature of the ride sharing business will create hundreds of millions of dollars more in losses. If the capital market, which has been accommodating so far, dries up, Lyft faces the real danger of not making it to ride sharing nirvana. It is a concern amplified by Mark Shurtleff at Green Wheels Mobility Solutions, a long-time expert and consultant in the ride sharing and mobility business, who points to Lyft's concentration in a few cities and cash burn as potential danger signs.

    Pricing The Ride Sharing Companies
    While none of the ride sharing companies are publicly traded and there are therefore no prices (yet) for me to compare these valuations to, there have been investments in these companies that can be extrapolated at some risk to estimate what these investors are pricing these companies at. In keeping with my theme that price and value come from different  processes, recognize that these are prices, not values.

    The VC Pricing
    I took at look the most recent VC investments in ride sharing companies and what prices they translate into.
    CompanyLast VC round investment amount (in US$ millions)DateLead InvestorsImputed Pricing for the company (in US $ millions)
    Lyft$530.0015-MayRakuten, Didi Kuaidi, Carl Icahn$2,500.00
    Uber$1,000.0015-JulMicrosoft$51,000.00
    Didi Kuaidi$2,000.0015-JulChina Investment Fund$15,000.00
    Ola$310.0015-MarDST Global$2,300.00
    GrabTaxi$200.0015-JulCoatue Management & others$1,500.00

    * Sources: Public News Reports, Mark Shurtleff
    The danger in extrapolating VC investments to overall value, which is what the press stories that report the overall prices do, is that the only time that a VC investment can be scaled up directly to overall value is if it comes with no strings attached. Adding protections (ratchets) or sweeteners can very quickly alter the relationship, as I noted in this post on unicorns

    The Drivers of Price
    Notwithstanding that concern, is there a logic to this pricing? In other words, what makes Uber more than three times more valuable than Didi Kuaidi and Didi Kuaidi six times more valuable than Lyft? To answer these questions, I pulled up the statistics that I could find for each of these companies:

    CompanyEstimated Value (Price)Gross Billing in $ millions (2015)Revenues (2015)*Operating Profit or Loss (2015)Cities served (2015)# ridesPotential Market (in $ millions)# Drivers
    Lyft$2,500$1,200$300-$100 65156$55,000100000
    Uber$51,000$10,840$2,000-$470 3001460$205,000800000
    Didi Kuaidi$15,000$12,000$450-$1,400 1372190$50,0002600000
    Ola$2,500$1,200$150NA 85100$13,000250000
    GrabTaxi$1,500$1,000$50NA 26300$6,00075000
    BlaBlaCar$1,600$600$72NA 100NA$20,000NA

    * The revenues are estimated using the revenue slice that these companies report, but with customer give aways and other marketing costs, the actual revenues were probably lower.

    Note that almost all of these numbers come from leaks, guesses or judgment calls, and that there are many items where the data is just not available. For instance, while we know that Ola, GrabTaxi and BlaBlaCar are all losing money, we do not know how much. At the risk of pushing my data to breaking point, I computed every possible pricing multiple that I could for these companies:

    CompanyValue/Gross BillingValue/RevenuesValue/CityValue/Ride Value/Potential Market
    Lyft2.088.33$38.46$16.030.0455
    Uber4.7025.50$170.00$34.930.2488
    Didi Kuaidi1.2533.33$109.49$6.850.3000
    Ola2.0816.67$29.41$25.000.1923
    GrabTaxi1.5030.00$57.69$5.000.2500
    BlaBlaCar2.6722.22$16.00NA0.0800
    Average2.3820.5470.18$17.560.1861
    Median2.0822.2248.08$16.030.2205
    Aggregate2.7622.98103.93$17.240.2123

    On a pure pricing basis, Lyft looks cheap on every pricing multiple, and Uber looks expensive on each one, perhaps providing some perspective on why Carl Icahn found Lyft to be a bargain, relative to Uber. Didi Kuaidi looks expensive on any measure other than gross billing and GrabTaxi looks cheap on some measures and expensive on others.  It is worth noting that these companies have different revenue models, with Lyft and Uber hewing to the 20% slice model, established in the US and Ola (which has more of a taxi aggregating model), at least according to the reports I read, follows the same policy. BlaBla is mostly long-distance rides and gets about 10-12% of the gross billing as revenue, GrabTaxi gets only 5-10% of gross billings, Didi Kuaidi, which had its origins in a taxi hailing app, gets no share of a big chunk of its revenues and BlaBlaCar derives its revenues more from long distance city-to-city traffic than from within city car service. Given how small the sample is and how few transactions have actually occurred, I will not attempt to over analyze these numbers, other than wondering, based on my post on corporate names, how much more an umlaut would have added to Über's hefty price.

    With all of these companies, the prices paid have risen dramatically in the last year and a half and I believe that this pricing ladder is driven by Uber's success at raising capital. In fact, as Uber's estimated price has risen from $10 billion early in 2014 to $17 billion last June to $40 billion at the start of 2015 to $51 billion this summer, it has ratcheted up the values for all of the other companies in this space. That should not be surprising, since the pricing game almost always is played out this way, with investors watching each other rather than the numbers. As with all pricing games, the danger is that a drop in Uber's pricing will ratchet down the ladder, causing a mark down in everyone's prices.

    Big versus Small Narratives
    If narrative drives numbers and value, which is the argument that I have made in valuing Uber and Lyft in these last two posts, the contrast between the two is also in their narratives. Uber is a big narrative company, presenting itself as a sharing company that can succeed in different markets and across countries. Giving credit where it is due, Travis Kalanick, Uber’s CEO, has been disciplined in staying true to this narrative, and acting consistently. Lyft, on the other hand, seems to have consciously chosen a smaller, more focused narrative, staying with the story that it is a car service company and further narrowing its react, by restricting itself the US. 

    The advantage of a big narrative is that, if you can convince investors that it is feasible and reachable, it will deliver a higher value for the company, as is evidenced by the $23.4 billion value that I estimated for Uber. It is even more important in the pricing game, especially when investors have very few concrete metrics to attach to the price. Thus, it is the two biggest market companies, Uber and Didi Kuaidi, which command the highest prices. Big narratives do come with costs, and it those costs that may dissuade companies from going for them. 
    1. It can distract: Big narratives will require companies to deliver on multiple measures and that may distract management from more immediate needs. 
    2. It can be costly: Having to grow faster and in multiple markets (different businesses and different geographies) at the same time will be more costly than focusing on a smaller market and having more measured ambitions.
    3. It can create disappointments: The flip side of convincing investors that you can reach for the heights is that if you don’t make it, you will disappoint them, no matter how good your numbers may be. 
    With Uber, you see the pluses and minuses of a big narrative. It is possible that Uber Eats (Uber’s food delivery service), UberCargo (moving) and UberRush (delivery) are all investments that Uber had to make now, to keep its narrative going, but it is also possible that these are distractions at a moment when the ride sharing market, which remains Uber’s heart and soul, is heating up. It is undoubtedly true that Uber, while growing at exponential rates, is also spending money at those same rates to keep its big growth going and it is not only likely, but a certainty, that Uber will disappoint their investors at some time, simply because expectations have been set so high. 

    It is perhaps to avoid these risks that Lyft has consciously pushed a smaller narrative to investors, focused on one business (ride sharing) and one market (the US). It is avoiding the distractions, the costs and the disappointments of the big narrative companies, but at a cost. Not only will it cede the limelight and excitement to Uber, but that may lead it to be both valued and priced less than Uber. Uber has used its large value and access to capital as a bludgeon to go after Lyft, in its strongest markets.

    As an investor, there is nothing inherently good or bad about either big or small narratives, and a company cannot become a good investment just because of its narrative choice. Thus, Uber, as a big narrative company, commands a higher valuation ($23.4 billion) but it is priced even more highly ($51 billion). Lyft, as a small narrative company, has a much lower value ($3.1 billion) but is priced at a lower number ($2.5 billion). At these prices, as I see it, Lyft is a better investment than Uber. 

    Block and Draft
    It is clear that Uber and Lyft have very different corporate personas and visions for the future and that some of the difference is for outside consumption. It serves Uber well, in its disruptive role, to be viewed as a bit of a bully who will not walk away from a fight, just as it is Lyft’s best interests to portray itself as the gentler, more humane face of ride sharing. Some of the difference, though, is management culture, with Uber drawing from a very different pool of decision-makers than Lyft does. If this were a bicycle race, Uber reminds me of the aggressive lead rider, intent on blocking the rest of the pack and getting to the finish line first, and Lyft is the lower profile racer who rides just behind the leader, using the draft to save energy for the final push. This is going to be a long race, and I have a feeling that its contours will change as the finish line approaches, but whatever happens, it is going to be fun to watch!

    YouTube Version

    Ride Sharing Series (September 2015)



    The Ferrari IPO: A Price Premium for the Prancing Horse?

    I live in a prosperous suburb, sustained largely by financial service businesses, but as far I know, there is only one Ferrari in my town. Much of the week, the car sits in a garage which has its own security system, more secure than the one protecting its owner's house, and on a nice weekend, you see the owner drive it around town. It is a remarkably inefficient transportation mode, too fast for suburban roads, too expensive to be parked at a grocery story or pharmacy, and too cramped for car pool. All of this comes to mind, for two reasons. The first is the imminent initial public offering of the company, with all the pomp and circumstance that surrounds a high-profile offering. The second is that this offering has set in motion the usual talk of brand names and the price premiums that we should pay to partake for investing in them.

    Ferrari: A Short History and Background
    The Ferrari story started with Enzo Ferrari, a racing car enthusiast, starting Scuderia Ferrari in 1929, to assist and sponsor race car drivers driving Alfa Romeos. While Enzo manufactured his first racing car (Tipo 815) in 1940,  Ferrari as a car making company was founded in 1947, with its manufacturing facilities in Maranello in Italy. For much of its early existence, it was privately owned by the Ferrari family, though it is said that Enzo viewed it primarily as a racing car company that happened to sell cars to the public. In the mid-1960s, in financial trouble, Enzo Ferrari sold a 50% stake in the company to Fiat.  That holding was subsequently increased to 90% in 1988 (with the Ferrari family retaining the remaining 10%). Since then, the company has been a small, albeit a very profitable, piece of Fiat (and FCA).

    The company acquired its legendary status on the race tracks, and holds the record for most wins  (221) in Formula 1 races in history. Reflecting this history, Ferrari still generates revenues from Formula 1 racing, with its share amounting to $67 million in 2014. Much as this may pain car enthusiasts everywhere, some of Ferrari's standing comes from its connection to celebrities. From Thor Batista to Justin Bieber to Kylie Jenner, the Ferrari has been an instrument of misbehavior for wealthy celebrities all over the world.

    The Auto Business
    In earlier posts, where I valued Tesla, GM and Volkswagen, I argued that the auto business bore the characteristics of a bad business, where companies collectively earn less than their cost of capital and most companies destroy value. In fact, I used the words of Sergio Marchionne, CEO of Fiat Chrysler (and the parent company to Ferrari) to make the case that the top managers at auto companies were delusional in their belief that the business would magically turn around. Looking at the business broadly, here are three characteristics that reveal themselves:

    1. It is a low growth business: The auto business is a cyclical one, with ups and downs that reflect economic cycles, but even allowing for this cyclicality, the business is a mature one. That is reflected in the growth rate in revenues at auto companies.

    YearRevenues ($)% Growth Rate
    20051,274,716.6
    20061,421,804.2 11.54%
    20071,854,576.4 30.44%
    20081,818,533.0 -1.94%
    20091,572,890.1 -13.51%
    20101,816,269.4 15.47%
    20111,962,630.4 8.06%
    20122,110,572.2 7.54%
    20132,158,603.0 2.28%
    20142,086,124.8 -3.36%
    During this period, the emerging market economies in Asia and Latin America provided a significant boost to sales, but even with that boost, the compounded annual growth rate in aggregate revenues at auto companies between 2005 and 2014 was only 5.63%.

    2. With poor profit margins: A key point that Mr. Marchionne made about the auto business is that operating margins of companies in this business were much too slim, given their cost structures. To illustrate this point (and to set up my valuation of Ferrari), I computed the pre-tax operating margins of all auto companies globally, with market capitalizations exceeding $1 billion, and the graph below summarizes my findings.

    Source: S&P Capital IQ
    3. And high reinvestment needs: The auto business has always required significant investments in plant and equipment, but in recent years, the advent of technology has also pushed up R&D spending at auto companies. One measure of the drag this puts on cash flows is to look at net capital expenditures (capital expenditures in excess of depreciation) and R&D, as a percent of sales, for the entire sector:

    It is this combination of anemic revenue growth, slim margins and increasing reinvestment that is squeezing the value out of the auto business. (You can download the data for all auto companies, with profitability measures and pricing ratios by clicking here.)

    The Super Luxury Automobile Business
    If, as has been said before, the only difference between the rich and the rest of us is that the rich have more money, the difference between the rich and the super rich is that super rich have so much money that they have stopped counting. The super luxury car manufacturers (Ferrari, Aston Martin, Lamborghini, Bugatti etc.), with prices in the nose bleed segment, cater to the super rich, and have seen sales grow faster than the rest of the auto industry. Much of the additional growth coming from newly minted rich people in emerging markets, in general, and China, in particular. Like the rest of the companies in the super luxury segment, Ferrari is less auto company and more status symbol, and draws its allure from four key characteristics:
    1. Styling: I am not a car lover, but even I can recognize that a Ferrari is a work of art. That is not accidental, since the company spends substantial amounts on styling and the little details that go into every Ferrari.
    2. Speed: There is no absolutely no chance that you will test the upper limits of the car's engine capacity, but you could get from LA to San Francisco in about 3 hours, if you could maintain the car at its top speed (I am not recommending this). So, if you grew up with dreams of being a Formula 1 driver, and now have the money to fulfill them, a Ferrari is probably as close as you are going to get to these dreams.
    3. Story: The car comes with a story that draws as much from its celebrity connections as it does from  its speed exploits. 
    4. Scarcity: Notwithstanding the first three points, it would be just another luxury car if everyone had one. So, it has to be kept scarce to command the prices that it does, both as a new car and in its used versions.
    To illustrate how exclusive the Ferrari club is, in all of 2014, the company sold only 7255 cars, a number that has barely budged over the last five years. (The Lamborghini club is even more exclusive, with only 2000 cars sold annually.)  The company has its roots in Italy but is dependent on a super- rich clientele globally for its sales:

    Note that a significant slice of the revenue pie comes the Middle East and that Ferrari, like many other global companies, is becoming increasingly dependent on China for growth.

    Valuing Ferrari
    As many of you reading this blog are aware, I am a believer that all valuations start with stories and that different stories can yield different valuations. With Ferrari, there are two plausible stories that you can offer for the future of the company, with valuations to back them up:

    1.The Status Quo (Super Exclusive, Low Production, High Margin)
    The story: Ferrari remains a extra-exclusive automobile company, keeping production low and prices high. The benefits of this strategy are high operating margins (Ferrari has among the highest in the auto business) partly because of the high prices, and partly because the company does not have to spend much on expensive ad campaigns or selling. It also will keep reinvestment needs to a minimum, since capacity expansion will not be necessary, though the company will continue spending on R&D to preserve its edge (on speed and styling). In addition, by focusing on a very small group of super rich people around the world, Ferrari may be less affected by macroeconomic forces than other luxury auto companies.
    The inputs: The inputs into my valuation reflect the story, with low revenue growth, high margins and low reinvestment driving value:

    The valuation: With these assumptions, the value for equity of 6,310 million Euros (approximately $7 billion). You can download the spreadsheet here.

    2. Rev it Up (Increase production, Introduce a lower-priced model)
    The story: Ferrari tries to broaden its customer base, perhaps by introducing a lower-priced version; this would mirror what Maserati did with its Ghibli model. That will allow for higher revenue growth but like Maserati, Ferrari will have to yield some of its operating margin, since this strategy will require lower prices and higher selling costs. Seeking a larger market will also expose it to more market risk, pushing its cost of capital in high growth to 8.5% and its cost of capital beyond to 7.5%.
    The inputs: This strategy will generate higher sales (doubling number of units sold in next ten years) but at the expense of lower margins (from lower prices and higher selling costs) and higher risk (as the clientele will be more sensitive to economic conditions).

    The valuation: With this strategy, the value for equity of 6,042 million Euros (approximately $6.75 billion). You can download the spreadsheet here.

    At least based on my estimates, it is more sensible for Ferrari to stick with its low-growth, high price strategy and keep itself above the fray of the auto business, a bad business where most companies seem to have a tough time earning their cost of capital.

    The Brand Name Premium
    There is a lot of casual talk about how Ferrari will command a premium because of its name and some have suggested that you should add that premium on to estimated value. In an intrinsic valuation, it is double counting to add a premium and the reason is simple. The values that I have estimated already incorporate the premium. If you are wondering how, take a look at the operating margin of 18.20% that I have used for Ferrari, a number vastly in excess of the margins earned by other auto companies. That high margin, in conjunction with limited growth in cars sold, also allows Ferrari to earn a return on capital of 14.56%, well above its cost of capital. These inputs yield a value premium, with the magnitude varying across multiples:

    Ferrari (my estimated value)Auto SectorReason for difference
    EV/Sales2.100.94Ferrari's operating margin is 18.2% versus Industry average of 6.58%.
    EV/Invested Capital1.971.02Ferrari earns a much higher return on capital (14.56%) than the sector (6.68%)
    EV/EBITDA12.579.05Ferrari EBITDA/Invested capital is 15.68% versus Industry average of 14.45%.
    PE22.8710.00Ferrari has a debt ratio of 9.43% versus Industry average of 39.06%.
    PBV2.561.29Ferrari has a slightly higher ROE and lower equity risk (because of less debt)

    Thus, the intrinsic value estimates already are building in a hefty premium for the effects that Ferrari's brand name has on its operating margins and return on capital.

    Is it possible that the brand name can be utilized better? That is always possible but there is nothing to indicate that the brand is being mismanaged or that it can be easily exploited to generate additional value. In fact, the consolidation of voting power in the hands of the existing owners suggests that there the firm will remain largely unchanged after the IPO.

    IPO Related Issues
    An initial public offering does create a host of issues that can affect valuation, sometimes tangentially and sometimes directly. In the case of Ferrari, the three issues that merit the most attention are whether the proceeds from the offering will affect value, what the value per share will be, and how the augmentation of voting rights for the existing stockholders will play out.
    1. Use of proceeds: The proceeds from an IPO can have a feedback effect on value, but only if the IPO proceeds are kept in the firm to cover current or future investment needs. In this IPO, the billion dollars expected to be raised from the offering will go to Fiat for cashing out some of its ownership stake, and thus not benefit Ferrari stockholders. There is therefore no need to add these proceeds back to the cash balance (as I would have, if the IPO proceeds had been retained by the firm).
    2. Number of shares/IPO price per share: Note that in both my valuations, I have focused on the value of equity, rather than a per share value, for two reasons. The first is that the number of shares is still in flux (notice all the empty spaces in the prospectus). The second is that the per share value will be a function of the number of shares created in the company. Thus, if the value of equity is 6.3 billion Euros, Ferrari can create 100 million shares at 63 Euros per share or 2 billion shares at 3.15 Euros per share, with the same end result. The number of units and offering price will be set jointly, because setting one will also determine the other. The talk of the town is that the company will be valued at 50 Euros per share and the value of equity will be 10 billion Euros. At least based on those rumors, it seems like the Ferrari will create 200 million shares, and if that is the correct number, the value per share that I arrive at is about 31.5 Euros per share (based on my 6.3 billion Euro status quo value).
    3. Control: After the IPO, Ferrari will become an independent firm but control will still remain concentrated in the hands of its current owners, Fiat and the Ferrari family. In fact, the existing owners will get twice the voting rights on their shares, relative to the those who buy shares in the IPO, for their loyalty. The two big owners, Exor (the investment fund for the Agnelli family) and the Ferrari family will control 49% (Update: I erroneously stated the they would control 51% of the voting rights, but with the rest of the holdings dispersed, that is effectively majority control) of the voting rights with about 33% of the shares. The shares that you and I will have a chance to buy at the IPO will be the low-voting right shares, I guess because we are disloyal investors. I don't see much of a discount on these shares since even without the additional voting rights, it is unlikely that anyone can force the company to change its operations, if that change is against the wishes of the Agnelli/Ferrari clan.
    Conclusion
    It will be interesting to see this game play out, as the offering gets closer. There is a push to attach a valuation of 11 billion Euros for the Ferrari shares, both because it will get more cash for Fiat from the offering, and more importantly, because the increased value of its remaining holdings in Ferrari will then feed into Fiat's market capitalization. The push may succeed because investors seem eager to buy these shares, at least according to this story, and the price premium will be justified with the argument that Ferrari is a premium brand that caters to the rich. Off to the races!

    YouTube Video


    Data Attachments
    1. Ferrari Prospectus
    Spreadsheets 
    1. Auto Industry: Company Data
    2. Ferrari Valuation (Status Quo)
    3. Ferrari Valuation (Rev it up)
    4. Google Shared Spreadsheet: Ferrari Valuations




    Value and Taxes: Breaking down the Pfizer- Allergan Deal

    A week ago, I began my series of posts on the drug business, starting with my perspective on how the business is changing and then moving on to posts on Valeant's business model and the runaway story of Theranos. I am finishing this series with a post on Pfizer's plan to merge with Allergan and the economics of the merger. This deal, which will make one of the largest pharmaceutical companies in the world even larger has drawn attention not just because of its magnitude, but also for its motives. While there is some desultory chatter about synergy (as is the case with every merger), this deal seems focused on two specific motivations: the first is that this is a bid by Pfizer to buy Allergan's higher growth and the second is that this is a deal designed to save taxes. Not surprisingly, the latter is attracting attention not just from investors and financial journalists, but also from politicians. 

    Growth but at what cost?

    One of the most dangerous maxims in both corporate finance and investing is that it is better to grow than to not grow, and that a company that faces stagnant or declining revenues (and income) should seek out higher growth (at any price). In a post from a long time ago, I looked at the value of growth and noted that the net effect of growth depends on how much you pay to get it, and that overpaying for growth will give you higher growth and a lower value. In the graph below, you can see the effect of growth on value for three companies, all of which grow, the first by making investments that generate returns that exceed the cost of capital, the second by making investments that earn the cost of capital and the third by making investments that earn less than the cost of capital.

    It is this perspective on growth that makes me skeptical about companies that grow through acquisitions, especially when those acquisitions are big and are of public companies. Since you have to pay market price plus (a premium of 20-30%) to acquire a public company, for a growth-motivated acquisition to create value, you have to be able to find a growth company that is under valued by more than 20% or 30%, given its growth rate, at the time that you initiate the deal to be able to walk away with value added. Note that, much as I am tempted to do a riff about the wondrous benefits of bringing both Botox and Viagra under one corporate entity,  I am deliberately keeping synergy out of the equation since it can justify a premium.

    Let's consider then the proposition that the Pfizer deal for Allergan is driven by the motivation of buying growth. The basis for the story is visible in this comparison of Pfizer and Allergan's operating numbers over the last five years:

    Over these five years, Pfizer's revenues shrank about 6% a year whereas Allergan's revenues grew at 40.62% a year. That makes the case for the acquisition, right? Not quite, because it depends on whether the market is already pricing in Allergan's growth. If it is, buying Allergan will allow Pfizer to grow faster, but not create value and may in fact destroy value if the premium paid is large enough.  To examine whether Allergan offers growth at a bargain, I considered valuing Allergan, but very quickly abandoned the idea, because it reminded me of Valeant, insofar as it has grown rapidly through acquisitions, funded with significant amounts of debt and its financial statements are a mess. Thus, while it clear that Allergan has grown fast, the question of whether it has grown sensibly is a question that remains to be answered. Looking at the multiples at which Allergan was trading, prior to the Pfizer bid, there is almost no multiple on which it looks like a bargain.

    PharmaceuticalsAllerganAllergan Premium
    PE Ratio31.24NANA
    Price/Book Equity4.114.376.33%
    EV/EBIT20.1253.15164.17%
    EV/EBITDA13.9719.3238.30%
    EV/EBITDAR9.7116.5870.75%
    EV/Sales4.717.8566.67%

    What is the bottom line? If I were a Pfizer stockholder, I would be concerned if buying growth were the primary reason for this acquisition, since the growth at Allergan is not only at a premium price but also untested (insofar as it is acquired growth rather than organic growth). I would be terrified, especially after recent scares, that the acquisition accounting at the company may be hiding bad surprises.

    The Insanity of the US Tax Code

    One of the most surprising aspects of this deal is how open the Pfizer management has been about the tax motivations for the deal, with Ian Read, the CEO of Pfizer, saying that "the company is at a tremendous disadvantage under the U.S. corporate tax code and that Pfizer is competing against foreign companies with one hand tied behind our back.” This planned "inversion", of course, has triggered a heated response, understandable (at least politically), though some of the critics don't quite understand the US tax law and what exactly Pfizer will gain by leaving behind its US incorporation. 

    I have vented extensively about the absurdity of US tax law and how it encourages perverse behavior from businesses (and individuals). Rather than repeat myself, let me focus in on the three aspects of the law that makes it so damaging: 
    1. The level of rates: There was a time four decades ago when the US federal corporate tax rate, at 40%, was in the middle of the global tax rate distribution, with many countries adopting a policy of punitive corporate taxation. The corporate tax rate in the US was last lowered in 1986 to 34%, then raised to 35% in 1993 and has remained unchanged since. With state and local taxes, it amounts to close to 40% in 2015. The rest of the world has moved away from the US and lowered corporate tax rates, leaving it with one of the highest marginal tax rates in the world in 2015. (See this KPMG site for tax rates around the world
      Source: KPMG
    2. Global versus Territorial taxation: Adding to the US tax code's woes is the requirement that US companies pay the US tax rate not just on US income but on income generated elsewhere in the world. In 2015, it remains one of six countries that follow this practice, whereas the rest of the world has moved to a territorial tax model, where companies get taxed based on where they generate income (and are done). The Global tax model, which was born in an age when the US economy was the driver of the global economy and US companies were domestically focused, results in US multinationals facing much higher tax rates on world income than multinationals incorporated elsewhere.  (Interestingly, Ireland is one of the six countries with a global tax model but with its low tax rate, the effect is muted.)
    3. The Repatriation Trigger: To cap off this trifecta, US tax law adds a clause that specifies that the “additional US tax” due on foreign income has to be paid only when that income is repatriated to the United States. In response, US companies have had the logical reaction and not repatriated foreign income, leaving that income “trapped” in foreign locales. In 2015, it was estimated that the trapped cash amounted to more than $2 trillion, money that cannot be used to pay dividends, buy back stock or make investments in the US, but can be used to make investments anywhere else in the world
    The benefit to a company of removing itself from US tax incorporation, i.e., inversion, is therefore two fold:
    1. No US taxes on foreign income: While the company will continue to pay the US tax rate on its US income, its foreign income will be taxed only at the foreign domicile's tax rate. 
    2. Untrap cash: To the extent that the company has built up trapped earnings (in foreign locales) that it is restricted from using, it can release the cash without any tax penalties.
    Given US tax law, the question is not why some companies seek to leave its tax jurisdiction, but why more of them do not, and the answer lies in an uneasy middle ground, a wait-it-out scenario that many US companies have adopted, where they let income accumulate in foreign markets and wait for one of two developments. One is a change in US tax law, which people on both sides of the aisle seem to agree is needed, but don't seem to want to bring to fruition. The other is that Congress will blink yet again and pass another one of its "tax holidays", a "once in a lifetime" chance (that shows up once every decade)  that will be given to companies to bring their cash home with no penalties. The net effect is that the US ends up with the worst of all worlds: a tax code that is ineffective at collecting taxes (as evidenced by the drop in corporate tax collections over the last three decades) while encouraging companies to borrow more and more money (and save on taxes at the marginal rate).

    Pfizer: The Numbers 
    To understand how exposed Pfizer is to the vagaries of US tax law, I started by looking at the geographical distribution of Pfizer revenues over time:
    Note that Pfizer generated only 43.08% of its revenues in the first nine months of 2015. If Pfizer were to be taxed, at the marginal rate in each region, based on where it generated its revenues (regional tax), its tax rate in those nine months would have been 30.68%. As a US company, though, Pfizer would have to pay almost 40% of this income as taxes, translating into significantly higher taxes each period.  Pfizer, of course, chose not to take this course, as manifested in two numbers. The effective tax rate that Pfizer has paid over the last five years has averaged to 23.45%, well below 40%, and a significant portion (my rough estimate is $12 billion) of Pfizer’s cash balance of $20.66 billion is trapped. Binging it back will result in a tax bill of $1.99 billion (using a differential tax rate of 16.55%, the difference between the US marginal tax rate of 40% and the effective tax rate of 23.45%). 

    Valuing Pfizer 
    To illustrate the impact that changing the tax code that governs Pfizer has on its value, I considered three scenarios. 
    1. Patriot Games: In this scenario, I assume that Pfizer does its patriotic duty (as some critics would label it) and not only decide to bring all of its trapped cash home today (and pay the differential taxes) but repatriate all of its foreign income each year back to the US and pay a 40% marginal tax rate on that income. 
    2. Wait-it-out (Tax Limbo): In this scenario, Pfizer will leave its trapped cash overseas, continue to pay taxes to foreign governments on foreign income but not repatriate the cash. That will leave their effective tax rate well below the US marginal tax rate and Pfizer will have to hope that US tax law gets fixed or that Congress does another one of its “once in a lifetime” tax holidays. 
    3. Go Irish: In this scenario, Pfizer buys Allergan and meets the requirements for shifting its incorporation to Ireland. Note that doing so does not affect their taxes on US income but it will not only un-trap their cash but also remove the constraint they face today on foreign income. 
    The different assumptions that I make about taxes under the three scenarios are summarized:

    Tax ModelMarginal tax rate (for cost of debt)Effective tax rate (next 10 years)Effective tax rate (in stable growth)Trapped Cash
    Patriot Games40%40%40%Return immediately & pay taxes now.
    Wait-it-out (Tax Limbo)40%23.45%, with taxes on deferred taxes paid in year 10.40%Return in ten years & pay taxes then.
    Go Irish (Invert)40%23.45%30.68%No taxes due

    In the table below, I value Pfizer under each scenario (see spreadsheet), first using the conventional accounting numbers (which treat R&D as an operating expenses) and next using adjusted numbers (where I capitalize R&D):
    Patriot GamesWait-it-outGo IrishEffect of Inversion
    R&D ExpensedEquity Value$154,806.00$176,047.00$209,637.00$33,590.00
    Per share$25.09$28.53$34.39$5.86
    R&D capitalizedEquity Value$121,074.00$135,156.00$162,309.00$27,153.00
    Per share$19.62$21.91$26.60$4.69

    The rationale for an inversion is that it will increase Pfizer’s equity value by $27.2 billion and its share price by $4.69 per share. This calculation, though, is based on the assumption that US tax law will never change, and that its dysfunctional components will continue in perpetuity. If you assume that the current bipartisan talk of fixing the law will result in changes (in either the corporate tax rate or in the global tax feature), the value increase will drop off substantially.

    Deal or No Deal?
    I applaud Ian Read's focus on shareholder value but will this deal create that value? I am skeptical and here is why. Even if you accept the upper limit of the value of inversion ($27.2 billion), that increase in value does not incorporate two potential costs associated with inversion.
    1. The new rules covering inversions will require that Pfizer go through contortions to qualify and some of these contortions will add to the cost of the deal.
    2. There is the possibility of a backlash, not so much from customers, but from politicians. There are senators who are already threatening the company with consequences, though I am not sure that any of them would actually go as far as to ban or restrict Pfizer product sales in the US (since that would hurt those who need the drugs the most). Even if they do, given that the US Senate is disproportionately composed of older men, I am confident that they will carve out a "Viagra exception" for themselves.
    There is a second and even bigger concern that I would have as a Pfizer stockholder. If the rumors that Pfizer is planning to pay a 30% premium are right, that would translate into a premium of more than $30 billion over Allergan's market capitalization to buy the company. Since the growth is already priced in (at least in my view), the only way you can create value is to draw on synergy and nothing that either company has said suggests any concrete benefits from the combination.

    The bottom line is that this looks like a bad deal for the wrong company, at the wrong time and at the wrong price, the wrong company because Allergan's accounting statements are a mine field due to acquisition accounting, the wrong time because we may actually be on the verge of a major change in US corporate tax code and at the wrong price because of the premium on an already large market capitalization.

    The Morality Play? 
    As I was writing this post last week, I had a conversation with a friend about Pfizer. After I explained why I thought the Pfizer plan to acquire Allergan made sense, given the tax code and Pfizer's global exposure, her response was that Pfizer should not do this because “it is immoral". While I was floored initially by her assertion, it would be have been both futile and hubristic for me to try to prove her wrong. She is entitled to her moral judgments, just as I am entitled to mine, but it is moral, rather than economic, differences that usually lie at the heart of tax debates and that is perhaps why it is so difficult to get a consensus.

    If you own a business that would benefit from shifting away from the US for tax reasons, and you have patriotic or moral reasons for not doing so, you are well within your rights in staying US-bound and I support you in your choice. If you are the manager of a publicly traded company and you face the same choice, I am afraid that you cannot impose your patriotic or moral judgments on your stockholders. Not only are many of them foreign investors (with a very different sense of what comprises patriotism), but quite a few of them will part ways with you on your judgment that maximizing taxes paid  to the government is a moral calling.

    YouTube Video


    Blog Posts in this series
    1. Divergence in the Drug Business: Pharmaceuticals and Biotechnology
    2. Checkmate or Stalemate? Valeant's Fall from Grace
    3. Runaway Stories and Fairy Tale Endings: The Theranos Lesson
    4. Value and Taxes: Breaking down the Pfizer- Allergan Deal
    Datasets

    1. Tax Rates by Country
    Spreadsheets






    Runaway Stories and Fairy Tale Endings: The Cautionary Tale of Theranos

    I saw the new Steve Jobs movie, with the screenplay by Aaron Sorkin, over the weekend. As a long-time Apple user and investor, I must confess that I was bothered by the way in which the film played fast and loose with the facts, but I also understand that this is a movie. Sorkin clearly saw the benefit of using the launches of the Macintosh in 1984 and the iMac in 1997 as the bookends of the movie and the tortured relationship between Jobs and his daughter to create an emotional impact, and took dramatic license with the truth. As I watched the movie though, I kept thinking about Theranos, a company with a gripping narrative and a CEO who, like Steve Jobs, wears only black and who seemed headed for a biopic until a few weeks ago.

    The Theranos Story: The Build Up

    The Theranos story has its beginnings in March 2004, when Elizabeth Holmes, a 19-year old sophomore at Stanford, dropped out of college and started the company. The company was a Silicon Valley start-up with a non-Silicon Valley focus on an integral, but staid part, of the health care experience, the blood test. Ms. Holmes, based on work that she had been doing in an Stanford lab on testing blood for the SARS virus, concluded that she could adapt technology to allow for multiple tests to be run on much smaller quantities of blood than the conventional tests did and a quicker and more efficient turn around of results (to doctors and patients). In conjunction with her own stated distaste for the needles required for conventional blood tests, this became the basis for the Theranos Naotainer, a half-an-inch tube containing a few drops of blood that would replace the multiple blood containers used by the conventional labs.


    The story proved irresistible to just about everyone who heard it, her professor at Stanford who encouraged her to start the business, the venture capitalists who lined up to provide her hundreds of millions of dollars in capital and health care providers who felt that this would change a key ingredient of the health care experience, making it less painful and cheaper. The Cleveland Clinic and Walgreens, two entities at different ends of the health care spectrum, both seemed to find the technology appealing enough to adopt it. The story was irresistible to journalists, and Ms. Holmes quickly became an iconic figure, with Forbes naming her the “the youngest, self-made, female billionaire in the world” and she was the youngest winner of "The Horatio Alger award" in 2015.

    From the outside, the Theranos path to disrupting the business seemed smooth. The company continued to trumpet its claim that the drop of blood in the Nanotainer could run 30 lab tests and deliver them efficiently to doctors, going as far as listing prices on its website for each test that were dramatically lower (by as much as 90%) than the status quo. In venture capital rankings, Theranos consistently ranked among the most valuable private businesses with an estimated value in excess of $9 billion, making Ms. Holmes one of the richest women in the world. The world seemed truly at her feet and reading the news stories, the disruption seemed imminent.
    Source: Wall Street Journal

    The Theranos Story: The Let Down
    The Theranos story started to come apart on October 16, when a Wall Street Journal article reported that the company was exaggerating the potential of the Nanotainer and that it was not using it for the bulk of the blood tests that it was running in house. More troubling was the article’s contention that senior lab employees at the company found that the nanotainer’s blood test results were not reliable, casting doubt on the science behind the product.

    In the following days, things got worse for Theranos. It was reported that the FDA, after an inspection at Theranos, had asked the company to stop using the Nanotainer on all but one blood test (for Herpes) because it had concerns about the data that the company had supplied and the product's reliability. GlaxoSmithKline, which Ms. Holmes had claimed had used the product, asserted that it had not done business with the start up for the previous two years and the Cleveland Clinic also backed away from its adoption. Theranos initially went into bunker mode, trying to rebut the thrust of the critical articles rather than dealing with the substantial questions. It was not until October 27 that Ms. Holmes finally agreed that presenting the data that the Nanotainer worked as a reliable blood testing device would be the most “powerful thing” that the company could do. It is entirely possible that the data that the company has promised to deliver will be so conclusive that all doubts will be set aside, but it does seem like the spell has been broken. 

    The Lessons
    Looking back at the build up and the let down on the Theranos story, the recurring question that comes up is how the smart people that funded, promoted and wrote about this company never stopped and looked beyond the claim of “30 tests from one drop of blood” that seemed to be the mantra for the company. I don’t know the answer to the question but I can offer three possible reasons that should operate as red flags on future young company narratives:
    1. The Runaway Story: If Aaron Sorkin were writing a movie about a young start up, it would be almost impossible for him to come up with one as gripping as the Theranos story: a nineteen-year old woman (that already makes it different from the typical start up founder), drops out of Stanford (the new Harvard) and disrupts a business that makes us go through a health ritual that we all dislike. Who amongst us has not sat for hours at a lab for a blood test, subjected ourselves to multiple syringe shots as the technician draw large vials of blood, waited for days to get the test back and then blanched at the bill for $1,500 for the tests? To add to its allure, the story had a missionary component to it, of a product that would change health care around the world by bringing cheap and speedy blood testing to the vast multitudes that cannot afford the status quo. The mix of exuberance, passion and missionary zeal that animated the company comes through in this interview that Ms. Holmes gave Wired magazine before the dam broke a few weeks ago. As you read the interview, you can perhaps see why there was so little questioning and skepticism along the way. With a story this good and a heroine this likeable, would you want to be the Grinch raising mundane questions about whether the product actually works?
    2. The Black Turtleneck: I must confess that the one aspect of this story that has always bothered me (and I am probably being petty) is the black turtleneck that has become Ms. Holmes’s uniform. She has boasted of having dozens of black turtlenecks in her closet and while there is mention that her original model for the outfit was Sharon Stone, and that Ms. Holmes does this because it saves her time, she has never tamped down the predictable comparisons that people made to Steve Jobs. If a central ingredient of a credible narrative is authenticity, and I think it is, trying to dress like someone else (Steve Jobs, Warren Buffett or the Dalai Lama) undercuts that quality. 
    3. Governance matters (even at private businesses): I have always been surprised by the absence of attention paid to corporate governance at young, start ups and private businesses, but I have attributed that to two factors. One is that these businesses are often run by their founders, who have their wealth (both financial and human capital) vested in these businesses, and are therefore as less likely to act like “managers” do in publicly traded companies where there is separation of ownership and management. The other is that the venture capitalists who invest in these firms often have a much more direct role to play in how they are run, and thus should be able to protect themselves. Theranos illustrates the limitations of these built in governance mechanisms, with a board of directors in August 2015 had twelve members: 
    4. Board MemberDesignationAge
      Henry KissingerFormer Secretary of State92
      Bill PerryFormer Secretary of Defense88
      George SchultzFormer Secretary of State94
      Bill FristFormer Senate Majority Leader63
      Sam NunnFormer Senator77
      Gary RougheadFormer Navy Admiral64
      James MattisFormer Marine Corps General65
      Dick KovocovichFormer CEO of Wells Fargo72
      Riley BechtelFormer CEO of Bechtel63
      William FoegeEpidemologist79
      Elizabeth HolmesFounder & CEO, Theranos31
      Sunny BalwaniPresident & COO, TheranosNA
    I apologize if I am hurting anyone’s feelings, but my first reaction as I was reading through the list was “Really? He is still alive?”, followed by the suspicion that Theranos was in the process of developing a biological weapon of some sort. This is a board that may have made sense (twenty years ago) for a defense contractor, but not for a company whose primary task is working through the FDA approval process and getting customers in the health care business. (Theranos does some work for the US Military, though like almost everything else about the company, the work is so secret that no one seems to know what it involves.) The only two outside members that may have had the remotest link to the health care business were Bill Frist, a doctor and lead stockholder in Hospital Corporation of America, and William Foege, worthy for honor because of his role in eradicating small pox. My cynical reaction is that if you were Ms. Holmes and wanted to create a board of directors that had little idea what you were doing as a business and had no interest in asking, you could not have done much better than this group of septuagenarians.

    My sense of Ms. Holmes's unquestioned authority was reinforced when I read a December 2013 letter that she sent to investors in the company, asking them to agree to a five for one stock split and the creation of two classes of shares with different voting rights (class A would have one vote per share and class B would get 100 votes per share), with Ms. Holmes retaining the voting shares and voting control of the company. Lest I be accused of being sexist in begrudging her this power, I have been just as harsh in my assessments of Mark Zuckerberg (with Facebook) and the Brin/Page duo (with Google) for their desire to raise money from investors but not give them a proportional say in how the business gets run, and Ms. Holmes has not quite earned the rights (that Zuckerberg and Brin/Page have claimed) to be a corporate dictator.

    Bottom Line
    I would like to believe that I would have asked some fundamental questions about the science behind the product and how it was faring in the FDA approval process, if I had been a potential investor or journalist. However, it is entirely possible that listening to the story, I too would have been tempted to go along, wanting it so much to be true that I let hope override good sense. Some of my worst mistakes in investing (and life) have been when I have fallen in love with a story so much that I have willed a happy ending to it, facts notwithstanding.

    The question of whether Theranos makes it back to being a valuable, going concern rests squarely on the science of its product(s). If the Nanotainer is a revolutionary breakthrough and what it needs is scientific fixes to become a reliable product, there is hope. But for that hope to become real, Theranos has to be restructured to make this the focus of the business and become much more transparent about the results of its tests, even if they are not favorable. Ms. Holmes has to scale back many of her high profile projects (virtuous and noble though they might be) and return to running the business. If the Nanotainer turns out to be an over hyped product that is unfixable, because it is scientifically flawed, Theranos has a bleak future and while it may survive, it will be as a smaller, low profile company. The investors who have put hundreds of millions in the company will lose much of that money but as I look at the list, I don’t see any of them entering the poor house as a consequence. There is a chance that the lessons about not letting runaway stories stomp the facts, never trusting CEOs who wear only black turtlenecks and caring about governance and oversight at even private businesses may be learned, but I will not hold my breath expecting them to have staying power.

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    Blog Posts in this series
    1. Divergence in the Drug Business: Pharmaceuticals and Biotechnology
    2. Checkmate or Stalemate? Valeant's Fall from Grace
    3. Runaway Stories and Fairy Tale Endings: The Theranos Lesson
    4. Value and Taxes: Breaking down the Pfizer- Allergan Deal





    Checkmate or Stalemate? Valeant's Fall from Investing Grace

    In my last post, I looked at how the pharmaceutical and biotechnology businesses have diverged, especially in the last decade, and the implications for earnings, R&D and market pricing of these companies. The pharmaceutical business, in particular, faces a new landscape with many companies still stuck with a business model that does not work in delivering value, as growth eases and margins come under pressure. It is no surprise therefore that investors are looking for a drug company with a new business model, and that may explain the meteoric rise of Valeant over the five years, making its recent collapse all the more shocking.

    Valeant: The Rise

    The best way to illustrate Valeant's rise in the drug business is trace its history in numbers. The graph below looks at the time line of revenues, operating income and net income from 1993 to the the last twelve months ending in September 2015:
    As you can see, the inflection point is in 2010, when Valeant went from a company with small, slow-growing revenues into hyper speed, increasing revenues almost ten fold between 2010 and 2015. That increase in revenues was accompanied by increases in operating income and net income, albeit smaller in proportional terms. The story of how Valeant was able to accelerate its growth has been widely told, but the numbers again tell it better.
    YearR&DAcquisitionsR&D/SalesAcquisitions/Sales
    2005$69.42 $- 7.40%0.00%
    2006$77.80 $- 7.29%0.00%
    2007$100.61 $- 11.94%0.00%
    2008$69.81 $101.90 9.22%13.46%
    2009$47.58 $- 5.80%0.00%
    2010$67.91 $(308.98)5.75%-26.16%
    2011$65.69 $2,464.10 2.71%101.51%
    2012$79.10 $3,485.30 2.27%100.14%
    2013$156.80 $5,253.50 2.72%91.12%
    2014$246.00 $1,102.60 2.98%13.35%
    LTM$297.60 $14,123.20 2.98%141.46%
    The growth has been driven almost entirely by acquisitions, totaling $26.4 billion since 2010. Looking closer at the 23 acquisitions that Valeant has made since 2013, the company has bought more private businesses (18 out of the 23) than public, though a very large proportion of the total cost can be accounted for with two acquisitions, one of a public company (Salix for $12.5 billion) and one of a private business (Bausch and Lomb for $8.7 billion. Valeant seems to have also paid for almost all of these acquisitions with cash, which raises the interesting follow up question of where they came up with the cash. Again, the answer is in the numbers, with the chart below providing a breakdown of funding sources during the period from 2011-2015, the peak period for Valeant's acquisitions:
    Source: Valeant Statement of Cash Flows

    At least during this period, the market liked the Valeant business model of growth through acquisitions, and delivered its verdict by pushing up Valeant's market capitalization and pricing multiples.

    Valeant: The Fall
    It is perhaps because Valeant rose so quickly from its mid-cap status to become a star that its precipitous fall has been so shocking. The decline started with a report, on October 19, on a court filing in California and picked up steam when it was highlighted on October 21 by Citron, an outfit that has long been critical of Valeant's accounting and operating practices. That report claimed that Valeant had hidden a relationship with shadowy pharmacy entities and that it had used that relationship to cook its books. While some were quick to dismiss the report as motivated by Citron's short position in Valeant, the report triggered scrutiny and Valeant's initial explanations satisfied no one and the market reacted accordingly:

    Recognizing that it faced a major market calamity, Valeant called a press conference on October 26, where they tried to clear the air, succeeding only in making it murkier by the time they were done. In the days since, the piling on has begun with even long time investors in the company finding aspects of the company that they had never liked. The stock price dropped below $80 per share on November 5, down more than 60% from its peak in August. In fact, things have gotten so bad that the CEO of Valeant, Michael Pearson, was forced to sell $100 million of his shares in the company to cover a margin call.

    Valeant's Business Model
    The formula that Valeant used to grow exponentially, i.e., acquiring smaller companies and bringing them under one corporate umbrella, is not new, and given the mixed track record of companies that have tried it, it is not generally greeted with the rapturous response that Valeant received. To add to the puzzle, many of the investors who were drawn to the stock were from the old-time value investing crowd, with the Sequoia Fund and Bill Ackman among its biggest cheerleaders. So, what is it that attracted these presumably hard-headed investors to the Valeant business model?
    1. Buy low, sell high:  I believe that value investors were attracted to Valeant because it seemed to adapt an old-time value investing maxim of buying "cheap and selling expensive" to the drug market. At the risk of over simplifying Valeant's strategy, a central focus of its acquisition strategy was buying companies that owned the rights to "under priced" drugs and repricing to what the market would bear
    2. Use debt capacity: One of the enduring mysteries of the drug business, where mature companies have large and stable cash flows from developed drugs, is why these companies do not borrow more to take advantage of the tax code's tilt towards debt. As you can see from the funding pie chart above, Valeant seemed to have no qualms about using its borrowing capacity to fund its acquisitions. 
    3. R&D is not sacred: In my last post on the drug business, I noted the reduced payoff (in growth) to R&D expenditures at pharmaceutical companies and the unwillingness on the part of these companies to draw back their R&D expenditures. Again, Valeant seemed to be one of the few companies in the business that viewed R&D like any other capital investment and scaled it back, as the payoff decreased.
    4. Quick conversion into earnings: Many acquisitive companies fail at converting great sounding stories into earnings, but Valeant seemed to be exception. Its acquisitions seemed to translate quickly into revenues and operating income, vindicating their strategy, though you had to take the company's word that its acquisition-related expenses were transitional and one-time charges. As an added bonus, Valeant used its acquisition-related expenses to keep its tax bill low, getting tax credits from 2011 to 2013 and keeping its effective tax rate below 10% in the most recent twelve months.
    The collapse of Valeant's stock price has created more than the usual second guessing and rewriting of history, with some glee mixed in, given the pedigree of the investors who have lost money on the company. While my deep seated skepticism about acquisitions has meant that I was never tempted to buy Valeant, even in the good times, I understand its appeal to investors. In a business (pharmaceuticals), where inertia and denial seem to drive management decisions at most companies, Valeant looked like an outlier with a business template that worked.

    Game Changer?
    I have argued in prior posts that big shifts in intrinsic value don't come from earnings surprises or market panics, but from big changes in narrative. The question that investors (both current and potential have to ask about Valeant is whether the company narrative has been altered enough by the news stories that we are reading for it to lose more than half of it's value. If you accept my description of the Valeant business model (acquisitions focused on repricing drugs, funded with debt and quickly converted into earnings), there is reason to believe that a critical portion of the Valeant's business model is broken and cannot be fixed.
    1. Health care is different: Unlike perfume, soda or an automobile, where charging what the customer will pay is exactly what businesses should aspire to do, it seems inhumane and perhaps even immoral to push prices up 60% or 70% for medicine that patients need.  Even if you don't have moral objections to the practice, you may still have issues with it as a citizen and taxpayer, since these costs are spread across all of us through the health insurance system. It is surprised that Valeant has not been subject to more scrutiny for this practice, but  it was becoming clear even before the recent blow up that the company was drawing attention, as evidenced by this article in the New York Times on October 14 (a few days before the short seller stories appeared in the press). Now that Valeant is in the public eye, there is no way that, even if this scandal passes, they can return to anonymity. Every drug price increase for a Valeant drug will be held up to scrutiny and subject to second guessing and any target company that want to fight off a Valeant acquisition bid will now be pre-armed. 
    2. Distribution network: The distribution and sale of drugs is different from most other conventional businesses, with doctors, pharmacies and insurance companies all operating in constrained environments,  with the constraints becoming more binding with changes in health care laws. Thus, doctors are asked to consider the relative prices of drugs when writing prescriptions and pharmacies are under pressure from insurance companies to consider cost when filling these prescriptions. As I read the news stories about the pharmacies controlled by Valeant, my suspicion is that the company used this  convoluted network (see the picture below from the Globe and Mail about Valeant's holdings)  to extract higher prices through to insurance companies and patients, rather than as device to cook its accounting books. Now that the relationship has come to light, it is probable and perhaps even likely that if this type of relationship is legal now, it will get more regulated or even banned in the future.
    3. Accounting games: Part of Valeant’s rise can be attributed to the laziness of analysts, who apply multiples (that they pull from a cursory assessment of the comparable) on pro forma earnings, and some of it to the debris of acquisition accounting (goodwill, impairment of goodwill and acquisition-related restructuring charges).  I have written before about the damage that goodwill does to both accounting statements and to good sense, but the degree to which acquisition accounting has muddied up the numbers at Valeant can be captured by looking at how they have taken over Valeant's financials in the last 5 years:
      Source: Valiant Financial Statements
    4. Complexity: Valeant is a complex company, and its complexity is brought home by both the bulk of its annual filing (its last 10K from 2014 runs 537 pages) and its detail. That complexity comes partly from its strategy of growing through acquisitions and partly from the accounting for acquisitions, but some of it is clearly by design (with the pharmacy network and chess names for holdings).  Complexity is a double-edged sword, though, since in good times, investors assume the best about the things that they do not know or understand and in bad times, the fog created by complexity creates a backlash. 
    As with every scandal, I am sure that there will be new revelations and news stories in the week ahead, some pointing to accounting problems, some to business model failures and some to legal jeopardy. Even if Valeant emerges unscathed legally from this mess, I just don’t see how they can revert to their old business model, and it is not clear to me that without it, they are anything more than a middling pharmaceutical company.

    The Bottom Line
    Does the imminent collapse of Valeant's core business model imply that I agree with the short sellers who have used the Enron analogy to argue that this company is a shell worth nothing? No, and here is why. Unlike Enron, a company that used special purpose entities and complex holdings to hide it debt and had no assets with tangible value at the time of its troubles, Valeant pharmacy holdings seem designed more for pricing power than accounting sleight of hand and it owns assets that have real value. Thus, even if Valeant's capacity to grow productively is removed tomorrow, it will still have value as a going concern or as a collection of assets.

    Going concern value

    If Valeant is able to make it through its troubles intact, one option that is available to it is to become a more conventional drug company, resting on R&D for (low) growth and making money of its established products. To value Valeant in this scenario, here are the assumptions that I made:
    • Base year earnings: One of the positive effects of suspending an acquisition-driven strategy is that the expenses associated with acquisitions should also dissipate. Consequently, I added back acquisition-related expenses (impairment of goodwill, acquisition charges) to operating income to get to an adjusted operating income for the last twelve months. (Update: As some of you have pointed out, the most twelve months of financials include only six months that include Salix and thus understate revenues and operating income. To remedy this, I need to bring in Salix's revenues and operating income from the last quarter of 2014 and the first quarter of 2015 into my trailing numbers. Unfortunately, Salix did not file a first quarter earnings report for this year, but here is an approximation. In 2014, Salix generated $1.134 billion in revenues but reported an operating loss. If you assume that revenues come in evenly over the year and you allow for the operating margin of 25.51% that Salix earned in 2012 & 2013, you get revenues of about $567 million and operating income of $145 million for the missing quarters. Adding these to the trailing 12 month numbers increases the value per share to $77. A more optimistic take, where Valeant is able to earn its higher operating margin increases the value per share to $81. The bottom line is that bringing in Salix's bump to revenues and operating income, which is likely to create growth in the next twelve months, pushes up value per share but not by enough to change my basic conclusion, which is that the stock is, at best, fairly valued.)
    • Pricing backlash: I assumed that the controversy over Valeant's drug pricing strategy will result in roll backs of price increases on some of its drugs, resulting in a permanent drop of 10% in earnings. (Update: Though this number seems to come out of left field (and it is subjective), it comes from lowering Valeant's pre-tax operating margin (prior to adjustments) of 28.3% towards that of other drug companies which is 25.5%; the drop of 2.8% is roughly the 10% drop. I am also assuming that once the losses from prior acquisitions roll off, the tax rate will move up to 20%, lower than the tax rate paid by US pharmaceutical companies, reflecting the company's Canadian base.)
    • Low growth: If Valeant follows the standard pharmaceutical company practice of investing in R&D and hoping for payoffs, its expected growth rate will drop to anemic levels (as suggested by my last post on drug companies). I will assume a 3% growth rate in earnings for the next 10 years, well below the 20% posted by Valeant over the last 5 years, but much of that growth was acquired. (Update: I know that management is forecasting 10% from organic growth. That may very well be true for next year, as the Salix bump kicks in, but it is tough to sustain thereafter, with substantially increasing R&D.)
    • R&D spending: I will assume that Valeant will have to invest in R&D to keep this growth going, and in my valuation, that investment will reflect the return on capital of 15.25% that I have estimated for the company (with the adjusted earnings).
    • Cost of capital: Factoring in both the good side of Valeant's high debt ratio (the tax effected cost of debt) and the bad side (higher cost of debt and equity) and the revenue exposure for Valeant (75% from developed markets, 25% from emerging markets), I estimate a cost of capital of 7.52%.
    The value that I estimate for Valeant's equity, on a per share basis, is $72.10, which is about 14% lower than the price of $83.64 at the close of trading on November 10. Your views on Valeant may be very different from mine, and you are welcome to use my spreadsheet to reflect those views. The table below summarizes the effect on value per share of varying some of the assumptions:
    Spreadsheet with valuation
    Given my perspective on the company, and it is undoubtedly flawed, I don't see Valeant as a significantly under valued stock, in spite of the price drop over the last few weeks. I also don't see it as bubble waiting to burst, a stock heading towards being worth nothing. For the moment, I think will sit on the sidelines and watch.

    Sum of the parts
    If this scandal has legs and not only lingers, but creates legal problems that taint Valeant as a corporation, there is a second option. Just as Valeant’s rise in value was built on additions, you could create a reverse strategy where value is generated by subtraction. Thus, Valeant could sell itself piece by piece (drugs and divisions) to the highest bidders, since each piece will be worth more to an untainted buyer than it would be worth to Valeant. If this is the optimal path, it will be interesting to see if this team that has built the company up over the last five years is willing to set aside hubris and break it down over the next few years.

    The Bottom Line
    The Valeant story reinforces many of my existing biases against companies that grow primarily through acquisitions. I am willing to concede that this strategy can pay off, if companies maintain discipline, but my experience with these companies is that they inevitably hit a wall, either because they become too large to stay disciplined or because the accounting creates too many opportunities to obfuscate and hide problems. While Valeant's attempt at creating a new model for a drug business may have failed, that does not make the existing drug company model a success either. The search has to go on!

    YouTube Version


    Blog posts in this series
    1. Valeant 10K and 10Q
    2. Valeant historical financials

    Spreadsheets
    1. Valeant Valuation in November 2015






    Divergence in the Drug Businesses: Pharmaceuticals and Biotechnology

    In the last two weeks, I have started writing about Pfizer’s courting of Allergan, the epic fall of Valeant and the unraveling of the Theranos story, but I have held back because all three stories have to be set against the backdrop of the changing health care business. While there are numerous stories being told about how this is changing, I decided that it made sense to start by looking at the evolution of the health care business over the last 25 years  and how changes in its core characteristics may explain all three stories.

    The Story
    To understand the drug business, I went back to 1991, towards the beginning of a surge in spending in the US on health care. The pharmaceutical companies at the time were cash machines, built on a platform of substantial up front investments in research and development. The drugs generated by R&D that made it through FDA approval and into commercial production were used to cover the aggregated cost of R&D and to generate significant excess profits. The key to this process was the pricing power enjoyed by the drug companies, the result of a well-defended patent system, significant growth in health care spending, splintered health insurance companies and lack of accountability for costs at every level (from patients to hospitals to the government). In this model, not surprisingly, investors rewarded pharmaceutical companies based on the amounts they spent on R&D (secure in their belief that the costs could be passed on to customers) and the fullness and balance of their product pipelines.

    So, how has the story changed over the last decade? The rise in health care costs seems to have slowed down and the pricing power of drug companies has waned for many reasons, with Obamacare being only one of many drivers. First, we have seen more consolidation within the health insurance business, potentially increasing their bargaining power with the pharmaceutical companies on drug prices. Second, the government has used the buying clout of Medicaid to bargain for better prices on drugs, and while Medicare still works through insurance companies, it can put pressure on them to negotiate for lower costs. Third, the pharmacies that represent the distribution networks for many drugs have also been corporatized and consolidated, and are gaining a voice in the pricing process. The net effect of all of these changes is that R&D has much more uncertain payoffs and has to evaluated like any other large capital investment, that it is good only when it creates value for a business. Consequently, investors have had to become more measured in their judgment of R&D spending at drug companies, rewarding companies for spending more on R&D only if it is productive and punishing them when it is not.

    The Operating Numbers
    The diminished pricing power story is not a new one and others have made the points that I have but it is still just a story. The real question is whether the numbers back the story and to answer that question, I looked at key operating metrics for publicly traded drug companies from 1991 to 2014, with the intent of eking out trends in the numbers.
    The Revenue Growth Story: The Rise of Biotech
    The growth in health care costs continued into the last decade, albeit at levels much more moderate than in the 1990s, but the big story was the rise of biotechnology companies in the space. At inception, the distinction between pharmaceutical and biotech companies wass the method by which they produced drugs, with pharmaceutical firms working with chemicals and biotechnology companies using live organisms (bacteria, cells or yeast) to generate their drugs. Given that both R&D processes are designed to generate drugs that go through similar FDA approval processes and get sold through the same distribution channels, this difference is one that only scientists can relate to, and one that is becoming meaningless as R&D departments at both groups poach on the other's territory. The rest of the differences that people point to between the two, i.e, that biotech companies spend more time on research, tend to lose money and are riskier than pharmaceutical firms have less to do with business differences than life cycle differences.

    In the picture below, I look at the aggregate revenues reported by pharmaceutical and biotechnology companies from 1991 to 2014.
    Source: Classification by S&P Capital IQ
    Note that by the last decade, and especially since 2010, almost all of the growth in the drug business has come from the biotech companies, with pharmaceutical companies reporting flat revenues between 2010 and 2014. In 2014, biotech companies accounted for 30.63% of total revenues at drug companies, up from 19.23% in 2010.


    The generalization that biotech companies tend to be younger and earlier in the life cycle is being put to the test as some biotech companies age. In 2014, for instance, four of the top ten drug companies in the US, in revenues, were biotechnology companies.

    Company NameIndustry ClassificationsRevenues in 2014
    Johnson & Johnson (NYSE:JNJ)Pharmaceuticals (Primary)$74,331.00
    Pfizer Inc. (NYSE:PFE)Pharmaceuticals (Primary)$49,605.00
    Merck & Co. Inc. (NYSE:MRK)Pharmaceuticals (Primary)$42,237.00
    Gilead Sciences Inc. (NasdaqGS:GILD)Biotechnology (Primary)$24,890.00
    Amgen Inc. (NasdaqGS:AMGN)Biotechnology (Primary)$20,063.00
    AbbVie Inc. (NYSE:ABBV)Biotechnology (Primary)$19,960.00
    Eli Lilly and Company (NYSE:LLY)Pharmaceuticals (Primary)$19,615.60
    Bristol-Myers Squibb Company (NYSE:BMY)Pharmaceuticals (Primary)$15,879.00
    Allergan plc (NYSE:AGN)Pharmaceuticals (Primary)$13,062.30
    Biogen Inc. (NasdaqGS:BIIB)Biotechnology (Primary)$9,700.30
    In fact, many of these companies have blurred the line between pharmaceutical and biotechnology companies further, and some like Pfizer describe themselves as biopharmaceutical companies.

    The Money Machine: Profitable but for how long?
    In keeping with the hgh pricing power story, pharmaceutical companies have always been able to enjoy sky-high operating margins, a fact rendered even more impressive by the fact that the accounting at these companies treats R&D, the biggest capital expenditure that these firms have, as an operating expense (thus depressing reported profits and margins). In the graph below, I look at the evolution of operating margins at pharmaceutical and biotech companies from 1991 to 2014, using two measures, one looking at operating profit (EBIT) as a percent of sales and one with R&D added back to operating income (EBITR&D) estimates as a proportion of sales.
    Ratios based on aggregated values of Sales, EBIT and R&D
    On the surface, at least, no one will shed tears for pharmaceutical companies since companies in most other sectors would gladly trade for their margins. In fact, while operating margins for pharmaceutical companies have dropped from their highs in 2001 and 2002, they are not very different from what they were in the 1990s. The story again, though, is in the biotech space, where companies have moved from losing money in the early 1990s to collectively generating higher margins than pharmaceutical firms, with the difference being even more pronounced on a pre-R&D basis.

    The Payoff to R&D: No longer a slam dunk!
    The argument for spending money on R&D has always been a simple one. By investing in R&D, you are investing for future growth and it is an equation that has held well for much of the last 25 years. In the table below, I report revenue growth and R&D expenses as a percent of sales each year for pharmaceutical and biotech companies each year from 1991 to 2014.


     Pharma
     Biotech
    YearR&D/SalesRevenue GrowthGrowth to R&DR&D/SalesRevenue GrowthGrowth to R&D
    199110.17%49.30%4.8526.22%1444.23%55.08
    199210.64%6.40%0.6023.80%82.91%3.48
    199310.97%3.58%0.3326.87%48.36%1.80
    199410.30%15.85%1.5433.50%27.66%0.83
    199510.37%17.32%1.6731.72%42.99%1.36
    199610.44%11.38%1.0934.18%18.61%0.54
    199710.61%13.20%1.2437.80%14.23%0.38
    199811.15%19.92%1.7933.44%21.49%0.64
    199911.08%15.66%1.4137.39%0.32%0.01
    200011.41%8.15%0.7138.46%4.79%0.12
    200113.74%-8.17%-0.5940.23%11.96%0.30
    200213.95%4.80%0.3439.19%11.34%0.29
    200314.72%16.26%1.1033.86%44.21%1.31
    200414.79%8.17%0.5533.43%35.49%1.06
    200515.40%1.49%0.1031.43%19.26%0.61
    200616.08%2.86%0.1833.49%19.43%0.58
    200716.21%8.57%0.5333.76%14.29%0.42
    200815.94%6.21%0.3930.35%15.20%0.50
    200915.58%-4.87%-0.3122.18%54.79%2.47
    201015.17%19.82%1.3121.25%11.42%0.54
    201114.30%3.77%0.2619.19%22.76%1.19
    201214.48%-2.99%-0.2119.53%10.52%0.54
    201314.28%2.34%0.1620.80%10.50%0.51
    201414.36%1.67%0.1219.04%29.59%1.55
    1991-9510.49%18.49%1.8028.42%329.23%12.51
    1996-0010.94%13.66%1.2536.26%11.89%0.34
    2001-0514.52%4.51%0.3035.63%24.45%0.71
    2006-1015.80%6.52%0.4228.21%23.02%0.90
    2011-1414.36%1.20%0.0819.64%18.34%0.95
    I know that there is a substantial lag between R&D spending and revenue growth, but as a simplistic measure of the contemporaneous payoff to R&D, I computed a growth to R&D ratio:
    Growth to R&D Ratio = Revenue Growth Rate/ R&D Spending as percent of sales
    Notwithstanding its limitations, this ratio illustrates the biggest divergence between the two subsectors, dropping close to zero for pharmaceutical firms from 2010-14 time period, while remaining relatively healthy (though lower then in earlier periods) for biotech companies. 

    What does this all mean? First, this table suggests that pharmaceutical companies have not cut back on internal R&D spending as much as some stories suggest that they have and that much of the slack has been picked up by biotech companies. Second, this table also suggests that pharmaceutical companies should be spending less money on R&D, not more, as the growth payoff to R&D becomes lower and lower. Third, it provides at least a partial explanation for why some pharmaceutical companies have embarked on the acquisition path, focusing on buyer younger, smaller companies for the products in their research pipeline. 

    The Pricing
    As the operating metrics for pharmaceutical and biotech companies have changed, the market has also adjusted to reflect these changes, though the argument always can be made that it has adjusted too slowly and not enough or too fast and too much.

    Market Capitalization
    If markets are assessing companies on fundamentals, the market capitalization should reflect everything that we have talked about in the last section. Rather than take that on faith, I looked at the aggregate market capitalizations of pharmaceutical and biotechnology companies from 1991 to 2014:
    Aggregate Market Capitalization at end of each calendar year

    In 2014, biotechnology companies accounted for 38.16% of the total market capitalization of drug companies, up from 26.87% of value in 2010.

    EV Multiples
    Bringing the changes in operating metrics and market value over time into one measure is difficult partly because biotechnology companies have lost money for the bulk of the last 25 years. The only multiple that can be computed for both groups is the ratio of enterprise value ( to earnings before interest, taxes and R&D (EBITR&D) and the graph below captures the shifts over time:
    Biotech companies traded at huge multiples in the late 1990s, partly because they earned so little and were being priced for future growth. As they have became larger contributors to earnings in the drug business, the multiple at which they trade has come down and both groups traded at roughly similar multiples of EBITR&D in 2008 and 2009. Since 2010, though, the multiple of EBITR&D at which biotech companies trade has risen relative to pharmaceutical companies.

    The Aging of the Drug Business
    As many of you have been reading this blog know, one of my favorite devices for explaining shifts in businesses and companies is the corporate life cycle. As companies age, not only should the focus change but so will the way investors judge them:

    Just as the aging of technology companies has created more diversity in that space, an argument that  I made in this post, the health care business is showing signs of aging. The older, more established companies in the business, for the most part, are in their mature phases, and not surprisingly, their focus has shifted to consolidation, capital structure changes and tax management. The younger companies in the space will increasingly carry the burden of investing for growth, but will have to be far more disciplined in their R&D spending than their older counterparts were two decades ago. If health care cost growth continues to be contained and drug company pricing power remains muted, you should expect to see less aggregate spending on research and development at drug companies. While that will undoubtedly provoke hand wringing on the part of experts, pundits and politicians, it is the logical consequence of a changing health care landscape.

    YouTube Version




    Intergalactic Finance: Valuing the Star Wars Franchise

    I saw the newest Star Wars movie last week and it brought back memories that stretch back almost four decades. Watching Harrison Ford and Carrie Fisher on the screen reminded me of my age, though, once I learned how much Ford made for being in this episode, I understood the movie's story line much better. As I came out of the theater, though, I decided that it would be fun to update a valuation I did of the Star Wars franchise in 2012, when Disney acquired the rights from Lucas Films.

    The Movies- Box Office Bonanza
    If you are one of the few people on the face of the earth that has not followed the Star Wars story, it began in 1977 when George Lucas produced the first Star Wars movie, the fourth episode in what he saw as a six-episode series. That movie made history and remains one of the highest grossing movies of all time. It was followed in 1980 by the fifth episode, The Empire Strikes Back (my favorite), and in 1983 with the sixth in the series, The Return of the Jedi.  Those first three movies created an entire generation of Star Wars fans, who then had to wait 16 years for the first in the series, The Phantom Menace (my pick for the worst of the series), which was followed  by Attack of the Clones in 2002 and Revenge of the Sith in 2005. The six movies represent one of the most valuable movie franchises of all time, generating billions of dollars in box office receipts, with the appeal spreading globally.
    The movies are shown in chronological order and the box receipts on the first three movies include the collections from their re-release in theaters in the 1990s.

    The Add-Ons - Bigger than the Movies?
    If you stopped just at box receipts, Star Wars might not be the most valuable franchise at all time, lagging the James Bond movies and perhaps even the Harry Potter and Lord of the Rings franchises. It is the magnitude of the add-ons to box receipts that make Star Wars unique and as someone who has partaken in all of them, I can attest to their power. I have owned the Star Wars tapes and DVDs, collected every Star Wars figure made, played Star Wars video games (very badly) and even used a GPS with a Yoda voice to drive from New York to Chicago (I love Yoda but he is a really bad navigator). The Star Wars empire stretches far and wide to include:
    1. VHS/DVD/Rentals: The additional revenue from this stream reflects as much the hold that Star Wars has had on our collective imaginations, as it does the changing of technologies for home video watching over the decades. Starting with video tapes (VHS) sales and rentals in the 1970s, morphing into DVD sales in the last decade and continuing into streaming in today's environment, this add-on has generated $7.7 billion (unadjusted for inflation) in revenues.
    2. Toys and Merchandise: This is the crown jewel of the franchise, as toy and merchandise sales have outstripped all other sources of revenue. The revenues from action figures sold by Kenner  (1978-1985) and Hasbro (1995-2011) amounted to almost $10 billion (unadjusted for inflation) and adding in other merchandise, the collective revenues from toys and merchandise over the history of the franchise is in excess of $12 billion. 
    3. Gaming: As with the video rentals, the Star Wars games track shifting technologies, starting with an unlicensed game for the Apple II on a cassette tape, followed by table-top game by Kenner and games for the Atari. Starting in 1992, the games shifted away from the films to the expanded Star Wars universe, first with the X-wing computer games and later with Dark Forces, a shooter game. In 2013, Disney revealed that Electronic Arts would retain the rights to produce games for PCs and consoles, while Disney would retain the rights for other platforms. The collective revenues from all of these games between 1977 and 2015 is $3.4 billion.
    4. Books: There have been almost 360 books, with 76 authors, in the Star Wars series and total sales have amounted to more than $1.8 billion. The staying power of the franchise is backed up by the fact that the first books were in print in 1978 and that there have been at least ten Star Wars novels a year, every year from 1991 to 2014.
    5. TV Series/Other: Given its success on so many dimensions, it is surprising that the Star Wars franchise has not spawned a higher profile TV series. The longest lived TV series, Clone Wars, has had seven seasons and a second one, Star War Rebels, produced by Disney, has had two seasons. There have been periodic rumors about other TV series in the works, with the latest one suggesting that Netflix is planning three live-action series
    The collective revenues from these add-ons make the Star Wars revenue pie much larger than any competing movie franchise:

    Note that the movie revenues in the table are not adjusted to 2015 $, since the revenues from the add-ons are not available in current dollars. In the table below, I scale the revenues from each of the add -ons to the box office receipts to get a measure of the value added from the rest of the Star Wars ecosystem:

    In effect, for every dollar that Star Wars has made at the box office, it has generated four dollars in revenues from other sources. That number is a conservative estimate, since there have been undoubtedly others who have profited from the franchise unofficially (and illegally).

    The New Series: Disney takes over
    In 2012, Disney acquired the Star Wars franchise for $4 billion, from George Lucas, with plans to produce three more Star Wars movies. At the time of the acquisition, I argued that it was a fair price, given Disney's history with developing, maintaining and merchandising franchises, but had to draw on the potential for synergy to justify the number. With the release of Star Wars: The Force Awakens just about ten days ago, Disney seems to be more than delivering on its promise, as the movie has broken box office records and is on its way to delivering a global box office of $2 billion or more.

    To the extent that this movie, like its predecessors, will generate add-on revenues, there will be substantially more money to be made over the next few years. The next two movies are scheduled for 2017 and 2019, and there will be three spin offs in the intermediate years, with less ambitious budgets. After 2020, Disney's plans are not specific, but if the appetite remains, there will be undoubtedly more movies in the pipeline. More importantly, the movies will not only create a new base of younger fans but augment the sales of merchandise, toys and games in the coming decade. The revenues that would have come from DVDs and video rentals will be replaced with streaming revenues and there will undoubtedly be games and apps directed at smartphones, devices and gaming systems. 

    Valuing the Franchise
    To value the franchise, I started with my estimates of worldwide box office receipts for Star Wars: The Force Awakens and the subsequent movies in the series. Though, the first two weekends have blown away expectations (with the movie making $1 billion), I will estimate $2 billion in revenues, for each of the three main movies, and half those proceeds for the spin offs, with an inflation adjustment of 2%.

    As with the prior movies, the bulk of the revenues from the franchise will come from add-ons, and in assessing the potential, here are some of my assumptions:
    1. Streaming: As viewers increasingly turn to watching streamed movies from services (Netflix, Amazon Prime) on their televisions and devices, the revenues from streaming are quickly catching up with box office receipts for movies, and by 2017, the total revenues from streaming are expected to exceed box office revenues. I will assume that each dollar in box office revenues from the new Star Wars movies will generate $1.20 in additional revenue in streaming, slightly higher than historical numbers (1.14).
    2. Toys/Merchandise: The Star Wars movies have historically generated $1.80 in revenues from toys/merchandise for every dollar in box office revenues. Given Disney's prowess at merchandising, I would not be surprised to see this number go up, and I will assume that each dollar at the box office will translate into two dollars in merchandising revenues, a little higher than the historical value of $1.80 per box office dollar. Keep in mind that this franchise is a merchandisers' dream, with an almost endless potential for new opportunities in the Expanded Universe.
    3. Books and eBooks: This is the stream that is perhaps most at risk, and I will assume that while a way will be found to adapt the publishing stream to changing tastes in reading, the revenues from this books/e-books will drop to $0.20 per box office dollar (from $0.27, the historical number).
    4. Gaming: In keeping with the history of Star War games, I am convinced that that games will be adapted not only to gaming platforms (Xbox, Playstation and Nintendo) but also to smartphones and tablets. I will leave the gaming revenues at $0.50 per dollar in box office receipts.
    5. TV Shows/Other: This is the one add-on where I will assume a significant improvement over historical numbers, as Disney, Netflix and others find ways to adapt the franchise to television viewers. I will assume that the revenues from TV shows will increase to $0.50 per dollar in box office receipts.
    Download Spreadsheet
    To estimate the franchise value, I used the operating margins of the movie (20.14%) and toy/merchandise businesses (15%) and netted out taxes (at a 30% tax rate), before discounting back at a 7.61% cost of capital, the entertainment sector average. (Disney will probably license most of the merchandise, passing of the risk to others, but settling for a share of the operating income.) At least based on my projections, the value of the Star Wars franchise, if it can maintain my estimated numbers (for add-ons) and deliver at the box office, is almost $10 billion. The value is obviously a function of movie revenues and the add-on dollar values:

    Not only does that make Disney's $4 billion investment three years ago a very good one, but any synergies that Disney can gain in its other businesses (like this one) will create more upside. As always, you are welcome to make your own assumptions and revalue the franchise, using this spreadsheet.

    An Acquisition Model that works?
    I am not a fan of acquisition-driven growth, primarily because the process so often leads to over paying for growth, but Disney may have found an acquisition model (albeit a limited one) that works with its Star Wars and Marvel acquisitions. In both cases, the company bought established movie franchises and has used its merchandising machine to generate value. Those results have already borne fruit with Marvel, especially with the Avenger movies, and we may be be seeing the beginnings of the Star Wars dividends this week. 

    During the week, while I was in the city (New York), I saw at least three Stormtroopers and a Darth Vader on Times Square and every store that I went into had something related to Star Wars, on sale. If you are a Star Wars purist, appalled by the shameless merchandising of the movie, I am afraid that you ain't seen nothing yet. If you are a Star Wars collector, and think that you have the entire collection already (for you or your kids), here is something for you to ponder. If you are a Disney stockholder like me,  may the force be with you!

    YouTube Video


    Attachments
    1. Star Wars: Valuing the Franchise (Spreadsheet)
    2. Star Wars: Franchise Value Picture (jpg file)





    The Compressed Tech Life Cycle: The Investor Challenge

    Much of what we learn and practice as investors represent models and methods developed in a different age, one where the market was composed of consumer product, infrastructure and manufacturing companies. While those lessons may have been good ones for old economy markets, I will argue in this post that they can provide misleading signals with short corporate life-cycles,  an affliction common among, but not unique to, tech companies. Lest this be construed as an attack on a specific group of investors, I will spread my critique across investor classes, starting with value investors, then moving on to growth investors and market timers and then turning it on intrinsic valuation practitioners (which is where I count myself).

    The Tech Challenge for Value Investors
    If you are a value investor, you may have been told that everything you need to know about valuation is in Ben Graham's Security Analysis. I will make a confession.  I love Ben Graham for his philosophy and intellect, but I think that using the techniques suggested in it to value tech companies is akin to using a hammer to do surgery. It is not Graham's fault, since he wrote the book at a time when the corporate world was populated with railroads, utilities and manufacturing companies and much of his advice was directed at coaxing investors who were more interested in buying bonds, to consider stocks as an alternative. In fact, in the Graham world, a good stock looks like a perpetual bond, with ever-growing coupons. So, at the risk of arousing the ire of value purists, here is my list of old value investing chestnuts that need to be roasted on the tech fire.

    1. Don't trust earnings multiples: There are some pricing metrics that are singularly inappropriate for use with tech companies, and at the top of the list is price earnings (PE) ratios. Early in the life cycle, when growth is explosively high and R&D expenses are rising, the PE ratios for tech companies will be high, as markets price in future earnings, and tech companies will almost always look expensive, even if they are fairly priced. Later in the life cycle, when growth is not just low but often negative and R&D expenses are falling, the PE ratios for tech companies will be low, and tech companies will look cheap, even when they are not.

    To illustrate this dynamic, I created two companies, both with 20-year windows and similar risk, but made one a tech company, with intense growth (50%) for the first 5 years, a short mature period of 5 years (10%) and speedy decline thereafter and the other one a non-tech company, with less intense growth (25%) for the first 5 years, a longer mature period of 10 years and a more stable afterlife. The graph below shows the fair PE ratios for these firms, as they move through their lifetimes. The bottom line is that tech companies look expensive on a PE ratio, when they are young, and cheap on a PE ratio basis, when they age, even if they are fairly valued. This problem is exacerbated by the accounting mistreatment of R&D, which makes young tech companies look less profitable than they truly are and old tech companies more profitable. Multiples of revenues and book value are also affected, but not to the same degree. 
    I can offer some evidence for this proposition from my post on the aging of tech companies, where I classified all companies based on their age and compare old tech companies (older than 35 years) with old non-tech companies. In the graph below, I compare the earnings multiples at which old tech companies(>35 years) trade, relative to old non-tech companies:
    Old companies = Age greater than 35 years (since founding)
    Note that old tech companies look cheap on every earnings metric, relative to old non-tech companies. There may be a reason why companies like IBM and Microsoft keep showing up on the lists of cheapest stocks, when you run value screens.

    2. Don't buy and hold "good" companies: Not all value investors subscribe to this notion, but quite a few seem to accept the idea that if you find a good company (well managed, with strong competitive advantages), you should buy the company for your portfolio and hold for the long term (perhaps forever). That is not good advice with tech companies, where today's tech superstar can become tomorrow's dog. If you buy a tech company, you should be revaluing it at frequent intervals, selling it, if the price exceeds the value significantly.

    3. Don't prize dividends over stock buybacks: I have always believed that fixed dividends are a ill-suited way of returning cash on a residual claim (equity), especially because investors who receive them seem to view them as constants that should not be changed. With technology companies, I would argue that stock buybacks are not only more suited to their life cycle needs, but are also more reflective of what they can afford to pay out, than large dividends. Again, I can offer partial backing for this statement by comparing cash returned by old tech companies versus old non-tech companies.
    Old tech companies have, at least in the aggregate, returned far more cash to stockholders than old non-tech companies, have used buybacks more frequently and have held on to less cash wishing the companies, behavior that you would expect in the aggregate in the speeded up life cycle hypothesis, where decline is more precipitous.

    The Tech Challenge for Growth Investors
    While growth investors don't have the long traditions that value investors do, they have their own share of dos and don'ts accumulated through time. One is, of course, the idea of buying growth at a reasonable price (GARP), a notion made popular by Peter Lynch's work at Magellan and his resultant writings. In putting that  common sense notion into practice with tech companies,  growth investors draw on they own share of practices based on the premises that growth is good, that it is sustainable and if bought at a reasonable price, is a winning strategy. 
    1. Growth is not always good: I have long argued against the lazy notion that growth is good and that a company should therefore go for growth, at any cost. While that notion is dangerous at any company, it is particularly so at tech companies, where once the life cycle turns, growth is a value destroyer, not a value adder. 
    2. Growth may not be sustainable: Growth in the past has never been a great indicator of future growth across companies, but it is a particularly misplaced notion with tech companies where growth rates can change over night.
    3. PEG Ratios are misleading: If value investors put their trust in PE ratios, growth investors put their in PEG ratios, the ratio of PE to growth rate. A low PEG ratio is considered to be a signal that a company is under valued; this is dumbed down even more when a PEG ratio below one becomes a magical indicator of cheapness. Using the tech life cycle rubric, I would argue that the PEG ratio approach will lead to too many tech companies looking cheap during their high growth phase and too few in their decline, the mirror image of the problem faced by value investors. Here again, I can use the two companies from my example to illustrate my point:
    PEG = Trailing PE/ Expected Growth rate in EPS in next 5 years
    Note that early in the life cycle, tech companies have lower PEG ratios than non-tech companies and later in the life cycle, they look expensive.
    The Tech Challenge for Market Timers
    This is not a post on market timing, but there are lessons here for market timers as well. The composition of the S&P 500 has changed over time, with tech companies increasing as a proportion of the index from 6% of the index in 1990 to 20% of the index in 2015.

    While only the most successful of tech companies make it into the index, they do bring their specific life cycle characteristics with them. The effect on the index PE will depend in large part on where these companies are in their life cycles; if they are still in their growth phases, their presence will push up the index PE, but if they are in decline, they can depress the index PE.

    The Tech Challenge in Valuation
    As someone who lives in the intrinsic value world, I wrestle with this compressed life cycle concept, when I value technology companies. The typical framework for valuing a company, in a discounted cash flow valuation, is to estimate cash flows for a growth phase and then to estimate a terminal value, based on growth forever beyond that point.


    The defense that is offered, when someone notes that nothing lasts forever, is that if a company lasts decades, you might as well use the assumption of "forever", since your value will be approximately the same number. That argument loses its power with technology firms, raising the question of whether we are over valuing mature technology companies by using this standard mythology. There are three simple fixes, if the perpetual growth assumption troubles you with a technology company:
    1. Use a liquidation value, assuming that you disband the company and sell its assets. Since the assets of technology companies are not physical, this will yield a conservative estimate of value.
    2. Use a growing annuity equation, i.e., assume that your cash flows will continue after your terminal year but only for a finite period (10-15 years) and with limited growth.
    3. Use a growing perpetuity equation, with a negative growth rate in perpetuity, a practice that you don't see used often, but is well in line with what the model allows. Intuitively, you are assuming that the company will shrink over time and effectively disappear.
    As a final point, in intrinsic value, you have to make judgments about managers in companies, and when valuing declining tech companies, where managers are in denial about the decline, you have to value the consequences (bad investments, value destroying growth etc.).

    The Bottom Line
    As the market's axis tilts towards technology, it may be time for us to revisit the metrics and models that we have been using, almost on auto pilot, for many decades. The shorter lives and the higher failure rates of technology companies can make them look cheap, when they are expensive, if you are a value investor, and their high growth rates can draw in growth investors, who may not factor in the fact that this growth is not sustainable.

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    Tech Life Cycle Series



    The Compressed Tech Life Cycle: The Managerial Challenge

    In my last two posts, I first looked at Yahoo, in the context of the challenges associated with turning around an aging technology company, and then argued in my second post that the life cycle of tech companies is compressed, relative to non-tech companies. As some of you have noted, there are not only exceptions to this rule, but there are actions, some healthy and some not, that managers of tech companies can, and often do, take to fight aging.

    The Tech Life Cycle: The Manager's Handbook
    The hyper speed at which their firms move through the life cycle can upend conventional rules on how to manage and finance businesses and there are three strategies that managers at these firms can adopt to survive and each has both a good and a dark side to it.

    1. Acceptance/ Denial
    In the healthy version of this strategy, as a tech firm (and its managers), you accept the fact that your life cycle will be short and you manage accordingly. 
    1. During your ascendance, its all about growth: Since your period of growth will be steep and short, you have to keep your focus on delivering that growth. You also cannot afford distractions, whether they come from fights over control or from having to make debt payments.
    2. When mature, use debt with restraint and keep it short term: The conventional wisdom is that mature companies should avail themselves fully of debt, and use its tax advantages to augment value. The same advice is often doled out to technology firms, but they are exposed to far more danger from debt, since their mature phases may last only a few years, rather than decades. Thus, tech firms will be better served if they borrow less than non-tech companies and keep that debt short term.
    3. In decline, return cash with a vengeance: Your cash returns, whether in the form of dividends or stock buybacks, should reflect the speed of your decline, and to those advisors who worry that you may be signaling to the market that you have no investments, remind them that it is never wrong to signal the truth.
    All of these suggestions, though, are built around accepting the speeded up tech life cycle as a fact of life and working within its constraints.

    In the unhealthy version of this strategy, you do nothing to alter the life cycle dynamics for the firm, but manage the firm, in denial, breaking one or more of the three rules listed above. During your growth phase, you allow yourself to diverted by fights over control or debt financing and lose a portion of your growth potential. As your firm matures, you either continue to act like a growth company, pursuing growth (at any cost), and/or borrow money like a non-tech company. In decline, you try to reverse the process by going after the corporate equivalents of tummy tucks and face lifts, corporate do-overs that do not change the end game but enrich others in the process.

    2. Reseed and regrow
    If you are the manager or owner of a tech company, it is natural to look for an anti-aging serum, something that will let you extend your life. After all, you do have the exceptions to the short life cycle rule, companies that have managed to not just survive over long periods, but continue to grow. This strategy is built on the premise that it is tech products that have short life cycles, not tech companies, and that if you can keep coming up with new tech products, you can extend your life as a company. Your management strategy, if you go with this option, will be to advance the company along two tracks. While nurturing your primary product, you will look for opportunities to extend what you see as your strengths (technology, design, user base), by offering new products and services. In your dream scenario, your initial success gives you a leg up for future successes, leading you to have an extended life cycle as a company.

    Promising though this option may look, there are two caveats and they are what characterize the darker version of the strategy. The first is that whether the strategy pays off for your stockholders will depend in large part on what you pay to extend your product portfolio. If the price you pay to add new products and extend your life cycle is greater than the benefits of doing so, you will have a long life cycle, but you will lose value along the way. The second is that the new products that you offer have to scale up, as you become larger. Put differently, a new product that adds fifty million in value is a giant step forward, when you are a hundred million dollar company, but makes only a small difference if you are a billion dollar company. An added and related implication is that the more successful your initial product is in delivering profits and value, the more difficult it becomes to find new products that make a substantial growth contribution.

    3. Reinvent
    The third and perhaps most promising route for high tech firms that want to stretch out growth periods is to change the business model. Having used low cost entry, easy scaling up and customers switching to climb the growth ladder quickly, you have to work at removing those advantages for the firms that follow you. In particular, you have to try to do one or more of the following:
    1. Increase the cost of entry: To accomplish this, you can look to legal protection (perhaps through patenting) or by creating gate keepers that slow and perhaps stop new entrants. In my view, both Microsoft and Apple have been helped in their life cycle lengthening efforts by controlling the operating systems that are the standards that competitors often have to follow to enter their respective businesses.
    2. Increase the cost of scaling up: To the extent that low capital intensity allows competitors to grow fast, you can work to increase the capital needed for growth. 
    3. Increase the stickiness of customer preferences: If customers are quick to switch with technology products, you have to make it more costly to switch. This can be accomplished in many ways, by adding features to the product or service that become more user-customized with use (eg. search engines that remember your searches and online retailers that learn your preferences) or by creating work product that will be degraded or rendered useless by switching. As someone who has been frustrated with MS Office (for the Mac) at various times in the last few years, I have considered switching to competitors (Keynote and Pages, for instance) but have held back because I have thousands of Office documents from close to three decades that may or may not survive the switch.
    In the darker version of this strategy, the roadblocks you create to competition may expose you not only to bad public relations (as a bully or unfair competitor) but to legal jeopardy, as anti-trust regulators target and try to change your practices. Google and Microsoft, two companies that have adopted this strategy with extraordinary success over the last two decades, have faced this backlash, as a consequence of their success.

    The "Right" CEO
    The corporate life cycle structure comes with a subtext on what type of management skills are needed at each stage.

    Put briefly, the "right" CEO for a company in the growth phase will need vision, charisma and story telling skills to attract employees, investors and customers to the company. As growth levels off, you need a different set of skills in your CEO, more discipline in seeking out growth and recognizing its limits. In decline, you want a CEO with limited ambitions, who is swilling to shrink the company and sell its assets, at the right price. While this is true for all companies, the process is easier for non-tech companies with long life cycles, where each phases lasts long enough to allow the process to happen naturally (where the CEO ages with the company and hands the reins over to a new one).

    The Rest of the Story
    With tech companies, with speeded up life cycles, where a company can go from rising star to declining company in a period of a few years, there is a much greater risk that the start-up CEO (often a founder) will still be at the helm when the company enters its mature and perhaps even declining phases. The qualities that made the CEO a good fit in the start up and growth phases will become a liability as the company matures and declines. There are three implications:
    1. Denial is more deep set: The potential for value destruction from going for growth, when it no longer makes sense to do so, is greater at tech companies than an at non-tech companies, because the management in place is often the same one that nurtured the company through its high growth phase. The problem gets worse if the CEO happens to be the founder of the company and views its decline and failure in personal terms.
    2. Making the backlash stronger: The natural reaction to management denial is investor anger which will be manifested in activist investors pushing managers to change, and if they refuse, push them out.
    3. Which is reason to worry about voting rights: In the last decade, technology companies have moved away from the "one share, one vote" paradigm that governed US companies for decades. That trend, started by Google, but extended by the social media companies, has been ignored as these companies grow rapidly but will become an issue for investors, when growth slows at these companies and the founders/insiders go into denial model. If you are a stockholder in one of these young tech companies with unequal voting rights, you will regret your inability to have a say in how these companies are run, sooner rather than later.
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    Tech Life Cycle Series



    Aging in Dog Years? The Short, Glorious Life of a Successful Tech Company!

    The corporate aging theme is one that I have returned to repeatedly in my posts, and I have looked at how the aging process creates dysfunctional responses on the parts of managers, who want to find ways to reverse it, and investors, who make bets on such reversals. It was the under pinning for my last post on Yahoo, and in that post, I argued that technology companies have compressed life cycles, i.e., age in dog years, relative to non-tech companies. In this post, I would like to provide a rationale for why this may be the case and set the stage for my next post on what the implications are for managers and investors.

    The Corporate Life Cycle
    The corporate life cycle follows a familiar pattern. It begins with an idea, that develops into a product, which evolves into an operating business, that matures, and eventually dies. 

    I have also highlighted the transitions that determine whether a company moves to the next stage and the mortality rate especially early in the life cycle is high. There are wide differences across companies in how long they take to climb the life cycle, how much time they spend as mature companies and how quickly they decline. As legal entities, corporations do have a little more give in the process, i.e., the capacity to slow or even reverse the process for periods, than individuals do, but not as much as they (and their strategic advisors) think that they do.  The one reality that I think is incontestable is that even the most exceptional companies will age and that whether they deal with that aging gracefully is what determines how their stockholders will do during the process. 

    Determinants of the Life Cycle
    To get a sense of what drives differences across companies and how the life cycle evolves, I tried to take a look at the determinants of each phase of the cycle in the graph below:

    • When you start up, your focus is survival, and that will depend on (a) how much access you have to capital, (b) how much you need to invest to enter the market and (c) the time lag before you have a product or a service. Your chances of survival improve, if you have access to more capital and don't have to wait very long before you have a functioning product. 
    • The speed of your growth will depend on (a) how quickly the overall market is growing, (b) the ease of scaling up your operating and (c) how much inertia there is on the customers side. You will be able to grow faster, if the overall market is growing exponentially, scaling up is easy and you are dealing with customers who are willing to switch from incumbent products/services.
    • The length of the mature phase will depend upon the nature of your competitive advantages, how big they are and how long they last. If your competitive advantages are strong and sustainable, your mature phase can last for a long time. Consumer product companies with strong brand names, one of the strongest and most sustainable competitive advantages, have longer mature phases than companies that have a cost advantage, a more transient and short term competitive advantage.
    • In decline, the speed with which your business will deplete will depend upon (a) how quickly new companies can enter the market  (b) how quickly they can scale up and how willing customers are to try new products. In other words, you see that a mirror image of the qualities  that allow for speedy growth also contribute to a quick decline.
    • In the end game, your choices depend on what your remaining assets look like and whether they can be liquidated, without substantial losses. If they can, your end will be speedy and perhaps even painless. If not, your death throes can be long and painful.

    Tech versus Non-tech
    Before we start on a discussion of how tech companies are different from non-tech companies, we have to think about what separates the two groups, and that separation becomes hazier by the day. In the 1980s, at the start of the tech revolution, the distinction was a simple one. If a company’s products or services were computer-related (either personal or business computers), it was classified as a technology firm. That distinction allowed us to identify Microsoft, Apple and Atari as technology firms, and bring in HP, IBM and Digital Equipment as the old guard. That definition no longer works, as almost every product we buy (from appliances to automobiles) has a computerized component to it, and it has meant that deciding whether a company is a tech company is a judgment call. Given that reality, I would propose that rather than draw hard lines of distinction between tech and non-tech, we consider technology on a continuum, where at one end you have companies whose products and services are entirely technology driven (Google, Facebook) and at the other, you have companies that almost no technology component to them (consumer products and cosmetics companies, for instance). With this continuum, you can argue that Tesla and Ford are both auto companies, but that Tesla has a larger technology component than Ford. 

    Why do we care about these distinctions? First, they have practical implications for analysts and portfolio managers. Sell-side equity research analysts are usually put into sector silos and asked to keep their focus on the companies that they are assigned. With companies like Amazon, Netflix and Tesla, high profile names to follow, I have noticed that there are big differences across banks. Some assign these companies to the technology analysts, some to the businesses that these companies operate in (Tesla in autos, Netflix in entertainment and Amazon in retail) and some create new sector groupings just for these gray area companies. Second, for better or worse, the categorization of a company can affect its pricing. Tesla, classified as an auto company, will look expensive, compared to other auto companies, but classified as a young tech company, it may look cheap. That is perhaps why companies seek out the tech label for themselves, even if technology is only a small component of their offerings.

    The Tech Life Cycle
    If you accept my argument that technology is a continuum, then you can perhaps live with my definition of “tech” companies as those that get the predominant portion of their value from technology. With that definition, I can revisit the corporate life cycle and its determinants and make the following generalizations (and I am sure that you can think of exceptions with each one):
    • Scaling up is easy: Tech companies often operate in businesses where entry is not restricted, the up front investment is minimal and scaling up in easy. If market conditions are favorable, they are aided and abetted by access to  capital and by less sticky customer preferences in their markets. Not surprisingly, tech companies can grow quickly.
    • Holding on is tough: Once tech companies reach the mature phase, they don't get to have long harvest periods. Their competitive advantages are fleeting and quickly deplete.
    • Decline is rapid: The same forces that allow technology companies to grow, i.e., unrestricted entry, ease of scaling up and customer switching, also make them vulnerable to new entrants seeking to take their business away from them.
    • And there is little left in the end game: Unlike other businesses, which accumulate physical assets as they grow and thus have a liquidation potential, with technology companies, there is little of substance to fall back, once earnings power is exhausted.
    Here, for instance, is my contrast between the life cycle of the typical tech company, contrasted with a typical tech company.

    Is there evidence that this is what happens in the market? I could use Blackberry as an example, but I would then be guilty of using anecdotal evidence to advance my theory. Instead, I will argue that the evidence exists, albeit in scattered form. First, there is evidence that the small tech firms (that survive the first tests) are able to scale up faster in terms of revenue growth (at least) than small non-tech firms. The fact that they often lose money while doing so is as much a function of the accounting inconsistency of treating research and product development costs as operating expenses, as it a function of operating weakness. The second is that these tech firms, once established, have a more difficult time maintaining growth. The third is that decline, once it starts at tech firms, is more difficult to reverse and quicker to accelerate. All of these points are made in this  McKinsey article on growth at tech companies

    A Life Cycle Perspective on Disruption
    Disruption is the new buzz word in corporate strategy, a reason that I listed it as on my list of words that operate as weapons of mass distraction, and is often used to cut off debate or not talk specifics. From my perspective, the essence of disruption is a that it is a new way of doing business that radically changes the fundamentals of on established business. In the context of technology-driven disruption, it a company, with a tech model, coming into a non-tech business, characterized by long growth periods, extended mature phases and elongated declines.

    Consider car service, i.e., the taxi cab and limo business. The old non-tech model for this business required regulatory approval (making entry difficult) and substantial investment (in cars) in a market governed by customer inertia. Uber and the other ride sharing companies have upended the model by bypassing regulatory approval, not investing in cars and breaking through inertia by reaching out to customers through their smart phones. The results speak for themselves. Not only have Uber, Lyft and Didi Kuaidi grown at rates unlike any seen by traditional car service companies, but each has a market reach that is beyond the old model. No traditional cab company can afford to operate in 300 cities, like Uber does.

    The effect of disruption is that it upends the fortunes of mature companies from the old business model, coasting in their mature phase, convinced that change is slow. Unprepared for the speed of change emanating from the tech entrants, these old players wait too long to respond, looking to regulators and rule makers for protection, and not surprisingly, face an implosion. That, in a nutshell, is what has happened to the taxi cab and limo business in many cities. The new entrants, though, should not celebrate too quickly, since their tech model disruption comes with its dangers. Their models are difficult to mine for cash flows and are themselves susceptible to competition. As I noted in my post on the future of the ride sharing business, disruption is easy, but making money on disruption is hard.

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    Tech Life Cycle Series






    The Yahoo! Chronicles! Is this the End Game?

    The big news of the day from the tech world comes from Yahoo (I am going to skip the exclamation point through the entire story, but don't read significance into that exclusion), where stories suggest that the board of directors may soon decide whether to sell its operating business, leaving it as a shell company with holdings in two other public companies, Yahoo Japan and Alibaba. The story has resonance for many reasons. One is the presence, as is required in any good story, of a villain, a role that is usually assigned to an activist investor and in this case ably filled by Starboard Value, a fund that has been pushing for this divestiture. The second is the existence of a heroine, albeit a tarnished one, in the form of Marissa Mayer, who was supposed to save the company by boldly moving where Yahoo had not gone before. The third seems to be an almost existential question of whether the  potential end game for Yahoo, a company that many journalists grew up with as part of the technology landscape, is an indication of their own aging.

    Stepping back in time
    Let's start with a reality check. By the time Marissa Mayer became CEO of Yahoo in 2012, its glory days were well in its past, as you can see in this graph that traces its history from young, start-up to mature (and beyond) in the life cycle:


    Not only had Yahoo decisively and permanently lost the search engine fight to Google, but it was a company in search of a mission, with no clear sense of where its future lay. 

    Ironically, the two best investments that Yahoo made during the recent past were not in its own operations, but in the other companies, an early one in Yahoo Japan, which prospered even as its US counterpart stumbled, and the other in Alibaba in 2005, a prescient bet on a then-private company. Alibaba's online sites, Taobao and TMall, through which almost 75% of all online retail traffic in China flows, makes it a legitimate and valuable symbol of the China story and it went public late last year to fanfare and a record-breaking market capitalization (for an IPO). I valued Alibaba at the time of its IPO filing and I extended my analysis to include Yahoo, which at the time held 21% of Alibaba. While my valuations need to be updated to reflect what has happened in the last year, the picture that I drew in September 2014, breaking down Yahoo's intrinsic value into its component parts remains largely intact:
    Valuation in September 2014
    Note that of my estimated value of my total estimated value of $46 billion for the company, less than 10% (about $3.6 billion) comes from Yahoo's operating assets.

    The challenge that Ms. Mayer took on was to not only turn around a company that had lost its way in terms of its core business but one that derived most of its value from holdings in two companies that she had no control over. Her history of success at Google and the fact that she was young, attractive and female all played a role in some  choosing her as the anointed one, the savior of Yahoo.

    Why Marissa Mayer's quest was always long shot
    The odds of Ms. Mayer succeeding at Yahoo, at least in the ways that many of her strongest supporters defined success, were low right from the beginning, for two reasons:
    1. It is hard enough to turn around a company but it becomes even harder when you are given control of only the rump of the company. The reality is that, on any given day, the value of Yahoo as a company was more influenced by what Jack Ma did that day at Alibaba, than what Ms. Mayer did at Yahoo.
    2. In a post a few months ago, I noted that the tech business is an aging one, and that it is time for us to retire the notion that tech equals growth. I also argued that tech companies age in dog years, relative to companies in other sectors, and that a 20-year old tech company is closer to being geriatric than middle aged. It is for that reason that I give long odds to any aging technology company that tries to rediscover its youth. (I will be doing a follow-up post in a couple of days on my reasoning for why the tech business life cycle is compressed in time.)
    Lest I sound fatalistic, it is true that there are counter-examples, aging tech companies that have rediscovered their youth, as evidenced by IBM's rebirth in 1992 and Apple's new start under Steve Jobs. Much as we would like to give Lou Gerstner and Steve Jobs credit for pulling off these miraculous feats, I believe that it was a confluence of events (many of out of the control of either man) that allowed both miracles to happen. The Lou Gerstner turnaround at IBM was aided and abetted by the the tech boom in the 1990s and as for Steve Jobs, the myth of the visionary CEO who could do no wrong has long since overtaken the reality. By promoting both turnarounds as purely CEO triumphs, we set ourselves up for the Yahoo scenario, where a new CEO (Marissa Meyer) is assumed to have the power to turn a company around but we are then disappointed in her failure to do so.  I am less disappointed in Ms. Mayer than many others, since my expectations on what she could do at Yahoo! were much lower, right from the start.

    Betting the farm! 
    In a recent article in the New York Times, Farhad Manjoo, a writer that I enjoy reading and respect for his tech savvy, made a case that Ms. Mayer's failures can be traced to her lack of boldness at Yahoo, or as he put it, her unwillingness to bet the farm, an ill-suited choice of expressions in many ways, at least for this CEO, and this company. First, as the CEO of a publicly traded company, she would not have been betting her farm, but that of her stockholders. Second, if you buy into the notion of Yahoo the company, as a farm, it is  difficult to bet the farm, when you are given control of only the farmhouse (Yahoo operating assets), as Ms. Mayer was with Yahoo, and the rest of the farm (Yahoo's holdings in Alibaba and Yahoo Japan) is off-limits to you.. Third, betting the farm also connotes seeking out of long odds, in the hope of a big payoff, entirely okay if you are a young start-up, with little to lose, but not so in the case of Yahoo.

    Mr. Manjoo is not alone in believing that Marissa Mayer's fault was that she did not make a bigger acquisition or larger investment in some new business (for the most part, unspecified). In fact, it is part of what I termed the Steve Jobs syndrome, where CEOs aspire to be the next Steve Jobs. While some go so far as to don black turtlenecks and strut on the stage like he did, most settle for wanting to be heroic enough during their tenure to have books written about them, and Ashton Kutcher play them on the screen. More dangerous is what follows, since to be like Steve Jobs, you have to make a small company into a really big one, and the way to do that is to take dangerous risks or to "bet the farm". The end results reflect the laws of probability, and the stockholders in these firms end up paying for a CEO's play for celebrity status.

    If you accept my thesis that many aging tech companies resemble the Walking Dead, you should also accept the follow-up proposition that what these companies need are not "visionary" CEOs but pragmatic ones, less Steve the visionary, and more Larry the Liquidator, a person with limited ambitions and a readiness to preside over the dismantling of an enterprise. Unfortunately, if you are such a CEO, and your life were made into a movie (odds of which are low), you will be played by  Danny DeVito and not Ashton Kutcher, but there is always a price for doing the right thing. The debate about what Ms. Mayer should or could have done at Yahoo is a subtext to the other great debate  about buybacks at US companies, and especially those at tech titans like IBM and Microsoft. Rather than wringing our hands at how these buybacks are leading to less investment at these companies, we should be relieved that these companies have moved past the denial phase and are dealing with the reality of aging.

    What now?
    If I were to offer advice to the board, in keeping with the gambling theme created by betting the farm, I would suggest that they listen to this Kenny Rogers tune. It is time get past the denial and sell Yahoo's operating business, while there still is a business to sell, and to get the best possible price on the deal, I would suggest the following:
    1. Rather than talk about Yahoo's businesses (their search engine, advertising), which will draw the attention of potential buyers to the operating statistics (which are a downer), talk about the number of Yahoo users (the billion that you have overall and the 250 million who use Yahoo Mail). 
    2. Look for a buyer with an ambitious CEO (i.e., with Steve Jobs syndrome) who wants to bet the farm and pay a premium price (using shareholder money) for stardom. Taking a cue from the gambling business, it is much better to be the taker of big bets than the maker of these bets
    The cash from that sale and perhaps even the rest of the cash balance should be returned to stockholders, leaving Yahoo as a holding company, with Yahoo! Japan and Alibaba as its holdings. The tax consequences of selling these holdings will be substantial and the board should remove the resulting market discount by announcing its intent to continue to run Yahoo as a holding company, a closed-end fund with two holdings. As a stockholder in Yahoo, I can live with that, since I am getting Alibaba and Yahoo! Japan at a significant discount on their traded value, as can be seen below (even assuming that Yahoo gives away its operating assets for nothing):

    Market CapYahoo's shareValue of holding
    Yahoo! Japan (12/4/15)$23,900 35.00%$8,365
    Alibaba (12/4/15)$207,500 15.40%$31,955
    $40,320
    + Yahoo Cash (Sept 2015)$5,882
    - Yahoo Debt (Sept 2015)$2,161
    + Yahoo Operating Assets$-
    Value of Yahoo Equity$44,041
    Yahoo Market Cap (12/4/15)$32,390
    Discount on holdings28.90%

    Towards the end of my post on Yahoo from last year, I suggested that my returns on Yahoo would be inversely proportional to Ms. Mayer's ambitions and argued that my best case scenario would be one where she scaled the number of employees in the firm down to one (herself) and acquired two computer displays, one of which would deliver real time price quotes on Alibaba and the other the latest price of Yahoo Japan. If the board acts to sell Yahoo's operating assets, we may be closer to that vision than I ever thought I would get.

    If this is the end game, I am thankful that, while Ms. Mayer did show flashes of ambition, as revealed in her acquisitions (with the Tumblr deal being the largest)  over the last three years, she did not "bet the farm" on an outlandishly large acquisition or investment. Perhaps, I am giving her more credit than I should, and the only reason she showed restraint is because she could not find a tax advantaged way to get rid of Yahoo's investments in Yahoo Japan and Alibaba. If so, this may be one of the few times that I am thankful to the IRS for not allowing the transaction to go through, since on its completion, Yahoo would have ended up with $20 billion in cash, and I shudder to think of how much damage a "bet the farm" CEO could have done with that money.

    YouTube Version


    Lead-in Blog Posts



    Corporate Finance 101: A Big Picture, Applied Class!

    In my last seven posts, I played my version of Moneyball with company data from the end of 2015, looking at how companies invest their shareholders' money, how much they borrow and the determinants of how much cash they return to stockholders. That structure is the one that underlies the corporate finance class that I have taught every year since 1984, the first two years at UC Berkeley, and the last 30 years at the Stern School of Business. Each semester, for the last few years, I have also invited you, even if you are not a Stern MBA student, to follow the class online, if you so desire, in all its gory details. If you are considering this options, I thought it would make sense to take you on a mini-tour of corporate finance, as a discipline, and how I aim to tackle it in this class.

    Corporate Finance: The Big Picture
    There are many versions of corporate finance that are taught in class rooms. There is the accounting version of corporate finance, that uses the historical, rule-bound construct of accounting as the basis for corporate finance. Decision making is driven by accounting ratios and financial statements, rather than first principles. There is the banking version of corporate finance, where the class is structured around what bankers do for firms, with the bulk of the class being spent on areas where firms interact with financial markets (M&A, financing choices) and the focus is less on what's right for the firms, and more on how the deal making works. My version of corporate finance is built around the first principles of running a business and it covers every aspect of business from production to marketing to even strategy. In case you are skeptical about the big picture version of this class, here is what it looks like:
    All of corporate finance boils down to three broad decisions, the investment decision, which looks at where you should invest your resources, the financing decision, where you decide the right mix and type of debt to use in funding your business and the dividend decision, where you determine how much to hold back in the business (as cash or for reinvestment) and how much to return to the owners of the business.

    Applied, not Theory
    I find theory for the sake of theory to be arid, and I build my classes around a very simple proposition: if it cannot be applied, I don't talk about it. That application focus may put you off, but my class is essentially the equivalent of a corporate finance lab, where when I introduce a model or a hypothesis,  I get to try it out on real companies in real time. I use six companies through the entire class to illustrate both the theory and how its application can vary across companies:


    Thus everything I do in the class, from estimating hurdle rates to determining finance mix to assessing dividend policy, I try on Disney (a large, US, entertainment firm), Vale (a global mining company, based in Brazil, with a government interest in it), Tata Motors (an India-based auto company, part of a family group), Baidu (a Chinese search engine company, traded as a shell company on the NASDAQ), Deutsche Bank (a messy, money center bank, with regulatory constraints) and a small privately owned bookstore in New York City (owned by a third-generation owner).

    The Class Structure
    The class starts on February 1, with a session from 10.30 to 11.50, and continues through May 9, with sessions every Monday and Wednesday, with a break week starting March 14. The lectures are supplemented with slides and my book on applied corporate finance, with the latter being completely optional, since you can live without it.  The calendar for the class is at this link.

    There will be three 30-minute quizzes in the class, each worth 10%, spread out almost evenly across the first 22 sessions, and each quiz will be non-cumulative, covering only the 6-7 sessions prior. In keeping with my view that this is not about memorizing equations and formulas, the quizzes will be open books and open notes. There is a two-hour final exam, which is cumulative and will be after the final session  in May that will account for 30% of the grade.

    There will be two projects, with the first being an investment case (that I have not written yet) that will make you decide on whether to make a big investment or not (Apple in the electric car market, Google buying Twitter etc.) and the second being a semester-long exercise of trying every aspect of corporate finance on a company of your choice.

    The Online Version
    If you are in my class, there is little more to be said, since I will see you in class on Monday. If you are not, you can still partake in almost all of the class. The lectures will not be carried live, but will be recorded and the webcasts should be up by late in the day, Mondays and Wednesdays, through the entire semester. You can find those webcasts in one of three forums:
    1. My website: The links to the webcasts, as well as links to my other material (lecture notes, handouts, even emails to the class) can be found at this link
    2. iTunes U: If you prefer a more polished format, I will also be putting the class online on iTunes U, the app that you can download from the Apple store for any Apple device. The link to the class is here and if already have Apple iTunes U installed on your device, you can add this class with the enroll code of EPF-JFH-SHE. 
    3. YouTube Playlist: I will also be putting the classes up on a playlist on my YouTube account. With each session that I put up, I will also add links to the lecture notes used in the session and additional exercise. 
    Not only can you watch the lectures and review the notes, you can also try your hand at the quizzes and final exam, when they are given. I will post the exams, after the class has taken them, online and  I will post the solution, with the grading template that I used in class. You will be your own grader and may be tempted to go easy on yourself, but that's your choice. You can even do the case and the project, but I will unfortunately not have the resources to review or grade either. The good news is that none of this should dent your pocket book, but the bad news is that you will not get class credit or a certificate.

    Alternative Routes
    Each semester, I know that quite a few people start with my classes, but life very quickly gets in the way. One of the problems of online classes is that without the discipline of having to get to a physical class or concern about credit/grades, it is difficult to persevere to the end. I entirely understand this problem and if, after trying one or two classes or even a few, you decide that your life is too full for more stuff to be added on. I do have a few suggestions, if you still feel that you will gain from the class:
    1. Stretch it out: The class will stay online on all three forums for at least a year or two. Thus, you can stretch out the class to match your time schedule, instead of taking it in calendar time. I had at least three or four people completing the Spring 2012 class, last year.
    2. Online Corporate Finance class: If you find the 80-minute class sessions that make up this class unendurable, I do have a compressed version of the class, where I take each session and do it in 10-15 minutes, instead of 80 minutes. In a testimonial to how much we bulk up college classes, it was not that tough to do and you can find it on my website at this link, on iTunes U at this one or on YouTube at this one.
    3. Executive Corporate Finance class: I just completed a three-day corporate finance class for executive MBAs that is only a mildly compressed version of my regular class and you can find the links to the webcasts for that class on my website.
    The End Game
    I know that some of you may wonder what the catch is and where I plan to hit you up for fees. While you search for my hidden agenda, I have only one request of you. If you find any of the material in these classes to be useful to you, rather than thank me for it, please pass the favor on, by helping someone else learn, understand or do something. Not only will you get far more out of this simple act of kindness than the person that you offer it to, but I hope that you will also get a sense of why teaching is its own reward.

    YouTube Intro to Class


    Class links (Spring 2016 MBA class)
    1. My website
    2. iTunes U
    3. YouTube Playlist
    Lecture Notes for Class
    1. Syllabus and Project
    2. Lecture Note Packet 1
    3. Lecture Note Packet 2
     Book if you want it
    1. Applied Corporate Finance, 4th Edition (Warning: It is obscenely over priced but there is not much that I can do about it. Sorry!)




    January 2016 Data Update 7: Dividends, Potential Dividends and Cash Balances

    In the last six posts, I have tried to look at the global corporate landscape, starting with how the market is pricing risk in the US and globally, how much investors are getting as risk free returns in different currencies and then moving on to differences across companies on the costs of raising funding (it varies by sector and region),  the quality of their investments (not that good) and their indebtedness (high in pockets). In this, the last of these posts, I propose to look at the final piece of the corporate finance picture, which is how much companies around the world returned to stockholders in dividends (and stock buybacks) and by extension, how much cash they chose to hold on for future investments. 

    Dividends, Potential Dividends and Cash
    Dividend policy is often the ignored step child of corporate finance, treated either as an obligation that has to be met by companies or as a sign of weaknesses by those who believe that companies exist only to build factories and invest resources. The reality is that dividends are a central reason for investing and unless cash gets returned to investors, and I am willing to expand my notion of dividends to include buybacks, there is no real payoff to investing. That said, the question of how much a company can pay in dividends is affected in most businesses, by investing and financing choices. If equity is a residual claim, as it is often posited to be, dividends should be the end-result of a series of decisions that companies make:

    If  you accept the logic of this process, companies that have substantial cash from operations, access to debt and few investment opportunities should return more cash than companies without these characteristics.

    In practice, the sequencing is neither this clean, nor logical. Dividend policy, more than any other aspect of corporate finance, is governed by inertia (an unwillingness to let go of past policy) and me-too-ism (a desire to be like everyone else in the sector) and as a consequence, it lends itself to dysfunctional behavior. In the first dysfunctional variant, rather than be the final choice in the business sequence, dividends become the first and the dominant part driving a business, with the decision on how much to pay in dividends or buy back in stock made first, and investment and financing decisions tailored to deliver those dividends. 

    Not surprisingly, dividends then act as a drain on firm value, since companies will borrow too much and/or invest too little to maintain them.  In a diametrically opposite variant, managers act as if they own the companies they run, are reluctant to let go of cash and return as little as they can to stockholders, while building corporate empires.


    These companies can afford to pay large dividends, choose not to do so and end up, not surprisingly, with huge cash balances. It is worth noting that the corporate life cycle, a structure that I have used repeatedly in my posts, provides some perspective on how dividend policy should vary across companies.

    Dividend Policies across Companies
    As with my other posts on the data, I started by looking at the dividends paid by the 41,889 companies in my sample, with an intent of getting a measure of what constitutes high or low dividends. So, here were go..

    1. Measures of dividends: There are two widely used measures of dividends. The first when dividends are divided by net income to arrive at a dividend payout ratio, a measure of what proportion of earnings gets returned to stockholders (and by inversion, what proportion gets retained in the firm). The distribution of dividend payout ratios, using dividends and earnings from the most recent 12 months leading into January 2016,  is captured below:
    Source: Damodaran Online
    Note that more firms (23,022) did not pay dividends, than did (18,867), in 2015. Among those companies that paid dividends, the median payout ratio is between 30% and 40%.

    The other dividend statistic is to divide dividends paid by market capitalization (or dividends per share by price per share) to estimate a dividend yield, a measure of the return that you as a stockholder can expect to generate from the dividends, on your investment. The rest of your expected return has to come from price appreciation. Again, using trailing 12-month dividends leading into and the price as of December 31, 2015, here is the distribution:
    As with the payout, the yield is more likely to be zero than a positive number for a globally listed company, but the median dividend yield for a stock was between 2% and 3% in 2015.

    2. The Buyback Option: For much of the last century, dividends were the only cash flows that stockholders in corporations received from the corporations. Starting in the 1980s, US companies have increasingly turned to a second option to returning cash to stockholders, buybacks. From an intrinsic value perspective, buybacks have exactly the same consequences to the company making them, as dividends, reducing cash in the hands of the company and increasing cash in the hands of stockholders. From the stockholders' perspective, there are differences, since every stockholder gets dividends (and has to pay taxes on it) while only those who sell their shares back get cash with buybacks, but leave the remaining stockholders with higher-priced stock. In the table below, I look at the proportion of the cash returned that took the form of buybacks for companies in different regions in the twelve months leading into January 2016:
    While it is true that US companies have been in the forefront of the buyback boom, note that the EU and Japan are not far behind. Buybacks are not only here to stay, but are becoming a global phenomenon.

    3. The Cash Balance Effect: Any discussion of dividends is also, by extension, a discussion of cash balances, since the latter are the residue of dividend policy. In this final graph, I look at cash balances at companies, as a percent of the market capitalizations of these companies. 
    You may be a little puzzled about the companies that have cash balances that exceed the market capitalizations, but it can be explained by the presence of debt. Thus, if your market capitalization is $100 million and you have $150 million in debt outstanding, you could hold $150 million of that value in cash, leaving you with cash at 150% of market capitalization.

    Industry Differences: The Me Too Effect
    If a key driver of dividend policy is a desire to look like your peer group, it is useful to at least get a measure of how dividend policy varies across industries. Using my 95 industry groups as the classification basis, I looked at dividend yields and payout ratios, as well as the proportion of cash returned in buybacks and cash balances, and you can download the data here. While there are many measures on which you can rank industries on dividend policy, I decided to do the rankings based on the cash balances, as a percent of market capitalization, because it is the end result of a lifetime of dividend policy. In the table below, I list the 15 industries that have the lowest cash balances, as a percent of market capitalization, in January 2016.
    While this is a diverse listing, most of these industries are in mature businesses, where there is little point to holding cash and one reason for the low cash balances is that many of the companies in these sectors return more cash than they have net income.

    At the other end of the spectrum are industries, where cash accumulation is the name of the game. Below, I list the 15 industries (not including financial services, where cash has a different meaning and a reason for being) that had the highest cash balances as a percent of market capitalization.

    In a few of these businesses, such as engineering and real estate development, the cash balances may reflect operating models, where the cash will be used to develop properties or on large projects and is thus transitional. There are other businesses, such as auto, shipbuilding and mining, where managers may be using cyclicality (economic or commodity) as a rationale for the cash accumulation. The ratio may also be skewed upwards in highly levered companies, since market capitalization is a smaller percent of overall value in these companies.

    Regional Differences
    If me-tooism is the driver of why companies in a sector often have similar dividend policies, can it also extend to regions? To examine that question, I started by looking at dividend statistics, by region:
    Companies in Australia, Canada and the UK returned more cash collectively, in dividends, than they generated in net income, a reflection of both tax laws that favor dividends and a bad year for commodities (at least for the first two). Japanese companies are cash hoarders, paying the least in dividends and holding on to the most cash. Indian companies are cash poor on every dimension, paying little in dividends and having the least cash, as a percent of market capitalization, of any of the regional groupings. Finally, while much has been made about how much cash has been accumulated at US companies (about $2 trillion), the cash balance, as a percent of market capitalization, is among the  lowest in the world. Absolute values are deceptive, since they will skew you towards the largest markets.

    I also computed dividend statistics (dividend yield, cash dividend payout, cash return payout and cash as a percent of market capitalization) by country and plotted them on a heat map:
    Note that in some of these countries, the sample sizes are small and the statistics have to be taken with a lot of salt.

    The Bottom Line
    For both managers and investors, dividends are more than just a return of cash for which companies have no use. Dividends become a divining rod for the company's health, a number that companies stick with through good times and bad and one that has its roots in imitation more than fundamentals. Consequently, companies often get trapped in dividend policies that don't suit them, either paying too much and covering up the deficit with debt and investment cut backs or paying too little and accumulating mountains of cash.



    January 2016 Data Update 6: Debt, the double edged sword!

    In corporate finance, the decision on whether to borrow money, and if so, how much has divided both practitioners and theorists for as long as the question has been debated. Corporate finance, as a discipline, had its beginnings in Merton Miller and Franco Modigliani's classic paper on the irrelevance of capital structure. Since then, theorists have finessed the model, added real life concerns and come to the unsurprising conclusion that there is no one optimal solution that holds across companies. At the same time, practitioners have also diverged, with the more conservative ones (managers and investors) arguing that debt brings more pain than gain and that you should therefore borrow as little as possible, and the most aggressive players positing that you cannot borrow too much.

    The Trade off on debt
    The benefits of debt, for better or worse, are embedded in the tax code, which in much of the world favors borrowers. Specifically, a company that borrows money is allowed to deduct interest expenses before paying taxes, whereas one that is equity funded has to pay dividends out of after-tax earnings. This, of course, makes it hypocritical of politicians to lecture any one on too much debt, but then again, hypocrisy is par for the course in politics. A secondary benefit of debt is that it can make managers in mature, cash-rich companies a little more disciplined in their project choices, since taking bad projects, when you have debt, creates more pain (for the managers) than taking that same projects, when you are an all equity funded company.

    On the other side of the ledger, debt does come with costs. The first and most obvious one is that it increases the chance of default, as failure to make debt payments can lead to financial distress and bankruptcy. The other is that borrowing money does create the potential for conflict between stockholders (who seek upside) and lenders (who want to avoid downside), which leads to the latter trying to protect themselves by writing in covenants and/or charging higher interest rates.

    Pluses of DebtMinuses of Debt
    1. Tax Benefit: Interest expenses on debt are tax deductible but cash flows to equity are generally not. The implication is that the higher the marginal tax rate, the greater the benefits of debt.1. Expected Bankruptcy Cost: The expected cost of going bankrupt is a product of the probability of going bankrupt and the cost of going bankrupt. The latter includes both direct and indirect costs. The probability of going bankrupt will be higher in businesses with more volatile earnings and the cost of bankruptcy will also vary across businesses.
    2. Added Discipline: Borrowing money may force managers to think about the consequences of the investment decisions a little more carefully and reduce bad investments. The greater the separation between managers and stockholders, the greater the benefits of using debt.2. Agency Costs: Actions that benefit equity investors may hurt lenders. The greater the potential for this conflict of interest, the greater the cost borne by the borrower (as higher interest rates or more covenants). Businesses where lenders can monitor/control how their money is being used can borrow more than businesses where this is difficult to do.

    In the Miller-Modigliani world, which is one without taxes, bankruptcies or agency problems (managers do what's best for stockholders and equity investors are honest with lenders), debt has no costs and benefits, and is thus irrelevant. In the world that I live in, and I think you do too, where taxes not only exist but often drive big decisions, default is a clear and ever-present danger and conflicts of interests (between managers and stockholders, stockholders and lenders) abound, some companies borrow too much and some borrow too little.

    The Cross Sectional Differences
    Looking at the trade off, it is clear that 2015 tilted more towards the minus side than plus side of the equation for debt, as the Chinese slowdown and the commodity price meltdown created both geographic and sector hot spots of default risk. As in prior years, I started by looking at the distribution of debt ratios across global companies, in both book and market terms:
    Debt to capital (book) = Total Debt/ (Total Debt + Book Equity)
    Debt to capital (market) = Total Debt/ (Total Debt + Market Equity)
    In keeping with my argument that all lease commitments should be considered debt, notwithstanding accounting foot dragging on the topic, I include the present value of lease commitments as debt, though I am hamstrung by the absence of information in some markets. I also compute net debt ratios, where I net cash out against debt, for all companies:
    Damodaran Online
    While debt ratios provide one measure of the debt burden at companies, there are two other measures that are more closely tied to companies getting into financial trouble. The first is the multiple of debt to EBITDA, with higher values indicative of a high debt burden and the other is the multiple of operating income to interest expenses (interest coverage ratio), with lower values indicating high debt loads. In 2015, the distribution of global companies on each of these measures is shown below:

    By itself, there is little that you can read into this graph, other than the fact that there are some companies that are in danger, with earnings and cash flows stretched to make debt payments, but that is a conclusion you would make in any year.

    The Industry Divide
    To dig a little deeper into where the biggest clusters of companies over burdened with debt are, I broke companies down by industry and computed debt ratios (debt to capital and debt to EBITDA) by sector. You can download the entire industry data set by clicking here, but here are the 15 sectors with the most debt (not counting financial service firms), in January 2016.
    Damodaran Online, January 2016
    There is a preponderance of real estate businesses on this list, reflecting the history of highly levered games played in that sector. There are quite a few heavy investment businesses, including steel, autos, construction shipbuilding, on this list. Surprisingly, there are only two commodity groups (oil and coal) on this section, oil/gas distribution, but it is likely that as 2016 rolls on, there will be more commodity sectors show up, as earnings lag commodity price drops.

    In contrast, the following are the most lightly levered sectors as of January 2016.
    Damodaran Online, January 2016
    The debt trade off that I described in the first section provides some insight into why companies in these sectors borrow less. Notice that the technology-related sectors dominate this list, reflecting the higher uncertainty they face about future earnings. There are a few surprises, including shoes, household products and perhaps even pharmaceutical companies, but at least with drug companies, I would not be surprised to see debt ratios push up in the future, as they face a changed landscape.

    The Regional Divides
    If the China slow-down and the commodity pricing collapse were the big negative news stories of 2015, it stands to reason that the regions most exposed to these risks should also have the most companies in debt trouble. The regional averages as of January 2016 are listed below:
    Damodaran Online, Data Update of 41,889 companies in January 2016
    The measure that is most closely tied to the debt burden is the Debt to EBITDA number and that is what I will focus on in my comparisons. Not surprisingly, Australia, a country with a disproportionately large number of natural resource companies, tops the list and it is followed closely by the EU and the UK.  Canada has the highest percentage of money-losing companies in the world, again due to its natural resource exposure. The companies listed in Eastern Europe and Russia have the least debt, though that may be due as much to the inability to access debt markets as it is to uncertainty about the future. With Chinese companies, there is a stark divide between mainland Chinese companies that borrow almost 2.5 times more than their Hong Kong counterparts. If you are interested in debt ratios in individual countries, you can see my global heat map below or download the datasets with the numbers.


    If the biggest reason for companies sliding into trouble in 2015 were China and Commodities, the first three weeks of 2016 have clearly made the dangers ever more present. As oil prices continue to drop, with no bottom in sight, and the bad news on the Chinese economy continue to come out in dribs and drabs, the regions and sectors most exposed to these risks will continue to see defaults and bankruptcies. These, in turn, will create ripples that initially affect the banks that have lent money to these companies but will also continue to push up default spreads (and costs of debt) for all firms. 

    The Bottom Line
    Debt is a double edged sword, where as you, as the borrower, wield one edge against the tax code and slice your taxes, the other edge, just as sharp, is turned against you and can hurt you, in the event of a downturn. In good times, companies that borrow reap the benefits of debt, slashing taxes paid and getting rewarded with high values by investors, who are just as caught up in the mood of the moment. In bad times, which inevitably follow, that debt turns against companies, pushing them into financial distress and perhaps putting an end to their existence as ongoing businesses.  One constraint that I will bring into my own investments decisions in 2016 is a greater awareness of financial leverage, where in addition to valuing businesses as going concerns, I will also look at how much debt they owe. I will not reflexively avoid companies that have borrowed substantial amounts, but I will have to realistically assess how much this debt exposes them to failure risk, before I pull the "buy" trigger.

    Datasets
    1. Debt Ratios, by sector (January 2016)
    2. Debt Ratios, by country (January 2016)




    January 2016 Data Update 5: Making a case for corporate governance

    In my last post, I looked at the cost of capital, a measure of what it costs firms to raise capital. That capital, if put to good use by businesses, should earn returns higher than the costs to generate value. Simply put, the end game in business is not just to make money but to make enough to cover a risk-adjusted required return. In publicly traded companies, it is managers at these companies, for the most part, who are investing the capital that comes from stockholders and bondholders (or banks), and corporate governance is a measure of whether these managers are being held accountable for their investment decisions.

    Defining a good investment
    It is true that there are differences of opinion about how best to measure the cost of raising funds, but disagreements about the cost of capital are drowned out by disputes on how best to measure the returns that are generated by investing this capital. There are two widely used proxies for profitability. One is the profit margin, obtained by dividing the earnings by the revenues of the firm, and it can be estimated using either operating income (operating margin) or net income (net margin). Since the latter is a function of both the profitability of businesses and how much they have chosen to borrow, I will focus on operating margins and report on the distribution of both pre-tax and after-tax operating margin in the graph below:
    Source: Damodaran Online
    The second measure of profitability, and perhaps the more useful one in the context of measuring the quality of an investment, is obtained by scaling the operating earnings to the capital invested in a project or assets to estimate a return on invested capital. The capital invested is usually computed by aggregating the book values of debt and equity in a business and netting out the cash. The resulting return on invested capital can be compared to the cost of capital to arrive at the excess return (positive or negative) earned by a firm. In the figure below, I look at the mechanics of the return on capital computation in the picture below.

    Note the caveats that I have added  to the picture, listing the perils of trusting two accounting numbers: operating income and invested capital. I did try to correct for the accounting misclassifications, converting leases into debt and R&D into capital assets, and also computed an alternate return on capital measure, based on average earnings over the last ten years. Notwithstanding these adjustments, I am still exposed to a multitude of accounting problems and I have to hope and pray that the law of large numbers will bail me out on those.

    I computed the return on invested capital for each of the 41,889 firms in my sample and subtracted out the cost of capital for each one to arrive at an excess return. The graph below captures the distribution of this excess return across global firms in 2015:

    Overall, more than half of all publicly traded firms, listed globally, earned returns on capital that were lower than the cost of capital in 2015 and this conclusion is not sensitive to using average income or my adjustments for R&D and leases. The return on capital is a flawed measure and I have written about the adjustments that are often needed to it. That said, with the corrections for leases and R&D, it remains the measure that works best across businesses in capturing the quality of investments.

    Industry Excess Returns
    In the second part of the analysis, I broke down the 41,889 companies into 95 industry grouping and computed the excess returns for each industry group.  The full results are at this link, but I ranked companies based on the magnitude of the excess returns. Again, with all the reservations that you can bring into this measure of investment quality, the businesses that delivered the highest spreads (over and above the cost of capital) are listed below.


    The best-performing sector is tobacco, where companies collectively earned a return on capital almost 22% higher than the cost of capital. One potential problem is that many of the businesses on this list also happen to be asset-light, at least in the accounting sense of the word, and some of these returns may just reflect our failure to fully capitalize assets in these businesses.

    Looking at the other end of the spectrum, the following is a list of the worst performing businesses in 2015, based on returns generated relative to the cost of capital.

    Note that oil companies are heavily represented on this list, not surprising given the drop in oil prices during the year. That, of course, does not make them bad businesses since a turning of the commodity price cycle will make the returns pop. There are other businesses that have been affected by either the slowing down of the China growth engine, such as steel and shipbuilding, and the question is whether they can bounce back if Chinese growth stays low. Finally, there are some perennially bad businesses, with auto and truck being one that has managed to stay on this list every year for the last decade, grist for my post on bad businesses and why companies stay in them.

    In computing this excess return, I deliberately removed financial service firms from the mix, because computing operating income or invested capital is a difficult, if not impossible task, at these firms. Lest you feel that I am giving managers at these firms a pass on the excess return question, I would replace the excess return spread (ROIC - Cost of capital) with an equity excess return spread (ROE - Cost of Equity) for these companies.

    Regional Differences
    Are firms in some parts of the world  better at putting capital to work than others? To answer that question, I broke my global sample into sub-regions and computed both operating margins and excess returns (return on invested capital, netted out against cost of capital) in each one.


    Looking at the list, the part of the world where companies seem to have the most trouble delivering their cost of capital is Asia, with Chinese companies being the worst culprits and India being the honorable exception. US and UK companies do better at delivering returns that beat their hurdle rates than European companies.

    Again, I would be cautious about reading too much into the differences across regions, since they may be just as indicative of accounting differences, as they are of return quality. It is also possible that some of the regions might have a tilt towards industries that under performed during the year and their returns will reflect that. Thus, the excess returns in Australia and Canada, which have a disproportionate share of natural resource companies, may be reflecting the drubbing that these companies took in 2015. 

    A Case for Corporate Governance
    I have been doing this analysis of excess returns globally, each year for the last few, and my bottom line conclusions have stayed unchanged.
    1. The value of growth: If the value of growth comes from making investments that earn more than your hurdle rate, growth in a typical publicly traded company is more likely to destroy value than to increase value (since more than 50% of companies earn less than their cost of capital). For investors and management teams in companies, I would view this as a signal to not rush headlong into the pursuit of growth.
    2. Bad management stays bad: In my sample, there are firms that have been earning excess returns year after year for most of the last decade, casting as a lie any argument that managers at these firms might make about "passing phases" and "bad years" affecting the numbers. To the question of why these managers continue to stay on, the answer is that in many parts of the world, it is almost impossible to dislodge these managers or even change how they behave.
    3. Bad businesses: There are entire businesses that have crossed the threshold from neutral to bad businesses, but management seems to be in denial. These are the businesses that I have described in my corporate life cycle posts as the "walking dead" companies and I have explored why they soldier on, often investing more into these investing black holes.
    Is good corporate governance the answer to these problems? In much of the world, the notion that stockholders are part owners of a company is laughable, as corporations continue to be run as if they were private businesses or family fiefdoms, and politics and connections, not stockholder interests,  drive business decisions in others.. Even in countries like the United States, where there is talk of good corporate governance, it has become, for the most part, check-list corporate governance, where the strength of governance is measured by how many independent directors you have and not by how aggressively they confront managers who misallocate capital. Institutional investors have been craven in their response to managers, not just abdicating their responsibility to confront managers, where needed, but actively working on behalf of incumbent managers to fight off change. The sorry record of value creation at publicly traded companies around the globe should act as a clarion call for good corporate governance. In the words of Howard Beale, from Network, we (as stockholders) should be "mad as hell and should not take it any more".

    1. Paper on measuring ROIC, ROC and ROE (Warning: Extremely boring but could be cure for amnesia. Don't read for excitement value!)




    January 2016 Data Update 4: The Costs of Capital

    In this post, the fourth in my data update series, I turn my focus to the cost of capital. While the discussion of cost of capital is often obscured by debates about risk and return models, it is a number central to much of what we do in corporate finance and valuation, and it predates modern portfolio theory. You cannot run a business without a sense of what you need to make on your investments to break even and you cannot value a business without a measure of your opportunity cost. 

    The Swiss Army Knife of Finance
    I teach two classes, corporate finance and valuation, and I wear different hats, when looking at the same questions. In corporate finance, my focus is on how to run a business, using fundamental financial principles, and in valuation, I shift my attention to how value that business, using the same principles. Like Waldo, the cost of capital is a constant part of both classes, playing a key role in almost every discussion.

    In the corporate finance class, it shows up in each of the three big questions that every business has to answer. It helps you answer the first one, on where you should direct your investments, by suppling your business with a hurdle rate or rates for investments, with riskier investments having to meet a higher threshold, to be acceptable.

    In capital structure, the cost of capital  becomes an optimizing tool that helps you decide the right mix of debt and equity.

    In dividend policy, the cost of capital becomes the divining rod for whether you should be returning more or less cash to your stockholders. If you operate in a business where your returns on new investments consistently fall short of your cost of capital, you should be returning more cash to your investors. 

    In the valuation class, the cost of capital is the discount rate that you use to bring operating cash flows back to today, to arrive at a value for a business. It has, unfortunately, also become the instrument that analysts use to bring their hopes, fears and worries into value, adding premiums to the discount rate, if an asset is illiquid, or reducing it, if it provides other benefits.

    In short, it is difficult to do financial analysis without at least getting a sense of what the cost of capital is, for a business. The many uses to which it is put has also meant that it has become all things to all people, a number that is misused, misestimated and misunderstood.

    The Mechanics of Estimating Cost of Capital
    About a year ago, in the context of my 2015 data update, I had an extensive post on the mechanics of computing cost of capital. Rather than repeat that post, I will direct you to it and summarize the process in a picture, for estimating the cost of capital for a company in US dollars:

    Thus, the cost of capital is a composite cost of equity and debt and incorporates the tax benefits of debt (through the after-tax cost of debt) and the risk added by debt in increased costs for both equity and debt. If you want to estimate the cost of capital in a different currency, you have two choices. The first is to replace the US dollar risk free rate with the other currency's risk free rate (seem my earlier post on currencies) or to add the differential inflation rate between the US dollar and the currency in question to a US dollar cost of capital. Thus, if your US dollar cost of capital is 10%, the inflation rate in rubles is 9.5% and the US dollar inflation rate is 1.5%, your Russian ruble cost of capital will be approximately 18%. (It is a little more precise to compute this rate allowing for the compounding: (1.10) (1.095/1.015) -1, but I will leave it up to you to decide whether it is worth the effort.)

    The Cost of Capital - US companies
    Let me start off with the US-centric portion of this post, where I look at the distribution of costs of capital across my sample of 7480 firms that are listed in the United States. In making my assessments, I made some simplifying assumptions:
    1. I used the US 10-year bond rate of 2.27%, on January 1, 2016, as my risk free rate. I don't like to play games normalizing risk free rates.
    2. I used the average unlevered beta for the sector as the beta for the company and levered this beta with the current debt to equity ratio of the firm.
    3. I used the implied equity risk premium for the S&P 500 (6.12% on January 1, 2016, rounded down to 6%) as the equity risk premium for all US companies in estimating the cost of equity. I know that some US companies have operating risk exposure outside the US, but I see no easy way that I can compute regional-weighted ERPs for this many companies.
    4. For the cost of debt, I used the S&P bond rating, if one was available, to estimate the default spreads and pre-tax cost of debt of the firm. For non-rated company, I used the standard deviation in equity in conjunction with a look up table (see the cost of capital spreadsheet) to estimate the default spread and pre-tax cost of debt. I used 40% as the marginal tax rate for the US in estimating the after-tax cost of debt.
    5. I used the current market capitalization as the value of equity and added up all interest bearing debt with the present value of lease commitments (for the next 5 years and beyond) to get to the debt, in computing the weights for debt and equity.
    The resulting distribution of costs of capital across US companies is summarized below. Note that 90% of US firms have costs of capital between 5.23% and 10% and 50% of US firms have costs of capital between 6.60% and 9.20%.



    If you are skeptical about betas and don't like computing costs of equity based upon them, I have a suggestion. Use the distribution of costs of capital in this graph, as your basis, for estimating a cost of capital for your firm. Use the cost of capital at the 90th percentile as your cost of capital for a risky firm, 8% as your cost of capital for a mature firm and 5.23% as your cost of capital for a very safe firm, and you should be relatively safe.

    The Cost of Capital - Global Distribution
    I also computed the cost of capital differences across global regions. Note that the differences are not rooted in currency, since the cost of capital for every firm is computed in US dollars. As to why costs of capital vary across countries, the answer can be traced back to two factors. The first is that debt ratios vary across the world, and that this may explain some of the variation. The second is that the regions of the world with higher sovereign default spreads and equity risk premiums (they go together in my approach) will have higher costs of capital than regions that have less risk. The table below summarizes the difference.

    US companies have the lowest costs of capital, on average, in the world and East European and Russian companies carry the highest costs of capital. These are all in US dollars, but you can use the differential inflation approach to convert them into other currencies.

    The Cost of Capital - Sector Differences
     Starting with the 41,889 firms that I have in my global sample at the start of 2016, I estimated the cost of capital for each company in dollar terms and then looked at the average costs of capital by sector. While you can find the entire sector list for cost of capital at the bottom of this post, I have listed the ten non-financial sectors with the highest costs of capital and the ten with the lowest:
    Source: Damodaran Online
    So, what now? If you have to estimate the cost of capital for a sector or a company in that sector, in US dollar terms, you could use the cost of capital for any companies that you value, in this sector. Again, adding the inflation differential will give you the cost of capital in any other currency. 

    The Bottom line
    The cost of capital may be the most used number in finance, but it is also the most misused. Companies often use one cost of capital to assess investments with different risk profiles, acting on the presumption that the cost of capital is the cost of raising company, rather than a risk adjusted required return for investing in a  risky asset. Investors use the cost of capital as a dumping ground for all their fears about investments, augmenting the standard risk-adjusted discount rate with premiums for liquidity, small market capitalization and opacity. We can do better!

    Presentation
    1. Cost of Capital: Misused, Misestimated and Misunderstood



    January 2016 Data Update 3: Country Risk and Pricing

    I had a long  post on country risk in July 2015, as part of series of posts on the topic. At the time of the post, the Chinese market was in the midst of a meltdown, emerging markets were in turmoil and exchange rates were on the move. It is six months later, and nothing seems to have changed, but I think that the core lesson is worth reemphasizing. In a world of multinational businesses and global investors, there is no place to hide from country risk. 

    Country Risk Measurement
    I will not bore you by repeating much of what I said in my earlier post on how I view country risk in valuation, but it is built on two presumptions. First, a company's risk exposure is based on where it does business, not where it is incorporated or headquartered. Thus, Coca Cola and Nestle may be incorporated in developed markets (US and Switzerland) but derive a significant portion of their revenues from emerging markets and are thus exposed to risk in those markets. By the same token, Embraer is a Brazilian company that derives a substantial portion of its revenues in developed markets. Second, the risk of investing in equities varies across the world, resulting in higher equity risk premiums in some markets than others.  To estimate these risk premiums, I follow a four-step process:
    My paper on equity risk premiums
    As an example, let's assume that I want to estimate the equity risk premium for operating in India in January 2016. 
    1. I start with the implied equity risk premium for the S&P in January 2016, which I estimated to be 6.12% in my first data post a few days ago. I use a rounded down estimate of 6% as my mature market premium for the start of 2016.
    2. As a second step, I look up the local currency sovereign rating for India from Moody's and arrive at a Baa3 rating; the typical default spread for a Baa3 rated country at the start of 2016 was 2.44%.  I check this estimate against the sovereign CDS spread for India, which was 2.11% on January 1, 2016. I use the ratings-based spread of 2.44% as the default spread for India, though I would not raise too much of a fight, if you insisted on using the CDS spread.
    3. In the third step, I try to estimate how much riskier equities are than government bonds in emerging markets by using proxies for each one: the S&P Emerging BMI Index (an index of emerging market equities) for stocks, and the S&P Emerging Market Public (government and quasi government) bond index yield. The standard deviation in the former is 17.36% and the coefficient of variation in the latter is 12.91% and the ratio of the former to the latter is 1.34. Multiplying this ratio by the default spread in step 2 yields a country risk premium for India of 3.28%. (CRP for India = 2.44% * 1.34 = 3.28%)
    4. In the fourth step, I add the country risk premium to the implied premium of 6% that I estimated in step 1 to arrive at an equity risk premium for India of 9.28%.
    Is this number an estimate? Of course! Would you get a different number if you used the CDS spread as your measure of default risk and different indices for emerging market equities and bonds? The answer is yes. It is for this reason that the spreadsheet that I create for equity risk premiums allows you to replace my defaults with yours for any or all of these variables. Before you exhaust yourself in this effort, I would suggest that small differences in this number will not make or break your valuation. So, make your best estimates and move on!

    Country Risk Update - January 2016
    Using the approach described for India, I compute equity risk premiums for the 130 countries with a Moody's sovereign rating. For about fourteen more, with no Moody's rating for the country, I was able to find a sovereign rating on S&P that I convert to a Moody's rating and estimate an ERP. Finally, there are about 20 countries, loosely categorized as frontier markets, for which there is no rating or CDS spread; these include the hot spots of the world such as Syria and Iraq. For these, I use the only measure of country risk that I can find, a composite risk score from Political Risk Services (PRS) and use that score to compute an equity risk premium; I create a look up table using the countries that have both PRS scores and ERP to make these judgments. Desperation move? Perhaps, but if you can find a better way of doing it, I would be glad to follow your lead. The resulting equity risk premiums by country are available in the spreadsheet that I referenced earlier but are also in the map below (which adds nothing in terms of content but looks much better):


    Country Pricing Update - January 2016
    In my July 2016 updates, I also included one on how stocks are priced around the world, using multiples (PE, PBV, EV/Sales, EV/EBITDA, EV/Invested Capital). While that post has a more extensive explanation of why stocks should trade at different multiples around the world, I have updated the multiples, by country, in this spreadsheet. As you peruse these numbers, keep in mind that the number of companies that I have in data set is very small for some countries and the multiples can therefore yield strange values. To prevent outliers from hijacking my estimation, I also compute the multiple using aggregated values; thus, the PE ratio for China is computed by adding the market capitalizations of all companies listed in the market and dividing by the aggregated net income of these companies. 



    Much as I would like to read more into this picture (especially about cheap and expensive markets), these country numbers are more a first step in the investment process than a last one. 

    Bottom line
    I think that we are far too casual in our treatment of country risk, estimating equity risk premiums on auto pilot for countries and attaching these premiums to companies based on where they are incorporated, rather than where they do business. If there is a lesson from the last week's implosion in the Chinese market, it is that the emerging market growth story that so many developed market companies have pushed for the last two decades has a dark side, and that dark side takes the form of higher risk. It is easy to forget this intuitive concept in the good times, but the market lulls us into complacency before shocking us. 

    Datasets



    January 2016 Data Update 2: Interest Rates, Exchange Rates and Currencies

    In both corporate finance and valuation, interest rates and exchange rates play a big role, the former because they form the basis for estimating required returns on risky investments, and the latter, since they affect your earnings and cash flows. That said, the biggest mistakes that we make in finance often come from trying to forecast one or both variables, implicitly or explicitly, when making corporate finance or investment decisions. 

    Interest Rates
    For much of the last year, the focus for US interest rates stayed on the Fed and whether it would  abandon its "low rate" policy. I contested the notion that the Fed sets interest rates in a post on September 4, 2015, leading into a FOMC meeting, and argued that even if the Fed did change its policy, the effect on rates would be muted. The Fed did not act in September but it finally did in December, when it raised the Fed Funds rate for the first time since the 2008 crisis. Given the long and involved lead up to this action, you would have expected treasury rates to jump sharply right after, but they did not. In the graph below, the 3-month treasury bill rate and the 10-year treasury bond rate are plotted by day, through 2015:
    Source: Federal Reserve in St. Louis (Download spreadsheet)
    There was some action on the treasury bill front, with rates rising from close to zero percent to 0.25% in the weeks around the action (mostly between September and December), before ending the year at 0.21%. It was an uneventful year for treasury bonds, with barely perceptible movements for much of the year and no discernible effect from the Fed's actions; we started the year with a ten-year treasury bond rate of 2.17% and ended the year at 2.27%, still well below historic norms:
    Source: Federal Reserve in St. Louis (FRED) (Download spreadsheet)
    I know that looking at this graph, you feel the urge to normalize, just as you probably have each year for the last few, replacing today's rates with a longer term average. I have long argued against this practice and I will do so again. I believe that today's low rates across developed markets is not a passing phase or a central bank set anomaly but more a reflection of a low inflation (perhaps even deflation) and low real growth. Updating a data series that I have used before, I compute the intrinsic treasury bond rate as the sum of the inflation rate and real GDP growth rate that year and compare it to the actual treasury bond rate:
    Download spreadsheet
    The intrinsic ten-year bond rate, if you add the latest estimates for inflation (0.40%) and real GDP growth (2.1% annualized, through 3rd quarter), is 2.50%, close to the treasury bond rate of 2.27% on December 31, 2015. Unless one or the other of these variables changes significantly over the next year, I don't see rates moving back this year, with or without Fed action.

    While there was little movement in US treasury rates during the course of the year, there was volatility in the corporate bond market, especially in the last few weeks of the year.
    Source: Merrill Lynch Indices (from FRED) (Download spreadsheet)
    Corporate default spreads (over the US T.Bond) increased across the board during the course of the year, unusual for a year where the US economy was showing signs of strength, but indicative of both the globalization of the US corporate bond market and the corrosive effects of the commodity price meltdown. In November and December, the lowest rated bonds (CCC and below) saw default spreads widen dramatically, perhaps a precursor to the repricing of risk both in this and the equity markets.
    Currencies and Exchange Rates
    The world used to be a much simpler place before globalization. Most companies did business in the countries that they were incorporated in and raised their financing (debt and equity) in the local currency. If exchange rates were an issue, they had only a marginal impact on earnings and value and the effects were easily eliminated through hedging. Those days are in the past, as multinationals are now more the rule than the exception, not only spreading their operations around the world, but also raising funding in multiple currencies.  In a post in July 2015, I looked at how corporate financial decisions and valuations are distorted by decision makers mixing and mismatching currencies. As China's markets melt down and threaten to take the rest of the world down with them, and exchange rates are in turmoil, I decided to revisit some of the basic rules of dealing with currencies, using my most recent data update to fill in the blanks.
    1. There is no global risk free rate: While 2.27% is the US dollar risk free rate, it cannot be used as the risk free rate if you are working in Euros, Yen, Yuan or Reais. At the start of each year and again mid-year, I estimate risk free rates in different currencies, starting with the government bond rate in that currency (if available) and then adjusting for any default risk that may be embedded in that bond, using the local currency rating for the country. Thus, to estimate the risk free rate in Chilean pesos on December 31, 2015, I subtract out a default spread of 0.67% for Chile (based on its Moody's local currency rating of Aa3) from the 4.75% at which the ten-year Chilean government bond,  denominated in pesos, was trading to get a risk free rate of 4.08% in Chilean Pesos. I was able to repeat this process for 42 currencies and they are captured in the picture below:
      Spreadsheet with risk free rates
      The weakest links in these estimates are not the default spreads, but the government bond rates, since many government bonds are illiquid and controlled.
    2. Inflation is the core fundamental: In the long term, interest rates in different currencies and exchange rates across them are determined by inflation differentials. In fact, one check of whether the interest rates computed in the last section for different currencies are reasonable is to compare them to inflation in these currencies. For instance, consider the Vietnamese dong, where my estimate of the risk free rate (based on the government bond rate) was 2.06%, but where inflation averaged 10.54% over the last five years. Using the rate on the inflation-indexed treasury bond (0.73% on December 31, 2015) as a measure of the real interest rate (globally), the synthetic risk free rate for Vietnam would be 11.27%, much higher than the computed risk free rate. (This spreadsheet has synthetic risk free rates computed for countries.)
    3. The key to dealing with currencies is to be consistent: In my post on currencies in July 2015, I argued that valuation/corporate financial decisions should be currency invariant; a company that looks expensive, if you value it in US dollars, should not magically become cheap, if you value it in Indian rupees. The reason is simple. If you value a company in Indian rupees instead of US dollars, you will be using a higher discount rate (since the risk free rate in Indian rupees is about 3% higher than the risk free rate in US dollars) but the effect will be offset by the growth rate being higher by 3% as well. For companies with operations and financing in many countries and currencies, you therefore have two choices. The first is to pick a single currency to value the company in and to convert all of the numbers into that currency before doing your valuation; you can value Nestle in Swiss francs, US dollars or Russian Rubles. The second is to value each currency stream separately, using that currency's inflation in both the cash flows and the discount rate, and to add the values of the different streams. That may sound more precise but it is not only a lot more work but may require information at the regional level on investment and cash flows that is not always available.
    4. Exchange rates are momentum driven, but fundamentals ultimately win out: Currencies are momentum driven, allowing traders to make money for extended periods on strategies that build on momentum. However, when momentum shifts in currency markets (either because of a market mood shift or a government intervention), the profits generated from years of momentum trading can be wiped out in a fraction of the period. In my valuations, when I have to forecast exchange rates (to convert cash flows in future periods from one currency to another), I adopt a very simple strategy, using the differential inflation rates between the currencies as my basis for expected currency appreciation or depreciation (purchasing power parity). Thus, if I were required to forecast the US dollar/Indian rupee exchange rate for the next decade in a valuation, I would build in an expected depreciation in the rupee of about 3% (the same inflation differential between the Indian rupee and the US dollar that I used in the risk free rate computation). Not only does it keep my valuations internally consistent but it comes with two bonuses. The first is that my inflation mistakes cancel out; thus, if the expected inflation in India turns out to be 6% higher than the US inflation rate, instead of 3%, both my cash flows and my discount rates will be understated and the effects will offset. The second is that I save myself the aggravation of having to listen to currency experts, whose expertise seems to lie not in forecasting in the future but in providing elaborate rationales for past forecasting errors.
    Bottom line
    This has been the worst opening few days for equity markets in the United States in history, and the damage has been greater in many emerging markets. The US dollar is stronger, emerging market currencies are weaker and interest rates are on the move. The macroeconomic soothsayers will be out in full force, with predictions aplenty about where interest rates and exchange rates will be going this year. Much as you will tempted to alter your asset allocation mixes and investment strategies, based on their forecasts, my advice is that you chart your own course. I plan to take the karmic route for macro variables, accepting that change is the only constant and completely out of my control. While that strategy may do little to protect my portfolio, it does wonders for my psyche.

    Datasets
    1. US treasury bond rates (actual and intrinsic) - 1960-2015
    2. US treasury bond and bill rates (Daily for 2015)
    3. US corporate bond yield spreads (Daily for 2015)
    4. Risk free rates by Currency (January 1, 2016)
    5. Synthetic Risk free rates by Currency (January 1, 2016)
    Past Blog Posts on Interest Rates and Currencies






    Lazarus Rising or Icarus Falling? The GoPro and LinkedIn Question!

    As I watch GoPro and LinkedIn, two high flying stocks of not that long ago, come back to earth my mind is drawn to two much told stories. The first is the Greek myth about Icarus, a man who had wings of feathers and wax, but then soared so high that the sun melted his wings and he fell to earth. The other is that of Lazarus, who in the biblical story, is raised from the dead, four days after his burial. As investors, the decision that we face with GoPro and LinkedIn is whether like Icarus, they soared too high and have been scorched (perhaps permanently) or like Lazarus, they will come back to life.

    GoPro: Camera, Smart Phone Accessory or Social Media Company?
    GoPro went public in June 2014 at $24/share and quickly climbed in the months following to hit $93.85 in October of that year. When I first valued the company in this post, the stock was still trading at more than $70/share. Led by Nick Woodman, a CEO who had a knack for keeping himself in the public eye (not necessarily a bad thing for publicity seeking start up), and selling an action camera that was taking the world by storm, the company’s spanning of the camera, smartphone accessory and social media businesses seemed to position it to conquer the world. Even at its peak, though, it was clear the competitive storm clouds were gathering as other players in the market, noting GoPro’s success, readied their own products.

    In the last year, GoPro lost much of its luster as its product offerings have aged and sales growth has lagged expectations. It is a testimonial to these lowered expectations that investors were expecting revenues to drop, relative to the same quarter in the prior year, in the most recent quarterly earnings report from the company.

    The company reported that it not only grew slower and shipped fewer units than expected in the most recent quarter, but also suggested that future revenues would be lower than expected. While the company’s defense was that consumers were waiting for the new GoPro 5, expected in 2016, investors were not assuaged. The stock dropped almost 20% on the news, hitting an all-time low of $9.78, right after the announcement.

    To evaluate how the disappointments of the last year have impacted value, I went back to October 2014, when I valued the stock at $30.57. Viewing it as part camera, part smart phone and part social media company (whose primary market is composed of hyper active, over sharers), I estimated that it would be able to grow its revenues 36% a year, to reach about $10 billion in steady state, while earning a pre-tax operating margin of 12.5%. Revisiting that story, with the results in the earnings reports since, it looks like competition has arrived sooner and stronger than anticipated, and that the company’s revenue growth and operating margins will both be more muted.

    In my updated valuation, I reduced my targeted revenues to $4.7 billion in steady state, my target operating margin to 9.84% (the average for electronics companies) and increased the likelihood that the company will fail to 20%. The value per share that I get with my updated estimates is $17.66, 35% higher than the price per share of $12.81, at the start of trading on February 22, 2016.  Looking at the simulation of values, here is what I get:
    Spreadsheet with valuation
    At its price of $12.81, there is a 68% chance that the stock is under valued, at least based on my assumptions.

    I am fully aware of the risks embedded in this valuation. The first is that as an electronics hardware company that derives the bulk of its sales from one item, GoPro is exposed to a new product that is viewed as better by consumers, and especially so if that new product comes from a company with deep pockets and a big marketing budget; a Sony, Apple or Google would all fit the bill. The second is that the management of GoPro has been pushing a narrative that is unfocused and inconsistent, a potentially fatal error for a young company. I think that the company not only has to decide whether its future lies in action cameras or in social media and act accordingly, but it also has to stop sending mixed messages on growth; the stock buyback last year was clearly not what you would expect from a company with growth options.

    Linkedin: The Online Networking Alternative?
    LinkedIn went public in May 2011, about a year ahead of Facebook and can thus be viewed as one of the more seasoned social media companies in the market. Like GoPro, its stock price soared after the initial public offering:

    LinkedIn Stock Price: IPO to Current
    While it often lumped up with other social media companies, Linkedin is different at two levels. The first is that it is less dependent on advertising revenues than other social media companies, deriving almost 80% of its revenues from premium subscriptions that it sells its customers and from matching people up to jobs. The second is that its pathway to profitability has been both less steep and speedier than the other social media companies, with the company reporting profits (GAAP) in both 2013 and 2014, though they did lose money in 2015.

    Unlike GoPro, where expectations and stock prices had been on their way down in the year before the most recent earnings report, the most recent earnings report was a surprise, though, at least at first sight, it did not include information that would have led to this abrupt a reassessment:
    Linkedin delivered earnings and revenue numbers that were higher then expectations and much of the negative reaction seems to have been to the guidance in the report.

    While I have not valued Linkedin explicitly on this blog for the last few years, it has been a company that has impressed me for a simple reason. Unlike many other social media companies that seemed to be focused on just collecting users, Linkedin has always seemed more aware of the need to work on two channels, delivering more users to keep markets happy and working, at the same time, on monetizing these users in the other, for the eventuality that markets will start wanting more at some point in time. Its presence in the manpower market also means that it does not have to become one more player in the crowded online advertising market, where the two biggest players (Facebook and Google) are threatening to run up their scores. Nothing in the latest earnings report would lead me to reassess this story, with the only caveat being that the drop in earnings in the most recent year suggests that profit margins in the manpower business are likely to be smaller and more volatile than in the advertising business.

    Allowing for Linkedin’s presence in two markets, I revalued the company with revenue growth of 25% a year for the next five years, leading to $15.3 billion in revenues in steady state (ten years from now), and a target pre-tax operating margin of 18%, lower than my target margins for Twitter or Facebook, reflecting the lower margins in the manpower business. The value per share that I get for the company is $103.49, about 10% below where the market is pricing the stock right now. The results of the simulation are presented below:

    Spreadsheet with valuation
    At its current stock price, there is about a 40% chance that the company is under valued.  If you have wanted to hold LinkedIn stock, and have been put off by the pricing, the price is tantalizingly close to making it happen. As with other social media companies, LinkedIn’s user base of 410 million and their activity on the platform are the drivers of its revenues and value.

    The Acquisition Option
    If you are already invested in GoPro or LinkedIn, one reason that you may have is that there will be someone out there, with deep pockets, who will acquire the firm, if the price stays where it is or drops further, thus putting a floor on the value. That is not an unreasonable assumption but to me, this has always been fool's gold, where the hope of an acquisition sustains value and the price goes up and down with each rumor. I have seen it play out on my Twitter investment and I do think it gets in the way of thinking seriously about whether your investment is backed by value.

    That said, I do think that having an asset or assets that could be more valuable to another company or entity does increase the value of a company. It is akin to a floor, but it is a shifting floor, and here is why. Consider LinkedIn, a company with 410 million users. Even with the drop in market prices of social media companies in the last few months, the market is paying roughly $80/user (down from about $100/user a couple of years ago). You could argue that an acquirer would be a bargain, if they could acquire LinkedIn at $8 billion, roughly $20 a user. However, the price that an acquirer will be willing to pay for LinkedIn users will increase if revenues are growing at a healthy rate and the company is monetizing its users. 

    To evaluate the impact that introducing the possibility of an acquisition does to LinkedIn's value, I started by assuming that the acquisition price for LinkedIn would be $8 billion, but that the value would range from $4 billion (if revenue growth is flat and margins are low) to $12 billion (if revenue growth is robust). I then reran the simulation of LinkedIn's valuation, with the assumption that the company would be bought out, if the market capitalization dropped below the acquisition price. In the picture below, I compare the values across the two simulations, one without an acquisition floor and one with:

    You may be surprised by how small the effect of introducing an acquisition floor has on value but it reflects two realities. One is my assumption that the expected acquisition price is $8 billion; raising that number towards the current market capitalization of $15.4 billion will increase the effect. The other is my assumption that the acquisition price will slide lower, if LinkedIn's revenue growth and operating profitability lag. 

    Fighting my Preconceptions
    I must start with a confession. After watching the price drop on these two stocks, and prior to my valuations, I really, really wanted LinkedIn to be my investment choice. I like the company for many reasons:
    1. As noted earlier, unlike many other social media companies, it is not just an online advertising company.
    2. The other business (networking and manpower) that the company operates in is appealing both because of its size, and the nature of the competition.
    3. The top management of LinkedIn has struck me as more competent and less publicity-conscious that those at some other high profile social media companies. I think it is good news that I had to think a few minutes about who LinkedIn's CEO was (Jeff Weiner) and check my answer.
    I have a sneaking suspicion that my biases did affect my inputs for both companies, making me more pessimistic in my GoPro inputs and more optimistic on my LinkedIn values. That said, the values that I obtained were not in keeping with my preconceptions. In spite of my inputs, GoPro is significantly under valued and in spite of my implicit attempts to pump it up, LinkedIn does not make my value cut. Put differently, the market reaction to the most recent earnings report at LinkedIn was clearly an over reaction, but it just moved the stock from extremely over valued, on my scale, to close to fair value. 

    YouTube Video

    Datasets
    1. GoPro - Bloomberg Summary (including 2015 numbers)
    2. LinkedIn - Bloomberg Summary (including 2015 numbers)
    Spreadsheets
    1. GoPro - Valuation in February 2016
    2. Twitter - Valuation in February 2016
    Blog posts in this series
    1. A Violent Earnings Season: The Pricing and Value Games
    2. Race to the top: The Duel between Alphabet and Apple!
    3. The Disruptive Duo: Amazon and Netflix 
    4. Management Matters: Facebook and Twitter
    5. Lazarus Rising or Icarus Falling? The GoPro and LinkedIn Question!
    6. Investor or Trader? Finding your place in the Value/Price Game! (Later this year)
    7. The Perfect Investor Base? Corporation and the Value/Price Game (Later this year)
    8. Taming the Market? Rules, Regulations and Restrictions (Later this year)




    Management Matters: Facebook and Twitter!

    I am not a big user of social media. I have a Facebook page, which I don’t visit often, never respond to pokes and don’t post on at all. I tweet, but my 820 lifetime tweets pale in comparison to prolific tweeters, who tweet that many times during a month. That said, I have been fascinated with, and have followed, both companies from just prior to their public offerings and not only have learned about the social media business but even more about my limitations in assessing their values. The paths that these companies have taken since their public offerings also offer illustrative examples of how markets assess and miss-assess these companies, why management matters, and the roller coaster ride that investors have to be willing to take, when they make bets on these companies.

    Facebook

    In its brief life as a public company, Facebook has acquired a reputation of being a company that not only manages to make money while it grows but is also able to be visionary and pragmatic, at the same time. In its most recent earnings report on January 27, 2016, Facebook delivered its by-now familiar combination of high revenue growth, sky high margins and seeming endless capacity to add to its user base and more importantly, monetize those users:


    The market’s reaction to this mostly positive report was positive, with the stock rising 14% in the after market.

    I first valued Facebook a few weeks ahead of its IPO and again at the time of its IPO at about $27/share, laughably low, given that the stock is close to $100 today, but reflecting the concerns that I had on four fronts: whether it could keep user growth going, given that it was already at a billion users then, whether it could make the shift to mobile, as users shifted from computers to mobile phones and tablets, whether it could scale up its online advertising revenues and whether it could continue to earn its high margins in a business fraught with competition. The company, through the first four years of its existence has emphatically answered these questions. It has managed to increase its user base from huge to gargantuan, it has made a successful transition to mobile, perhaps even better than Google has, and it has been able to keep its unusual combination of revenue growth and sky-high margins. Prior to the prior year's last earnings report, in November 2015, I was already seeing Facebook as potentially the winner in the online advertising battle with Google and capable of not only commanding a hundred billion in revenues in ten years but with even higher margins than Google. The value per share of almost $80/share, that I estimated for the company in November 2015, reflects the steady rise that I have reported in my intrinsic value estimates for the company over the last five years. If anything, the story is reinforced after the earnings report, with revenue growth coming in at about 44% and an operating margin of 51.36%.

    The value per share that I get for the company, with this narrative, is about $95/share, just a little bit under the $102/share that the stock was trading at in February 2016.  As with my other valuations in this series, I ran a simulation of Facebook’s value and the results are below:
    At the prevailing price of $102/share, the stock was close to fairly priced on February 12, at least based on my inputs. 

    I am sure that there will be others who will put Facebook under a microscope to find its formula for success, but there are two actions that are illustrative of the company’s mindset. The first was its aforementioned conquest of the mobile market, where it badly lagged its competitors at the time of it IPO. Rather than find excuses for its poor performance, the company went back to the drawing board and created a mobile version which not only improved user experience but provided a platform for ad revenues. The second was the company’s acquisition of Whatsapp, an acquisition that cost the company more than $20 billion and provoked a great deal of head scratching among value minded people at time, since Whatsapp had little in revenues and no earnings at the time. I argued at the time that the acquisition made sense from a pricing perspective, since Facebook was buying 450 million Whatsapp users for about $40/user, when the market was pricing these users at $100/user. That acquisition may have been driven by pricing motivations but it has yielded a value windfall for the company, especially in Asia and Latin America, with more than 100 million Whatsapp users just in India. 

    It is true that Facebook’s latest venture in India, Free Basics, where it had partnered with an Indian telecom firm to offer free but restricted internet service, has been blocked by the Indian government, but it is more akin to a bump in the road than a major car wreck. At the risk of rushing in where others have been burned for their comments, I am cynical enough to see both sides of the action. Much as Facebook would like to claim altruistic motives for the proposal, the restriction that the free internet use would allow you access only to the portion of the online space controlled by Facebook makes me think otherwise. As for those who opposed Free Basics, likening Facebook’s plans to colonial expansion is an over reach. In my view, the problem with the Indian government for most of the last few decades is not that it's actions are driven by knee jerk anti-colonialism, but that it behaves like a paternalistic, absentee father, insisting to its people that it will take care of necessities (roads, sewers, water, power and now, broadband), while being missing, when action is needed.

    On a personal note, I was lucky to be able to buy Facebook a few months after it went public at $18, but before you ascribe market timing genius to me, I sold the stock at $45. At the time, Tom Gardner, co-founder of Motley Fool and a person that I have much respect for, commented on my valuation  (on this blog) and suggested that I was under estimating both Facebook's potential and its management. He was right, I was wrong, but I have no regrets!

    Twitter
    If Facebook is evidence that you can convert a large social media base into a business platform to deliver advertising and more, Twitter is the cautionary note on the difficulties of doing so. Its most recent earnings report on February 10, 2016, continued a recent string of disappointing news stories about the company:


    The market reacted badly to the stagnant user base (though 320 million users is still a large number) and Twitter’s stock price hit an all time low at $14.31, right after the report. The positive earnings may impress you, but remember that this is the reengineered and adjusted version of earnings, where stock based compensation is added back and other sleights of hand are performed to make negative numbers into positive ones.

    As with Facebook, I first valued Twitter in October 2013, just before its IPO and arrived at an estimate of value of 17.36 per share. My initial narrative for the company was that it would be successful in attracting online advertising, but that its format (the 140 character limit and punchy messages) would restrict it to being a secondary medium for advertisers (thus limiting its eventual market share).The stock was priced at $26, opened at $45 and zoomed to $70, largely on expectations that it would quickly turn its potential (user base) into revenues and profits. However, in the three years since Twitter went public, it is disappointing how little that narrative has changed. In fact, after the most recent earnings report, my narrative for Twitter remains almost unchanged from my initial one, and is more negative than it was in the middle of last year.


    Since the narrative has not changed since the original IPO, the value per share for Twitter, not surprisingly, remains at about $18. The results of my simulation are below:

    My estimate of value today is lower than my valuation in August of last year, when I assumed that the arrival of Jack Dorsey at the helm of the company, would trigger changes that would lead to monetization of its user base.

    So what’s gone wrong at Twitter? Some of the problems lie in its structure and it is more difficult to both attract advertising and present that advertising in a non-intrusive way to users in a Tweet stream. (I will make a confession. Not only do I find the sponsored tweets in my feed to be irritating, but I have never ever felt the urge to click on one of them.) Some of the problems though have to be traced back to the way the company has been managed and the choices it has made since going public. In my view, Twitter has been far too focused on keeping Wall Street analysts happy and too little on building a business. Initially, that strategy paid off in rising stock prices, as analysts told the company that the game was all about delivering more users and the company delivered accordingly. The problem, though, is that users, by themselves, were never going to be a sufficient metric of business success and that the market (not the analysts) transitioned, in what I termed a Bar Mitzvah moment, to wanting to see more substance, and the company was not ready. 

    Can the problems be fixed? Perhaps, but time is running out. With young companies, the perception of being in trouble can very easily lead to a death spiral, where employees and customers start abandoning you for greener pastures. This is especially true in the online advertising space, where Facebook and Google are hungry predators, consuming every advertising dollar in their path. I have said before that I don’t see how Jack Dorsey can do what needs to be done at Twitter, while running two companies, but I am now getting to a point where I am not sure that Jack Dorsey is the answer at Twitter.  As someone who bought Twitter at $25 late last year, I am looking for reasons to hold on to the stock. One, of course, is that the company may be cheap enough now that it could be an attractive acquisition target, but experience has also taught when the only reason you have left for holding on to a stock is the hope that someone will buy the company, you are reaching the bottom of the intrinsic value barrel. The best that I can say about Twitter, at the moment, is that at $18/share, it is fairly valued, but if the company continues to be run the way it has for the last few years, both price and value could move in tandem to zero. Much as I would like to hold on until the stock gets back to $25, I am inclined to sell the stock sooner, unless the narrative changes dramatically.

    The Postscript
    Valuing Facebook and Twitter after valuing Alphabet is an interesting exercise, since all three companies are players in the online advertising space. At their current market capitalization, the market is pricing Facebook and Google to not just be the winners in the game, but pricing them to be dominant winners. In fact, the revenues that you would need in ten years to justify their pricing today is close to $300 billion, which if it comes entirely from online advertising, would represent about 75% of that market. If you are okay with that pricing, then it is bad news for the smaller players in online advertising, like Twitter, Yelp and Snapchat, who will be fighting for crumbs from the online advertising table. This is a point that I made in my post on big market delusions last year, but it leads to an interesting follow up. If you are an investor, I can see a rationale for holding either Google or Facebook in your portfolio, since there are credible narratives for both companies that result in them being under valued. I think you will have a tougher time justifying holding both, unless your narrative is that the winner-take-most nature of the game will lead to these companies dominating  the online advertising market and leaving each other alone. If  Google, Facebook and the smaller players (Twitter, Yelp, a private investment in Snapchat) are all in your portfolio, I am afraid that I cannot see any valuation narrative that could justify holding all of these companies at the same time.

    Closing on a personal note, I have discovered, during the course of valuation, that I learn as much about myself as I do about the companies that I value. In the case of Facebook and Twitter, I have learned that I hold on to my expectations too long, even in the face of evidence to the contrary, and that I under estimate the effect of management, especially at young companies to deliver surprises (both positive and negative). I sold Facebook too soon in 2013, because my valuations did not catch up with the company’s changed narrative until later and perhaps bought Twitter too early,  last year, because I thought that the company’s user base was too valuable for any management to fritter away. I live and I learn, and I am sure that I will get lots of chances to revisit these companies and make more mistakes in the future.

    YouTube Video


    Datasets
    1. Facebook 10K (2015)
    2. Twitter - Bloomberg Summary (including 2015 numbers)
    Spreadsheets
    1. Facebook - Valuation in February 2016
    2. Twitter - Valuation in February 2016
    Blog posts in this series
    1. A Violent Earnings Season: The Pricing and Value Games
    2. Race to the top: The Duel between Alphabet and Apple!
    3. The Disruptive Duo: Amazon and Netflix 
    4. Management Matters: Facebook and Twitter
    5. Lazarus Rising or Icarus Falling? The GoPro and LinkedIn Question!
    6. Investor or Trader? Finding your place in the Value/Price Game! (Later this year)
    7. The Perfect Investor Base? Corporation and the Value/Price Game (Later this year)
    8. Taming the Market? Rules, Regulations and Restrictions (Later this year)



    The Disruptive Duo: Amazon and Netflix!

    Amazon and Netflix! Need I say more? Just the mention of those companies cleaves market participants into opposing camps. In one camp are those who believe that those who invest in these companies are out of their minds and that there is no way that you can justify buying these companies, perhaps at any price. In the other are those who argue that the old time value investors don't get it, that these companies are redefining old businesses and will emerge as winners, thus justifying their high prices. The truth, as always, lies in the middle.


    Amazon and Netflix: Reading the Pricing Entrails

    Amazon and Netflix have been market wonders, rising in market capitalization even in 2015, a year when most of the market was retrenching. Notwithstanding the steep drop in stock prices of both companies this year (with Amazon down 23% and Netflix down 22%), Amazon is still up 36% over the last year and Netflix is up 34% during the same period.


    One simple way to measure how much these companies have to come to dominate their playing fields is to compare them with traditional heavyweights in their businesses, Walmart, in the case of Amazon, and Time Warner, in the case of Netflix.

    Is it possible that Amazon is worth more than Walmart and that Netflix is more than 60% of Time Warner’s value? The answer is yes and the only way to find out is by valuing both companies.

    Amazon: The Field of Dreams Company

    In a post in October 2014, I described Amazon as a Field of Dreams company, with a CEO (Jeff Bezos) who has been remarkably consistent in his push to make the company larger, even if that means selling products and services at cost, or even below, with the objective of using that market power to generate profits later. His vision for the company can be seen in this 1997 letter to stockholders and the company has certainly delivered on at least one half of that vision and increased its revenues in retailing initially, entertainment later and cloud computing recently, while generating little in profits over much of its existence.

    In its most recent earnings report on January 28, 2016, Amazon delivered its by-now-usual high revenue growth, delivered close to expected numbers on its revenues and guidance, but came in well below expectations on its earnings per share. 


    The market reacted strongly to the earnings per share surprise, with the stock price dropping 15% and Amazon losing $45 billion in market capitalization. The response followed a pattern of large market reactions to earnings surprises at the company, perhaps suggesting that the market is dreaming less about revenues and wanting more in profits from Amazon.

    From a valuation perspective, Amazon’s results reinforced my existing story, with perhaps a tweak in the pathway to profitability:

    During the last year, Amazon has taken actions that suggest that it is heeding the call to show profits, shifting more of its focus to cloud computing and laying off employees for the first time in its corporate life. To get a measure of the company’s current and expected future profit margins, I decided to take Amazon’s substantial technology and product development costs, which amounted to $12.5 billion in 2015 out of the operating expenses, and capitalize them, on the rationale that as growth started to slow, the growth in this cost would level off. That adjustment does push the current operating margin for the company from 2.09% to 6.58%, while also significantly raising my estimates of how much Amazon is reinvesting to generate its high revenue growth. Assuming that there is still room for revenue growth (especially in Amazon’s media and cloud computing business) and margin expansion (to 8.80%, the weighted average of the margins in the retail, media and cloud business) gives me an updated story for Amazon. The value that I obtain is $323.55 per share and the results of the simulation in February 2016 using this updated story are below:

    Amazon Valuation Spreadsheet
    At $507 per share, the price on February 12, 2016, Amazon still looks over valued to me, but as you can see from the simulation, there is a sizeable probability that assuming higher growth and higher margins can get you values that exceed the price. If your rationale for buying Amazon is the cloud computing dream, I would suggest caution. The business is a big, potentially profitable one, but it is also one where other big players are stirring.

    Netflix: House of Cards or Global Streamer?
    Like Amazon, Netflix has a CEO in Reed Hastings, who has been both consistent and credible in selling a story of growth and potential. As the company approaches saturation in the US market, the growth story has a global twist to it. In its earnings report on January 19, 2016, Netflix beat expectations on both earnings per share and subscribers, with the growth in global subscribers tipping the scale. 

    While the report initially evoked a positive response, that price bounce quickly faded as investors took profits.

    I have never posted a Netflix valuation on my blog, but in my prior valuations of the firm, I have tended to value it as a primarily domestic company that acquires others’ content and streams it to subscribers While that remains the core business model, it seems to me that the story is shifting to a company that is increasingly global and more willing to generate its own content, with this earnings report providing further backing for the view. The connection between this story and my valuation inputs is below:

    Note that Netflix’s shift to content has mixed effects, decreasing profit margins (at least as I have defined them) while also reducing the reinvestment needed to generate growth (as the cost of buying content is replaced with the cost of making its own). The value per share that I obtain with these inputs is $61.44. Allowing the inputs to vary and be drawn from distributions, my estimated value distribution for Netflix is as follows:


    At $87.40/share per share, Netflix looks overvalued by about 40%, but as with Amazon, there are clearly combinations of revenue growth and margins that yield values that exceed the price.

    To GAAP or not to GAAP?

    Both Amazon and Netflix have a GAAP problem, insofar as neither company generates much in operating profits, using conventional accounting rules. I do believe that GAAP understates the profits at both companies, though not for the reasons used by many of the biggest cheerleaders for the company, including the adding back of stock-based compensation or the use of supplier credit as a source of capital (and cash flows). The problem is in the accounting categorization of expenses, with Amazon’s big investments in technology and content and Netflix’s even bigger spending on acquiring the rights to content (usually for multiple years) being treated as operating expenses. If we following accounting’s own first principle, which define capital expenditures as expenditures designed to create benefits over many years, Amazon’s technology investments and Netflix’s content commitments should both be moved out of operating expenses and the effects are captured in the table below:


    In summary, reclassifying these basic expenses changes the picture of these companies from low margin companies, that grow revenues with very little reinvestment, to higher margin companies, that reinvest significant amounts to deliver higher revenues. It also has a favorable impact on value per share, not because of the obvious reasons (that operating income is increased) but because the reinvestment at both companies has been value-generating.

    I don't worship at the GAAP altar and have come to the conclusion that while accountants might do some things well, measuring earnings at companies that are not stable, manufacturing firms is not one of those things.  They not only violate their own first principles (as evidenced by the treatment of R&D and contractual commitments as operating expenses) but also create inconsistencies across companies, making earnings at Amazon and Netflix not quite comparable with the earnings at GM or even at Walmart. That is one reason that I give short shrift to arguments against investing in Amazon, because it trades at several hundred times earnings, since cutting its technology development costs by $10 billion could quickly solve that PE problem while destroying the basis for the company's value.

    As businesses, the two companies share a common characteristic: they are willing to spend money now (on Prime and technology, in the case of Amazon, and original and acquired content, in the case of Netflix) to generate revenue growth, which they believe that they can turn into positive cash flows later. Both companies also realize that their growth ambitions will require them to grow outside the US, in less friendly regulatory standpoint and competitive environments. The biggest danger that the two companies face is that their revenue growth plans come to fruition, but that their costs stay high, as they have to keep spending money to keep their customers. There is one other characteristic that they share and it is one that may add to their value, though it is disquieting, at least to me. I have a feeling that Amazon knows more about my buying habits, and Netflix about my TV and movie watching proclivities, than I do myself. As an Amazon Prime user and Netflix subscriber of long standing, I know that they will use this knowledge to draw me deeper into their web, but I must confess that I am going in willingly.

    Investor or Trader?

    In the first post in this series, I differentiated between investors and traders and no two companies better illustrate the divide than Amazon and Netflix. The two stocks have created a Rorschach test  by forcing you to choose between staying true to your investing beliefs or capitulating to your pricing instincts. I would be lying if I said that I have not revisited my Amazon valuation from October 2014, when the stock was trading at about $300 and I found it to be over valued, as the stock doubled to more than $600 during the course of the next year or that I have not looked wistfully at Netflix, during its stock price rise last year.  That said, I have made my peace, for the moment, with the market, on these companies. I am an investor, for better or worse, and have to go with my estimates of value, flawed thought they might be, and will not buy either Amazon or Netflix, at their current prices. At the same time, I have enough respect for the power of markets to not sell short on either stock, since I have seen what momentum can do with both stocks. You can call me chicken, but I don't have the luxury of investing other people's money!
    YouTube


    Datasets
    1. Amazon 10K (2015)
    2. Netflix 10K (2015)
    Spreadsheets
    1. Amazon - Valuation in February 2016
    2. Netflix - Valuation in February 2016
    Blog posts in this series
    1. A Violent Earnings Season: The Pricing and Value Games
    2. Race to the top: The Duel between Alphabet and Apple!
    3. The Disruptive Duo: Amazon and Netflix 
    4. Management Matters: Facebook and Twitter
    5. Lazarus Rising or Icarus Falling? The GoPro and LinkedIn Question!
    6. Investor or Trader? Finding your place in the Value/Price Game! (Later this year)
    7. The Perfect Investor Base? Corporation and the Value/Price Game (Later this year)
    8. Taming the Market? Rules, Regulations and Restrictions (Later this year)



    Race to the top: The Duel between Alphabet and Apple!

    Apple and Alphabet, the two companies jockeying for the  prize of “largest market cap company in the world” are both incredibly successful businesses, with unparalleled cash machines (the iPhone and Google Search) at their core. That said, the last month has been eventful for both companies, just as it has for the rest of the market, as their latest earnings reports seem to suggest that these firms are on divergent paths. Having valued Apple multiple times on this blog over the last five years, and bought and sold the stock based on those valuations, the most recent earnings report is an opportune time for me to revisit Apple’s value. Having never valued Alphabet on this blog, though I have valued it in my classes multiple times, its earnings report is a good time to initiate the process with a valuation.

    The Apple Rollercoaster
    Apple’s most recent earnings report came out on January 26, 2016, and it contained mixed news. On the good news front, Apple announced the largest quarterly earnings in corporate history and higher earnings per share than expected by analysts. The bad news was that these earnings were generated on revenues that were close to flat for the year, that iPhone sales were lower than expected and that the management expected revenues to stay weak through next quarter (in its guidance). The market’s reaction was negative, with Apple’s stock declining by 6.57%, a drop in market capitalization of more than $30 billion, right after the announcement. In the picture below, I capture the pricing reaction to Apple, with its earnings history as background information:

    In summary, it looks like the market is weighing the iPhone and guidance bad news far more than the earnings good news in making its assessment, with Apple's history of beating earnings every quarter for the last eight weighing against it.

    To evaluate whether the earnings report merited the negative market reaction, I went back to the intrinsic value drawing board and updated my valuation of Apple, the last of which I posted in August 2015 and subsequently updated in November 2015, after its annual report (with a September 2015 year end) came out. My assessment of Apple’s value in November of 2015 was $134/share, but more importantly, the narrative that I had for Apple was that of a slow-growth , cash rich company (revenue growth rate of 3% in the next five years and a cash balance of $200 billion), with operating margins under pressure (declining from the 32.03% it earned as a pre-tax operating margin in the 2015 fiscal year to 25% over the next decade) and a very low probability of a difference-making disruption. Looking at the earnings report, it is true that revenue growth came in below expectations (but not by much, given my low expectations) and operating margins dropped, again in line with expectations.

    The net effect is that  my narrative changed little, and using a slightly lower revenue growth rate (2.2% instead of 3%) leads me to an updated assessment of value per share of $126 in February 2016 and almost all of the difference is coming from a repricing of risk (higher equity risk premiums and default spreads in the market). In keeping with my view that estimated value is a distribution, not a single number, I ran a simulation on Apple's value in February 2016:

    At the price of $94 at close of trading on February 12, 2016, Apple looks under valued by about 25% and at least based on my distribution, there is a more than 90% chance that it is under valued.

    Alphabet Soup
    Alphabet surprised markets on February 1, 2016, with on earnings report where the company reported higher revenue growth than anticipated, coupled with higher profit margins. Since it was also the first report that the company was releasing as holding company, where it was breaking itself down  by business, there was also excitement about what you would learn about the company from this report. As with Apple, I start by looking at the pricing effect of the earnings report, comparing, actual numbers to expectations and tallying the stock price reaction to the report:

    Markets were impressed by both the revenue and earnings numbers and the stock price increased by 8% in the immediate aftermath, briefly leading Alphabet to the front of the market cap race.

    As a counter to the market's excitement, I decided to compare the narrative (and value) that I had for Alphabet in November 2015 (after their last earnings report) to the narrative (and value) after this one (in February 2016).  In November 2015, my narrative for Google was that it would continue to be a dominant and profitable player in a growing online advertising market, growing 12% a year in the near term, maintaining its operating margins (left at 30% in pre-tax terms, in perpetuity).

    It is true that in their most recent earnings report, Alphabet reported double-digit growth in revenues (impressive given their size and the state of the global economy) and higher operating margins than they did in the previous quarter. I left my original narrative largely intact, with revenue growth remaining at 12% and pushed up the target pre-tax operating margin to 32%, and arrived at a value per share of $631/share. Presenting Google's value as a distribution, here is what I get:

    At $682.40, the price at which the class C shares were trading at on February 12, 2016, the stock is trading at about 8% above the median price, with a 35% chance of being under valued. Since these shares have no voting rights, attaching a value to voting rights, will make the shares a little more over priced.

    I know that one reason for Google's restructuring/renaming exercise last year was an ostensible desire to improve transparency, but I think that there may be less here than promised, at least at the moment. There were a few things that became transparent in Google's last earnings release, as captured in this picture of a key part of the earnings release from the company:
    1. It became transparently obvious that Google is almost entirely an online advertising company. All of Google's other businesses generate collective revenues of $448 million, while reporting operating losses of $3,567 million. To even call them businesses is perhaps stretching the definition of the word "business", since all they do well, right now, is spend money. While it is reasonable to cut them some slack because they are young, start-ups, there is nothing in this report that would lead you to think about them any differently than you always have, if you were a Google-watcher.
    2. It is transparently clear that in spite of its technological sophistication, this company uses financial terms loosely.  Note that what the company reports in its earnings release as operating income of $23,245 million in the 2015 fiscal year is really EBITDA, and perhaps the only thanks that we can give is that it is not an adjusted EBITDA. If you are going to be transparent, it is best if you not follow the dictum of Humpty Dumpty in Alice in Wonderland, and claim that a "word is what you choose it to mean".
    Transparency is good for investors, but with Alphabet, I will reserve my cheers until I see real evidence of it (and perhaps I will, in the full 10Q).

    Apple vs Alphabet
    If this were a boxing match, Apple and Alphabet would be the super heavyweights, fighting it out for the world championship. To judge which is the better company, though, you would have to specify on what dimension you are making the comparison, i.e., as a business, an investment or as a trade.

    I. As Businesses
    Apple and Alphabet share a few common features. First, each of them derives their value from one cash cow, the iPhone for Apple and the search engine for Google, that individually have values so large that they would exceed the GDPs of many small countries. Second, both companies are known for their attention to detail and customer focus, at least on their core products, perhaps explaining why they have been so successful over time. Third, both companies have work forces filled with brilliant people who seem to like working for them. In short, these companies are perfect illustrations of how customer focus, employee satisfaction and shareholder value maximization often go hand in hand.

    Each company, though, has areas where it has advantages. The Alphabet advantage is that its core product, its search engine, enriched with YouTube and the Google ecosystem, requires less care and maintenance to keep cash flows going, with Facebook perhaps being the only threat in the short or the medium term to profits. In contrast, Apple's iPhone franchise requires the company to constantly reinvent the product and make its own prior models obsolete, creating a two-year cycle that is both expensive and gut wrenching to watch. The Apple advantage, though, comes from its history of having survived a near-death experience (in the late 1990s) and reinvented itself. Consequently, the company is much more aware of how tenuous its hold on value is and it does try harder to find new game changers. There is one final difference that, at least at the moment, is working for Alphabet and against Apple, which is that Apple has made China its biggest foreign bet and Google has little exposure to the Chinese economy, thanks to the Chinese government's fear that all that stands between it and chaos is a good search engine.

    If I were to pick a better business at the moment, it has to be Google. The company's core is strong and will get stronger and the biggest threat it faces, i.e., that the way we look for things may change from search engines to social media sites, is more distant that the the one faced by Apple.

    II. As an Investment
    The quality of an investment does not always correlate with its quality as a business, with the price driving the divergence. Buying a great business at too high a price is a bad investment, just as buying a bad business at a low enough price can be a good investment. Both Apple and Alphabet are good businesses, but as an investor, my money is on Apple, rather than Alphabet, at the prevailing price:
    1. The break even points for the two companies to be fairly priced are wildly divergent. Apple does not need any revenue growth and can see its operating margins slashed by a third and it would still be a fairly valued investment at its current price. Google will have to deliver 12% revenue growth with its current already high pre-tax operating margin to break even. 
    2. This may just reflect my personal predilections, but I need a bonus to invest in a company that wants my money but is not interested in my input (my vote on key decisions). I have had my disagreements with Tim Cook, but Apple is a much stronger corporate democracy than Alphabet, which remains a dictatorship, albeit a benevolent one (at the moment). 
    I would hasten to add that I have never owned Google, as an investor, and that may reflect the fact that I continually under estimate the profit-making power of its online advertising engine. So, feel free to download my valuation, change the inputs you don't like and make it your own.

    III. As a Trade
    If momentum is the biggest driver in the pricing game, it is Alphabet that has the advantage right now, notwithstanding the decline in its price in the days since its last earnings report. Whether fair or not, markets have found the good news in almost every Alphabet story and find the storm clouds even on Apple's sunniest days. As long as the momentum game continues, you will make money far more easily and quickly with Alphabet than with Apple, but just a note of warning, from Apple's own recent past. Momentum will change, almost always without any advance warning and for no good fundamental reason, and when it does, I hope that you are able to get ahead of it.

    YouTube


    Raw Data
    1. Apple Last 10K (September 2015) and Current 10Q (December 2015)
    2. Google Last 10K, Last 10Q and Earnings Release (no current 10Q at the time of post)
    Spreadsheets
    1. Valuation of Apple in November 2015 and February 2016
    2. Valuation of Alphabet (Google) in November 2015 and February 2016
    Blog posts in this series
    1. A Violent Earnings Season: The Pricing and Value Games
    2. Race to the top: The Duel between Alphabet and Apple!
    3. The Disruptive Duo: Amazon and Netflix 
    4. Management Matters: Facebook and Twitter
    5. Lazarus Rising or Icarus Falling? The GoPro and LinkedIn Question!
    6. Investor or Trader? Finding your place in the Value/Price Game! (Later this year)
    7. The Perfect Investor Base? Corporation and the Value/Price Game (Later this year)
    8. Taming the Market? Rules, Regulations and Restrictions (Later this year)



    A Violent Earnings Season: Pricing and Value Perspectives

    The earnings season is upon us once again, the quarterly rite of passage where companies report their earnings results, the numbers get measured up against expectations, expectations get reset and prices adjust. As an investor, I sometimes find the process unsettling, but as a market observer, I cannot think of a better Petri dish to illustrate both the magic of markets and the vagaries of human behavior. This earnings season has been among the violent, in terms of market reaction, in quite a few years, as tens of billions of dollars in market capitalization have been wiped out overnight in some high flyers. In order to get perspective during these volatile times, it helps me to go back to a contrast that I have drawn before between the pricing and value games and how they play out, especially around earnings reports.

    Price versus Value: The Information Effect
    In finance, we use the words price and value, as if they were interchangeable and I have sometimes been guilty of this sin. It is worth noting that price and value not only come from different processes and are determined by different variables, but can also yield different numbers for the same asset at the same point in time. I try to capture the difference in a picture:


    The essence of value is that it comes from a company's fundamentals, i.e., its capacity to generate and grow cash flows; you can attempt to estimate that value using accounting numbers (book value) or intrinsic valuation (discounted cash flow). Fundamental information causes changes in a company's cash flows, growth or risk and by extension, will change its value. Pricing is a market process, where demand and supply intersect to produce a price. While that demand may be affected by fundamentals, it is more immediately a function of market mood/sentiment and incremental information about the company, sometimes about fundamentals and sometimes not.

    In an earlier post, I drew a distinction between investors and traders, arguing that investing is about making judgments on value and letting the price process correct itself, and trading is about making judgments on future price movements, with value not being in play. While the line between fundamental and incremental information is where the biggest battles between investors and traders are fought, it is not an easy one to draw, partly because it is subjective and partly because there are wide variations within each group on making that assessment. For instance, consider Apple, a company followed closely by dozens of analysts, and its earnings report on January 26, 2016. The company beat earnings expectations, delivering the most profitable quarterly earnings in corporate history, but also sold fewer iPhones than expected; the company lost almost $30 billion in market capitalization in the immediate aftermath. An investor valuing the company based on dividends would conclude that it was an overreaction, since not only are dividends not under immediate threat but the cash balance of $200 billion plus should allow the company to maintain those dividends in the  long term. A different investor whose valuation of the company was based on its operating cash flows might have viewed the same information as more consequential, especially since 65-70% of Apple's cash flows come from iPhones. A trader whose pricing of Apple is based on iPhone units sold would have drastically lowered the price for the stock, if his expectations for sales were unmet, but another trader whose pricing is based on earnings per share, would have been unaffected.

    Earnings Reports: The Pricing and Value Reaction
    While almost any story (rumor, corporate announcement) can be incremental information, it is quarterly earnings reports that keep the incremental information engine running, as revelations about what happened to a company in the most recent three-month period become the basis for reassessments of price and value.

    Earnings Reports: The Pricing Game
    The way traders react to earnings reports is, at least on the surface, uncomplicated. Investors form expectations about what an earnings report will contain, with analysts putting numbers on their expectations. The actual report is then measured up against expectations, and prices should rise if the actuals beat expectations and fall if they do not. The picture below captures this process, with potential complications thrown in.

    While the game is about actual numbers and expectations, it remains an unpredictable one for three reasons. The first is that the price catalyst in the earnings report, i.e, whether the market reacts to surprises on management guidance, revenues, operating income or earnings per share, can not only vary across companies but across time for the same company. The second is that while analyst expectations are what we focus on and get reported, the market's expectations can be different. The third is that the effect on stock prices, for a given surprise (positive or negative) can be different for different companies and in different time periods.
    1. Price Catalyst: It is easy enough to say that if the actual numbers beat expectations, it is good news, but actual numbers on what? While earnings reports two decades ago might have been  focused almost entirely on earnings per share, the range of variables that companies choose to report, and investors react to, has expanded to not only include items up the income statement, such as revenues and operating income, but also revenue drivers which can include units sold, number of users and subscribers, depending on the company in question.  In the last decade, companies have also increasingly turned to providing guidance about key operating numbers in future quarters, which also get measured against expectations. Not surprisingly, therefore, most earnings reports yield a mixed bag, with some numbers beating expectations and some not. Thus, Apple's earnings report on January 26, 2016, delivered an earnings per share that was higher than expected but revenue and iPhone unit numbers that were lower than anticipated.
    2. Whose expectations? News stories about earnings reports, like this one, almost always conflate analyst estimates with market estimates, but that may not always be correct. It is true that analysts spend a great deal of their time working on, finessing and updating their forecasts for the next earnings report, but it is also true that most analysts bring very little new information into their forecasts, are overly dependent on companies for their news and are more followers than leaders. To the extent that companies play the earnings game well and are able to beat analyst forecasts most or even in all quarters, the market seems to build this behavior into a "whispered earnings" number, which incorporates that behavior. 
    3. Effect of surprise: The market reaction to a surprise is also unpredictable, passing through what I call the market carnival or magic mirror, which can distort, expand or shrink effects, and three factors come into play in determining that image. The first is the company's history on on delivering expected earnings and providing guidance. Companies that have consistently delivered promised numbers and provided credible guidance tend to be cut more slack by markets that those that have a history of volatile numbers or stretching the truth. The second is the investor base acquired by the firm, with the mix of investors and traders determining the price response. On a pricing stock, it is traders who dominate the action and the market response is therefore usually more volatile, whereas on a value stock, it is investors who drive a more muted market reaction. The third has less to do with the company and more to do with the market mood. In a month like the last one, when fear is the dominant emotion, good news is oft overlooked or ignored, bad news is highlighted and magnified and the price reaction will tilt negative.
    Earnings Reports: The Value Game
    It is difficult to characterize the value game, precisely because it is played so differently by its many proponents. Some old-time value investors' concept of value is tied to dividends and other value investors are more open to expanding their measures of cash flows. To me, the one area where there should be agreement across investors is that every good intrinsic valuation should be backed by a narrative that not only provides structure to the numbers in the valuation, but also provides them with credibility. As I noted in this post from August 2014, it is this framework that I find most useful, when looking at earnings reports and I capture the "value" effect of earnings reports in this picture:

    If you accept the notion that value changes when your narrative changes, the following propositions follow:
    1. An earnings report can cause big change in value: For an earnings report to significantly affect value, a key part or parts of the narrative have to be changed by an earnings report. This could be news that a company has entered and is growing strongly in a market that you had not expected it to be successful in or on the flip side, news that the market that you see it is in is smaller and/or growing less than anticipated. 
    2. Big value changes are more likely in young companies: These significant shifts in value are more likely to occur with young companies than where business models are still in flux than with more established firms. Consequently, you should not be too quick in classifying a big price move on an earnings report as a market overreaction, especially with young firms like GoPro and Linkedin.
    3. There is more to an earnings report than the earnings per share: The relentless focus on earnings per share can sometimes distract investors from the real news in the earnings report which can be embedded in less publicized numbers on product breakdown, geographical growth or cost patterns.
    If you believe, like I do, that investing requires you to constantly revisit and revalue the companies that you have or wish you to have in your portfolio, new earnings reports from these companies provide timely reminders that no valuation is timeless and no corporate narrative lasts forever.

    The Rest of the Story
    This post has gone on long enough, but it will be the first in a series that I hope to do around earnings reports, built around four topics.
    1. Make it real: In the first set of posts, I will be looking at a few companies that I have valued before. I will start by looking at two companies, dueling for the honor of being the largest market cap company in the world, Alphabet (Google) and Apple, seemingly on different trajectories at the moment. I will follow up with Amazon and Netflix, two firms that are revolutionizing the entertainment business and were among the very best stocks to invest in last year. In the third post, I will turn my attention to two social media mainstays, one of which (Facebook) has unlocked the profit potential of its user base and the other (Twitter) that has (at least so far) frittered away its advantages. In the final post, I plan to pay heed to two high flyers, GoPro and Linkedin, that have hit rough patches and lost large portions of their value, after recent earnings reports.
    2. The Players: In the second set of posts, I will first focus on investors and traders and how they might be able to play the earnings game to their advantage, often using the other side as foil. I will then examine how corporations can adapt to the earnings game and look at different strategies that they use for playing the game, with the pluses and minuses of each. 
    3. The Government/Regulators/Society: In the final post, I will play a role that I am uncomfortable with, that of market regulator, and examine whether as regulator, there is a societal or economic benefit to trying to manage how and what companies report in their earnings reports and the investor reaction to these reports. In the process, I will look at the debate on whether the focus on delivering quarterly earnings diverts companies from a long term focus on value and how altering the rules of the game (with investor restrictions and tax laws) may make a difference.
    YouTube Video



    Blog posts in this series
    1. A Violent Earnings Season: The Pricing and Value Games
    2. Race to the top: The Duel between Alphabet and Apple!
    3. The Disruptive Duo: Amazon and Netflix 
    4. Management Matters: Facebook and Twitter
    5. Lazarus Rising or Icarus Falling? The GoPro and LinkedIn Question!
    6. Investor or Trader? Finding your place in the Value/Price Game! (Later this year)
    7. The Perfect Investor Base? Corporation and the Value/Price Game (Later this year)
    8. Taming the Market? Rules, Regulations and Restrictions (Later this year)



    January 2016 Data Update 8: Pricing, with an end of month update

    If you have been tracking the posts that I have about my data updates, you probably noticed that early on, I had planned eight posts but that this shrunk to seven by the time I was done. The reason was that the last post that I was planning to make was going to be on pricing numbers, i.e., the multiples that companies are trading at around the world, relative to book value and earnings. However, as the market dropped in January, I decided that posting the PE and EV/EBITDA multiples from January 1, 2016, would be pointless, since the numbers would be dated. I was also considering a post on the stock market turmoil during the month, and during the weekend, I decided that I could pull off a combined post, where I could look at both the pricing on January 1, and how it has changed during January 2016, by region, country and sector.

    The US story, as told through the ERP
    In my very first post this month, I looked at the equity risk premium for the S&P 500 on January 1, 2016, and estimated it to be 6.12%, based on dividends and buybacks over the last 12 months. I noted my discomfort with the fact that the cash returned in those twelve months exceeded the earnings, and estimated a buyback adjusted ERP of 5.16%, with buybacks reduced over time to a sustainable level. As in prior volatile months, I computed the ERP at the end of each trading day, using both measures of cash flows (trailing 12 months and modified to reflect earnings). The numbers are in the table below:
    Download spreadsheet
    The ERP rose about 0.60% (on both measures) during the month to peak on January 20, though it dropped back again in the last few days of the month. It is true that I left the cash flows and growth periods unchanged over the trading days, and that the bad news of the month may reverberate, with lower buybacks and growth expectations in the coming months. thus, the increase in the ERP is exaggerated, but, in my view, the bulk of the change will remain. The essence of a crisis month, like this one, is that the price of risk will increase during the month.

    The Five Trillion Dollar Heist: Who did it?
    The month started badly, with the Chinese markets dropping on the first trading day of the year and taking other markets down with them. Much of the month followed in the same vein, with extended periods of market decline followed by strong up days. Oil and China continued to be the market drivers, with oil prices continuing their inexorable decline and news of economic slowdown from China coming in at regular intervals. The damage inflicted during the month is captured in the chart below:


    The global equity markets collectively lost $5.54 trillion in value during the month, roughly 8.42% of overall value. The global breakdown of value also reflects some regional variations, with Chinese equities declining from approximately 17% of global market capitalization to closer to 15%. To the question of how the month measures up against the worst months in history, the good news is that there have been dozens of months that delivered worse returns in the aggregate. In fact, the US equity market's performance in January 2016 would not even make the list of 25 worst months in US market history, all of which saw double-digit losses or worse or even the 50 worst month list. 

    Whodunnit? Surveying the Regional Damage
    As you can see in the pie chart, the pain was not inflicted equally across the world. China was the worst affected market and the details of the damage by region are captured in the table below. 

    Country Performance Spreadsheet
    Not only did mainland Chinese stocks lose more than 20% of their market capitalization, more than 75% of all stocks in that country dropped more than 10% and 59% dropped by more than 20%; Hong Kong listings fared a little better, but still managed to come in second in the race for worst regional market. Indian and Japanese stocks were hard hit, but the rest of Asia (small Asia) did not do as badly. Among the developed markets, Australia was the worst affected but the UK, US and EU regions saw market capitalizations drop by 6-7%. 

    If you are a knee-jerk contrarian, you may be tempted to jump into the Chinese market, especially since mainland Chinese stocks traded at 15.73 times earnings, on January 31, 2016, down from 20.28 times earnings at the start of the month, and Hong Kong based Chinese stocks look even cheaper. In the global heat map below, you can look up how stock markets fared in each country during January 2016 and pricing multiples at which equities are trading at the end of the month. 


    The Sector Effects
    Just as the market damage varied across countries in January 2016, it also varied across industry groupings. Using my industry categorization, I looked at the change in market capitalizations, by industry, and key pricing multiples (PE, Price to Book, EV to EBITDA, EV to Invested Capital) at the start and end of January 2016. The entire list can be downloaded at this link, but the fifteen industries that fared the worst, in terms of drop in market capitalization, are listed below:

    Industry Spreadsheet
    The biggest surprise, given the news about continued drops in oil prices, is that none of the oil groupings (I have four) showed up on the list, with integrated oil companies dropping only 4.20%  and oil distribution companies dropping 8.93% during the month. Not surprisingly, there are a host of cyclical companies on this list, but biotech and electronics companies also suffered large drops in value. Looking at the fifteen industries that fared the best during the month, tobacco topped the list, as one of the three industries that managed to post positive returns, with utilities and telecom services being the other two. 
    Precious metals did well, reflecting the tendency of investors to flee to them during crisis, but most of the rest of the list reflects industries that sell the essentials (food and household products, health care).

    Where next?

    As investors, we often feel the urge to extrapolate from small slices of market history, and I am sure that there will be some who see great significance in the last month's volatility. They will dredge up temporal anomalies like the January effect to explain why stocks are doomed this year and that if Denver wins the Super Bowl, it is going to be catastrophic for investors. I am not willing to make that leap. What I learned from January 2016 is that stocks are risky (I need reminders every now and then), that market pundits are about as reliable as soothsayers, that the doomsayers will remind you that they "told you so" and that life goes on. I am just glad the month is over!

    Datasets
    1. ERP by day for the S&P 500 with ERP spreadsheet, if you want to do it yourself.
    2. Industry Price Performance (with multiples before and after)
    3. Country Price Performance 
    Data Update Posts



    Negative Interest Rates: Impossible, Unnatural or Just Unusual?

    In the years since the 2008 crisis, there is no question in finance that has caused more angst among investors, analysts and even onlookers than what to do about "abnormally low" interest rates. In 2009 and 2010, the response was that rates would revert back quickly to normal levels, once the crisis had passed. In 2011 and 2012, the conviction was that it was central banking policy that was keeping rates low, and that once banks stopped or slowed down quantitative easing, rates would rise quickly. In 2013 and 2014, it was easy to blame one crisis or the other (Greece, Ukraine) for depressed rates. In 2015, there was talk of commodity price driven deflation and China being responsible for rates being low. With each passing year, though, the conviction that rates will rise back to what people perceive as normal recedes and the floor below which analysts thought rates would never go has become lower. Last year, we saw short term interest rates in at least two currencies (Danish Krone, Swiss Franc) become negative and this year, the Japanese Yen joined the group, with rumors that the Euro may be the next currency to breach zero. While it has been difficult to explain the low interest rates of the last few years, it becomes doubly so, when they turn negative. I would be lying if I said that negative interest rates don't make me uncomfortable, but I have had to learn to not only make sense of them but also to live with them, in valuation and corporate finance. This post is a step in that direction.

    Setting the table
    There are a handful of currencies that have made the negative interest rate newswire, but it is worth noting that the rates that are being referenced in many of these stories are rates controlled by central banks, usually overnight rates for banks borrowing from the central bank. In March 2016, there were two central banks that had set their controlled rates below zero (Switzerland and Sweden) and two more (ECB and Bank of Japan) that had set the rate at zero. (Update: The ECB announced that it would lower its rates below zero on March 10.)
    February 2016
    Note that these are central bank set rates and that short and long term market interest rates in these currencies can take their own path. To provide a contrast, consider the Japanese Yen and Euro, two currencies where the central banks have pushed the rates they control to zero. In both currencies, short term market interest rates have in fact turned negative but only the Yen has negative long term interest rates:

    In a post from earlier this year, I looked at long term (ten-year) risk free rates in different currencies, starting with government bond rates in each currency and then netting out sovereign default spreads for governments with default risk. Updating that picture, the government bond rates across currencies on March 9, 2016, are shown below:
    Ten-year Government Bond Rates - March 9, 2016
    Joining the Japanese Yen is the Swiss Franc in the negative long term interest rate column. Why make this distinction between central bank set rates, short term market interest rates and long term interest rates? It is easier to explain away negative central bank set rates than it is to explain negative short term interest rates and far simpler to provide a rationale for negative rates in the short term than negative rates in the long term. Thus, there have been episodes, usually during crises, where short term interest rates have turned negative, but this is the first instance that I can remember where we have faced negative long term rates on two currencies, the Swiss Franc and the Japanese yen, with the very real possibility that they will be joined by the Euro, the Danish Krone, the Swedish Krona and even the Czech Koruna in the near future.

    Interest Rates 101
    I am not a macroeconomist, have very little training in monetary economics and I don't spent much time examining central banking policies. Keep that in mind as you read my perspective on interest rates, and if you are an expert and find my views to be juvenile, I am sorry. That said, I have to process negative interest rates, using my limited knowledge  of what determines interest rates.

    Intrinsic and Market-set Interest Rates
    When I lend money to another individual (or buy bonds issued by an entity), there are three components that go into the interest rate that I should demand  on that bond. The first is my preference for current consumption over future consumption, with rates rising as I value current consumption more. The second is expected inflation in the currency that I am lending out, with higher inflation resulting in higher rates. The third is an added premium for any uncertainty that I feel about not getting paid, coming from the default risk that I see in the borrower. When the borrower is a default-free entity, there are only two components that go into a nominal interest rate: a real interest rate capturing the current versus future consumption trade off and an expected inflation rate.
    Nominal Interest Rate = Real Interest Rate + Expected Inflation Rate
    This is, of course, the vaunted Fisher equation.  There is an alternate view of interest rates, where the interest rate on long term bonds is determined by the demand and supply of bonds, and it is shifts in the demand and supply that drive interest rates:

    How do you reconcile these two worlds? To the extent that those demanding bonds are motivated by the need to earn interest that covers the expected inflation and generate a real interest rate, you could argue that in the long term, the intrinsic rate should converge on the market set rate.

    In the short term, though, as with any financial asset, there is a real chance that the market-set rate can be lower or higher than the intrinsic rate. What can cause this divergence? It could be investor irrationality, where bond buyers overlook their need to cover inflation and earn a real rate of return. It could be a temporary shock to the supply or demand side of bonds that can cause the market-set rate to deviate; this is perhaps the best way to think about the "flight to safety" that occurs during every crisis, resulting in lower market interest rates. There is one more reason and one that many investors seem to view as the dominant one and I will address it next.

    The Central Bank and Interest Rates
    In all of this discussion, notice that I have studiously avoided bringing the central bank into the process, which may surprise you, given the conventional wisdom that central banks set interest rates. That said, a central bank can affect interest rates in one of two ways:

    • The first and more conventional path is for the central bank to signal, through its actions on the rates that it controls what it thinks about inflation and real growth in the future, and with that signal, it may alter long term rates. Thus, the Fed lowering the Fed funds rate (a central bank set rate that banks can borrow from the Fed Window) will be viewed as a signal that the Fed sees the economy as weaken and expects inflation to stay subdued or even non-existent, and this signal will then push expected inflation and real interest rates down. This will work only if central banks are credible in their actions, i.e., they are viewed as acting in good faith and with good information and are not gaming the market. 
    • The second channel is for the central bank to actively enter the bond market and buy or sell bonds, thus affecting the demand for bonds, and interest rates. This is unusual but it is what central banks in the United States and the EU have done since 2008 under the rubric of quantitive easing. For this to have a material effect on interest rates, the central bank has to be a big enough buyer of bonds to make a difference. 
    Thus, as you read the news stories about the Japanese central bank and the ECB considering negative interest rates, recognize that they cannot impose these rates by edict and that all they can do is change the rates that they control and let the signaling impact carry the message into bond markets.

    Measuring the Fed Effect
    Just ahead of the Federal Open Market Committee meetings last year, as debate about whether the Fed would ease up on quantitative easing, I argued that we were over estimating the effect that the Fed had on market set rates and that while it has contributed to keeping rates low for the last six years, an anemic economy was the real reason for low interest rates. To compute the Fed effect, I chose to track two numbers:
    • An intrinsic interest rate, computed by adding together the actual inflation each year and the real growth rate each year, two imperfect proxies for expected inflation and the real interest rate.
    • The ten-year US treasury bond rate at the start of each year, set by the bond market, but affected by expectation setting and bond buying by the Fed.
    The graph below captures both numbers, updated through 2015:

    Note how closely the US treasury bond has tracked my imperfect estimate of the intrinsic interest rate, and how low the intrinsic rate has become, post-crisis. At the risk of repeating myself, the Fed has, at best, had only a marginal impact on interest rates during the last six years and it is my guess that rates would have stayed low with or without the Fed during this period.

    Negative Interest Rates
    Turning to the question at hand, is it possible for nominal interest rates to be negative, based upon fundamentals? The answer is yes, but with a caveat. If the preference for current consumption over future consumption dissipates or gets close to zero and you expect deflation in a currency, you could end up with a negative interest rate. In fact, that is the common thread that runs through the economies (Japan, the Euro Zone, Switzerland) where rates have become negative.

    Now, comes the caveat. If you have nominal negative interest rates, why would you ever lend money out, since you have the option of just holding on to the money as cash. Historically, that has led many to believe that the floor on nominal rates should be zero. As rates go below zero, it is time to reexamine that belief. One way to reconcile negative interest rates with rational behavior is to introduce costs to holding cash and there are clearly some to factor in, especially in today's economies. The first is that while the proverbial stuffing cash under your mattress option is thrown around as a choice, you will increase your exposure to theft and may have to invest in security measures that are costly. The second is that there are some transactions that are extraordinarily cumbersome to get done with cash; imagine buying a million dollar house and counting out the cash for the payment. The Danish, Swiss and Japanese governments are embarking on a grand experiment, perhaps, of how much savers will be willing to pay for the convenience of staying cashless. In effect, the lower bound has shifted below zero but there is still one. To those who are convinced that negative interest rates have nothing to do with fundamentals and that they are entirely by central bank design, I would argue that the only reason that these central banks have been able to push rates below zero, is because real growth and inflation have become so low in their economies that the intrinsic rate was close enough to zero to begin with. There is no chance that the Brazilian and Indian central banks will follow suit.

    Interest Rates, Financial Assets and the Real Economy
    When central banks in these currencies strongly signal their intent to drive interest rates to zero and below, what could be the motivation? Put simply, it is the belief that lower interest rates lead to higher prices for financial assets and more real investment in the economy, either through the mechanism of "lower" hurdle rates for investments or a weaker currency making businesses more competitive globally. In this central banking heaven, where central banks set rates and the world meekly follows, this is what unfolds:

    So, why has it not worked? As interest rates in the US, Europe and Japan have tested new lows each year for the last few, we have not seen an explosion in real investment in these countries, and while stock prices have risen, the rise has had as much to do with higher earnings and cash flows, as it has to do with lower interest rates. In my view, the fundamental miscalculation that central banks have made is in assuming that their actions not only affect other pieces of this puzzle but are also read as signals of the future.  In particular, central bankers have failed to incorporate three problems: that interest rates do not always follow the central bank lead, that risk premiums on equity and debt may increase as rates go down and that exchange rate effects are muted by other central banks acting at the same time. In this reality-based central banking universe, the lowering of rates by central banks can have unpredictable and often perverse consequences, lowering financial asset prices, reducing real investment and making a currency stronger rather than weaker.

    This is all hypothetical, you may say, but there is evidence that markets have become much less trusting of central banking and more willing to go their own ways. For instance, as the risk free rate has dropped over the last few years, note that the expected return for stocks has stayed around 8% during that period, leading to higher and higher equity risk premiums.

    While bond markets initially did not see this phenomenon, last year default spreads on bonds in every ratings class widened, even as rates dropped. Interestingly, the most recent ECB announcement that they would push the rates they control lower was accompanied by news that they would enter the bond market as buyers, hoping to keep default spreads down. That is an interesting experiment and I have a feeling that it will not end well.

    Dealing with Negative Interest Rates
    My interests in negative interest rates are primarily in the context of valuation and corporate finance. In both arenas, the hurdle rates we use to pick investments and value businesses build off a long term risk free rate as a base and having that base become a negative value is disconcerting to some. There are two choices that you have:
    1. Switch currencies: You can value Danish companies in Euros or US dollars, where long term rates are still positive (albeit very low). This evades the problem, but you can run but you cannot hide. At some point in time, you will have to work in the negative interest rate currency.
    2. Normalize risk free rates: This is a practice that has become more prevalent in both the US and Europe, where risk free rates have dropped to historic lows. To compensate, analysts are using the average rate across long periods as a normalized risk free rate. I have problems with this approach at three levels. The first is that normal is in the eye of the beholder and what you call a normal 10-year T.Bond rate is more a function of your age than scientific judgment. The second is that given that the risk free rate is where you plan to put your money if you don't make your real investment, it seems singularly dangerous for this to be a made-up number. The third is that using a normalized risk free rate with the high equity risk premiums that are prevalent today will lead to too high a hurdle rate, since the latter are primarily the result of low risk free rates.
    3. Leave the risk free rate negative: So, what if the risk free rate is negative? In valuation, you almost never use the risk free rate standing alone, but only in conjunction with a risk premium. If you can update those risk premiums, they may very well offset the effect of having a negative risk free rate and yield a cost of equity and/or debt that does not look different from what it did prior to the negative interest rate setting. There is one other adjustment that I would make. In stable growth, I have been a proponent of using the risk free rate as your cap on the stable growth rate. With negative risk free rates, I would stick with this principle, since, as I noted earlier in this post, negative interest rates signify economies with low or no real growth combined with deflation and the growth rate in perpetuity for stable companies in these economies should be negative for those same reasons.
    What Real Negative Interest Rates Signify
    When interest rates of from being really small positive numbers (0.25% or 0.50%) to really small negative numbers (-0.25% to -0.50%), the mathematical consequences are small but I do think that breaching zero has consequences and almost all of them are negative.
    1. The economic end game: For those who ultimately care about real economic growth and prosperity, negative interest rates are bad news, since they are incompatible with a healthy, growing economy. 
    2. Central banks insanity, impotence and desperation: As I watch central bankers preen for the cameras and hog the limelight, I am reminded of the old definition of insanity as trying the same thing over and over, expecting a different outcome. After six years of continually trying to lower rates, with the expectation of economic growth just around the corner, it is time for central banks to perhaps recognize that this lever is not working. By the same token, the very fact that central banks revert back to the interest rate lever, when the evidence suggests that it has not worked, is a sign of desperation, an admission by central banks that they have run out of ideas. That is truly scary and perhaps explains the rise in risk premiums in financial markets and the unwillingness of companies to make real investments. 
    3. Unintended consequences: As interest rates hit zero and go lower, there will be some investors, in need of fixed income, who will look in dangerous places for that income. A modern-day Bernie Madoff would need to offer only 4% in this market to attract investors to his fund and as I watch investors chase after yieldcos, MLPs and other high dividend paying entities, I am inclined to believe that is a painful reckoning ahead of us. 
    4. An opening for digital currencies: In a post a few years ago, I looked at bitcoin and argued that there will be a digital currency, sooner rather than later, that meets the requirements of trust needed for a currency in wide use. The more central bankers in conventional currencies play games with interest rates, the greater is the opening for a well-designed digital currency with a dependable issuing authority to back it up.
    In the next few weeks, I am sure that we will read more news stories about central banks professing to be shocked that markets have not done their bidding and that economies have not revived. I am not sure whether I should attribute these rantings to the hubris of central bankers or to their blindness to market realities. Either way, I feel less comfortable with the notion that central bankers know what they are doing and that we should trust them with our economic fates.

    YouTube Video

    Datasets





    Valeant: Information Vacuums, Management Credibility and Investment Value

    As an investor, would you buy shares in a company that is at the center of a political and legal firestorm? What if this company has a CEO who has lost the faith of his board and an ex-CFO who is being accused of shady financial practices? And would you pull  the buy trigger if the company has delayed its scheduled annual filing by more than two months, and by doing so is running the risk of violating debt covenants and being pushed into default? And to top it all off, would you be a little worried  if the largest investor in the stock, a well known activist with his reputation and wealth on the line, is now calling the shots? No way, you say! At the right price, I would, and that is the reason that I decided to revisit my Valeant valuation last week, six months after I valued it for the first time, in the aftermath of a crisis born of hubris and happenstance. In structuring this post, I will draw on an old-time consulting matrix, where companies were classified into stars, cash cows, dogs and question marks, to illustrate the transience of these classifications, since Valeant has cycled through the entire matrix in a year.

    Valeant, the Star
    Valeant's rise from an obscure Canadian drug company to pharmaceutical star has been well chronicled and rather than drown you in prose, I think it is best captured in this picture, which shows the increase in market value (market cap and enterprise value) and operating numbers (revenues and operating income), especially between 2009 and 2015:
    Source: S&P Capital IQ
    During a period when other pharmaceutical companies were struggling with revenue growth and profit margins, Valeant outstripped them on both counts, growing revenues at almost 43% a year while posting higher operating profit margins than the rest of the sector. At least on the surface, the company seemed to be delivering the best of all combinations: high growth with high profitability.

    So, how did Valeant pull of this feat? In an earlier post on the company, in November 2015, I argued that the Valeant business model was a stool with three legs: growth from acquisitions, with the acquisitions funded primarily with debt, followed by a strategy of increasing prices on "under priced" drugs.

    The unique combination of growth and profitability made the company a target for value investors, making it a favored stop for investors as diverse as Bill Ackman, the activist investor, and the Sequoia Fund, a storied mutual fund, and a dominant part of their portfolios. In their defense, not only were these investors transparent about their big bets on Valeant, but at least until September 2015, their concentration was viewed as a strength rather than a weakness. In fact, when I posted on why diversification is a necessary component of even a value investing strategy, it was these two investors that were held up as a counters to my argument.

    To see the allure of Valeant to value investors, let me go back to mid-year last year, when the company's business model was going strong, its stock price was higher than $200/share and its enterprise value exceeded $100 billion. If the intrinsic value of a company is driven by cash flows from existing assets, value-creating growth and low risk, Valeant looked attractive on almost every dimension:

    Valeant was not only delivering the value trifecta, high revenue growth in conjunction with high operating profit margins and generous excess returns, but was doing so on steroids (taking the form of low taxes and high debt). One note of caution even then, though, was that the business model was built on an architecture of acquisitions, with acquisition accounting playing a large role in pushing up operating profitability and lowering taxes.  If you were unfazed by the acquisition accounting effect and assumed that the company could continue to deliver this combination going forward, the value per share that you would have obtained for the company would have been more than $200/share. 
    Download spreadsheet
    In estimating the value, I did lower the compounded revenue growth for Valeant to 12% for the next ten years, but that translates into revenues more than tripling over the decade. 

    From Star to Cash Cow
    While many trace Valeant's fall to September and October of 2015, when short sellers launched an assault on its links to Philidor, an online pharmacy, the business model was already under pressure in the months prior, a victim of its own financial success. The model was designed, in my view, to operate under the radar, since key parts of it (the drug pricing and acquisition accounting) would wither under exposure. While much of what Valeant did in 2010 and 2011, when the company was not a household name, went unnoticed, its actions in 2015, when it was a higher profile company, drew attention from unwelcome sources. The company's acquisition of Salix increased the scrutiny, both because of it's size and partly because the Salix drugs that Valeant acquired (and repriced) affected more people (and drew more complaints). The Philidor revelations pushed these concerns into hyperdrive and the stock lost almost 55% of its value in September and October, dropping from $180/share to $80/share.

    In my November post, I rehashed much of this story and argued that even if Valeant were able to survive legal and regulatory scrutiny, the company would never be able to return to its old business model. In effect, even in the absence of more bad news, Valeant would have to be run like other pharmaceutical companies, reliant on R&D, rather than acquisitions, for (more anemic) growth. Removing the debt-funded acquisitions and the drug repricing  from the business model yielded a company with lower revenue growth (3% a year, rather than 12%), lower margins (a pre-tax operating margin of 43.66%, instead of 49.82%) and higher taxes (with an effective tax rate of 20% replacing 16.51%).

    Download spreadsheet

    Note that these numbers were reflective of more conventional drug companies and reflect a profitable, albeit slow-growth business. With these numbers, though, the value per share that I obtained for Valeant was about $77, down substantially from its star status, but the market price, at $82, was higher. 

    From Cash Cow to Dog?
    If there were dark clouds on the horizon for Valeant in November 2015, the months since have only made them darker for four reasons:
    1. Information blackout: In November 2015, when I valued Valeant, I used the most recent financial filings of the company, from October 2015,  to update my numbers. Almost six months later, there have been no financial filings since, and the 10K that was expected to be filing in February 2016 was delayed, ostensibly because the company was still gathering information, and that delay has extended into April. 
    2. Managerial Double talk: In the intervening months, Valeant’s managers have been in the news, almost as often giving testimony to Congress, as holding press conferences. Arguing, as they did, that they grew through R&D like any other pharmaceutical company and that their revenue increases came mostly from volume growth (rather than price increases) was so much at odds with the facts that they became less credible with each iteration. Michael Pearson’s hospitalization for an undisclosed illness, just before Christmas, was something that was out of the company’s control but its handling added to the air of opacity around the company. 
    3. Legal Jeopardy: The Philidor entanglement, the original source of the crisis, did not go away. In fact, the company, after claiming that separation from Philidor would be low-cost and easy backtracked in January and February with disclosures that suggested deeper links, with the potential for legal problems down the road. 
    4. Debt load: Debt is a double edged sword, increasing earnings per share and providing tax benefits in good times but potentially making bad times worse. That argument got backing from what happened at Valeant, a company that accumulated more than $30 billion in debt during its acquisition binges, with about half of that debt being added on during 2015. That debt came with the added covenant that if financial disclosures were not filed by March 30, 2015, the firm could technically be in default, a possibility that spooked markets. 
    Without financial disclosures from the company, a management that seemed to be making up stuff as it went along and the possibility of a debt covenant being triggered, it is not surprising that the market marked down Valeant’s stock price further:


    This price collapse, following last year’s swoon, has reduced the market capitalization of the company to $11 billion, almost 85% lower than its value a year prior. In late March 2016, the company announced that Michael Pearson would be stepping down as CEO, the clearest sign yet that there will no return to the old business model, and Bill Ackman increased his involvement of the company in a bid to preserve what was left of his investment in the company and more importantly, his reputation as a savvy activist investor.

    With the stock trading at $32, the question of whether the stock is a good buy now looms large. Compared to my November 2015 estimate, the answer is an emphatic yes, but the caveat is that a great deal has happened to the company’s fundamentals during the last six months that could have shifted the value down significantly. The problem that I face, like any other investor in Valeant, is that in the absence of financial filings, there are no numbers to update. The solution seems simple. Wait for the delayed filing to come out in late April, early May or later, and use that updated information in my valuation. That is the low-risk option, but I think that it is also a low return option, since if the filing contains good news (that revenues have held up and profit margins remain healthy), the stock price will adjust before my valuation does. The alternative is scary, but it has a bigger payoff. I could try to make a judgment on Valeant’s value now, before the information comes out, and follow through by buying or selling the stock. In arriving at this value, here are some of the adjustments that I chose to make:
    1. The Dark Side of Debt: The debt at Valeant has become more burden than a help, as it has not only triggered worries about covenants being violated but has opened up the possibility that that the company will have trouble making its payments. In fact, Moody's lowered the bond rating for Valeant to B1, well below investment grade, in March 2016, causing an increase in the cost of capital used in the valuation from 7.52% (in my November 2016 valuation) to 8.29%. The secondary impact is that there is a chance now that Valeant's going concern status may be jeopardized by its debt commitments; I assume a 5% chance of this occurrence in conjunction with the assumption that a forced liquidation of its assets will come at a discount of 25% on fair value. 
    2. The Bad News in Delay: Delayed news is almost never good news and there are two key operating numbers where the delayed report can contain bad news. The first is that the company may restate revenues, reflecting its separation from Philidor and perhaps for other undisclosed reasons. The second is that the company may reveal that some or all its acquisition-related expensing from prior years may have been overdone, resulting in some or a big chunk of these expenses being moved back into the operating expense column. In my valuation, I will assume (and cheerfully admit that this is based on no news) that the revenue reduction will be small (about 2%) and that half of all acquisition expenses will be shifted to operating expenses, reducing the pre-tax operating margin to 40.39% (from the 43.66% that I used in November 2015). 
    Since I had already assumed that the existing business model was dead in my November 2015 valuation, I don't see any need to lower revenue growth further or to raise the effective tax rate. The value that I obtain with these updated numbers is below:
    Download spreadsheet
    The value per share that I obtain for Valeant is $43.66, higher than the stock price ($32) at the time of this analysis. That value, though, is clearly a bet on what the delayed financials will deliver as a surprise. One way to measure the exposure that you have to this risk is to measure value as a function of how much of a revenue and earnings surprise you get from the report:

    Is there a chance that the earnings report could contain news that make Valeant a bad investment at $32? Of course, and you will have to make your own judgment on that possibility, but based upon my priors (uninformed though they might be), it looked like a good investment at $32, late last week, and I own it now. 

    Conclusion
    I am sure that Valeant will be used to draw many lessons and I will extract my share in future posts about acquisition accounting, activist investing and corporate finance. The first is that acquisition accounting is rife with inconsistencies and plays into investor biases and preconceptions about companies. The second is that cookbook corporate finance, with its dependence on metrics and magic bullets, can have disastrous consequences when it overwhelms the narrative. The third is that activist investing, notwithstanding its successes, has two weak links: concentrated portfolios and investors who can become too wedded to their investment thesis.   I will continue to draw on Valeant as an illustrative example of how quickly views on a company and its business model can change in markets and why absolutism in investing (where you know with certainty that a business model is great or awful, that a stock is cheap or expensive) is an invitation for a market takedown. 

    YouTube Video


    Attachments
    1. Value of Valeant as Star (September 2015)
    2. Value of Valeant as Cash Cow (November 2015)
    3. Value of Valeant as Dog (April 2016)
     



    DCF Myth 3.2: If you don't look, its not there!

    In this, the last of my three posts on uncertainty, I complete the cycle I started with a look at the responses (healthy and unhealthy) to uncertainty and followed up with an examination of the Margin of Safety, by taking a more extended look at one approach that I have found helpful in dealing with uncertainty, which is to run simulations. Before you read this post, I should warn you that I am not an expert on simulations and that the knowledge I bring to this process is minimalist and my interests are pragmatic. So, if you are an expert in statistics or a master simulator, you may find my ramblings to be amateurish and I apologize in advance. 

    Setting the Stage
    The tools that we use in finance were developed in simpler times, when data was often difficult (or expensive) to access and sophisticated statistical tools required machine power that was beyond the reach of most in the finance community. It should come as no surprise then that in discounted cash flow valuation, we have historically used point estimates ( single numbers that reflect best judgments at the time of the valuation) for variables that have probability distributions attached to them. To illustrate, in my valuation of Apple in February 2016, I used a revenue growth rate of 2.2% and a target operating margin of 25%, to arrive at my estimate of value per share of $129.80.

    It goes without saying (but I will say it anyway) that I will be wrong on both these numbers, at least in hindsight, but there is a more creative way of looking at this estimation concern. Rather than enter a single number for each variable, what if I were able to enter a probability distribution? Thus, my estimate for revenue growth would still have an expected value of 2.2% (since that was my best estimate) but would also include a probability distribution that reflected my uncertainty about that value. That distribution would capture not only the magnitude of my uncertainty (in a variance or a standard deviation) but also which direction I expect to be wrong more often (whether the growth is more likely to be lower than my expected value or higher).  Similarly, the expected value for the operating margin can stay at 25% but I can build in a range that reflects my uncertainty about this number.

    Once you input the variables as distributions, you have laid the foundations for a probabilistic valuation or more specifically, for a simulation, where in each run, you pick one outcome out of each distribution (which can be higher or lower than your expected values) and estimate a value for the company based on the drawn outcomes. Once you have run enough simulations, your output will be a distribution of values across simulations. If the distributions of your variables are built around expected values that match up to the numbers that you used in your point estimate valuation, the expected value across the simulations will be close to your point estimate value. That may seem to make the simulation process pointless, but there are side benefits that you get from simulations that enrich your decision process. In addition to the expected value, you will get a measure of how much variability there is in this value (and thus the risk you face), the likelihood that you could be wrong in your judgment of whether the stock is under and over valued and the potential payoffs to be right and wrong. 

    Statistical Distributions: A Short Preview
    It is a sad truth that most of us who go through statistics classes quickly consign them to the “I am never going to use this stuff” heap and move on, but there is no discipline that is more important in today’s world of big data and decision making under uncertainty. If you are one of those fortunate souls who not only remembers your statistics class fondly but also the probability distributions that you encountered during the class, you can skip this section. If, like me, the only memory you have of your statistics class is of a bell curve and a normal distribution, you need to expand your statistical reach beyond a normal distribution, because much of what happens in the real world (which is what you use probability distributions to capture) is not normally distributed. At the risk of over simplifying the choices, here are some basic classifications of uncertainties/ risks::
    1. Discrete versus Continuous Distributions: Assume that you are valuing an oil company in Venezuela and that you are concerned that the firm may be nationalized, a risk that either occurs or does not, i.e., a discrete risk. In contrast, the oil company's earnings will move with oil prices but take on a continuum of values, making it a continuous risk. With currency risk, the risk of devaluation in a fixed exchange rate currency is discrete risk but the risk in a floating rate currency is continuous.
    2. Symmetric versus Asymmetric Distributions (Symmetric, Positive skewed, Negative skewed): While we don't tend to think of upside risk, risk can deliver outcomes that are better than expected or worse than expected. If the magnitude and likelihood of positive outcomes and negative outcomes is similar, you have a symmetric distribution. Thus, if the expected operating margin for Apple is 25% and can vary with equal probability from 20% to 30%, it is symmetrically distributed. In contrast, if the expected revenue growth for Apple is 2%, the worse possible outcome is that it could drop to -5%, but there remains a chance (albeit a small one) that revenue growth could jump back to 25% (if Apple introduces a disruptive new product in a big market), you have an a positively skewed distribution. In contrast, if the expected tax rate for a company is 35%, with the maximum value equal to the statutory tax rate of 40% (in the US) but with values as low as 0%, 5% or 10% possible (though not likely), you are looking at a negatively skewed distribution.
    3. Extreme outcome likelihood (Thin versus Fat Tails): There is one final contrast that can be drawn between different risks. With some variables, the values will be clustered around the expected value and extreme outcomes, while possible, don't occur very often; these are thin tail distributions. In contrast, there are other variables, where the expected value is just the center of the distribution and actual outcome that are different from the expected value occur frequently, resulting in fat tail distributions.
    I know that this is a very cursory breakdown, but if you are interested, I do have a short paper on the basics of statistical distributions (link below), written specifically with simulations in mind. 

    Simulation Tools
    I was taught simulation in my statistics class, the old fashioned way. My professor came in with three glass jars filled with little pieces of paper, with numbers written on them, representing the different possible outcomes on each variable in the problem (and I don't even remember what the problem was). He then proceeded to draw one piece of paper (one outcome) out of each jar and worked out the solution, with those numbers and wrote it on the board. I remember him meticulously returning those pieces of paper back into the jar (sampling with replacement) and at the end of the class, he proceeded to compute the distribution of his solutions.

    While the glass jar simulation is still feasible for simulating simple processes with one or two variables that take on only a few outcomes, it is not a comprehensive way of simulating more complex processes or continues distributions. In fact, the biggest impediment to using simulation until recently would have been the cost of running one, requiring the use of a mainframe computer. Those days are now behind us, with the evolution of technology both in the form of hardware (more powerful personal computers) and software. Much as it is subject to abuse, Microsoft Excel has become the lingua franca of valuation, allowing us to work with numbers with ease. There are some who are conversant enough with Excel's bells and whistles to build simulation capabilities into their spreadsheets, but I am afraid that I am not one of those. Coming to my aid, though, are offerings that are add-ons to Excel that allow for the conversion of any Excel spreadsheet almost magically into a simulation.

    I normally don't make plugs for products and services, even if I like them, on my posts, because I am sure that you get inundated with commercial offerings that show up insidiously in Facebook and blog posts. I am going to make an exception and praise Crystal Ball, the Excel add-on that I use for simulations. It is an Oracle product and you can get a trial version by going here. (Just to be clear, I pay for my version of Crystal Ball and have no official connections to Oracle.) I like it simply because it is unobtrusive, adding a menu item to my Excel toolbar, and has an extremely easy learning curve.

    My only critique of it, as a Mac user, is that it is offered only as a PC version and I have to run my Mac in MS Windows, a process that I find painful. I have also heard good things about @Risk, another excel add-on, but have not used it.

    Simulation in Valuation
    There are two aspects of the valuation process that make it particularly well suited to Monte Carlo simulations. The first is that uncertainty is the name of the game in valuation, as I noted in my first post in the series. The second is that valuation inputs are often estimated from data, and that data can be plentiful at least on some variables, making it easier to estimate the probability distributions that lie at the heart of simulations. The sequence is described in the picture below:



    Step 1: Start with a base case valuation
    The first place to start a simulation is with a base case valuation. In a base case valuation, you do a valuation with your best estimates for the inputs into value from revenue growth to margins to risk measures. Much as you will be tempted to use conservative estimates, you should avoid the temptation and make your judgments on expected values. In the case of Apple, the numbers that I use in my base case valuation are very close to those that I used just a couple of months ago, when I valued the company after its previous earnings report and are captured in the picture below:
    Download spreadsheet

    In my base case, at least, it looks like Apple is significantly under valued, priced at $93/share, with my value coming in at $126.47, just a little bit lower my valuation a few months ago. I did lower my revenue growth rate to 1.50%, reflecting the bad news about revenues in the most recent 10Q.

    Step 2: Identify your driver variables
    While there are multiple inputs into valuation models that determine value, it remains true that a few of these inputs drive value and that the rest go along for the ride. But how do you find these value drivers? There are two indicators that you can use. The first requires trial and error, where you change each input variable to see which ones have the greatest effect on value. It is one reason that I like parsimonious models, where you use fewer inputs and aggregate numbers as much as you can. The second is more intuitive, where you focus on the variable that investors in the company seem to be most in disagreement about. My Apple valuation is built around four inputs: revenue growth (growth), operating margin (profitability), the sales to capital ratio (investment efficiency) and cost of capital (risk). The graph below captures how much value changes as a function of these inputs:

    As you can see the sales to capital ratio has little effect on value per share, largely because the base case growth rate that I use for Apple is so low. Revenue growth and operating margin both affect value significantly and cost of capital to a much lesser degree. Note that the value per share is higher than the current price though every single what-if analysis, but that reflects the fact that only variable at a time in being changed in this analysis. It is entirely possible that if both revenue growth and operating margins drop at the same time, the value per share will be lower than $93 (the stock price at the time of this analysis) and one of the advantages of a Monte Carlo simulation is that you can build in interconnections between variables. Looking at the variables through the lens that investors have been using to drive the stock price down, it seems like the front runner for value driver has to be revenue growth, as Apple reported its first year on year negative revenue growth in the last quarter and concerns grow about whether the iPhone franchise is peaking. Following next on the value driver list is the operating margin, as the competition in the smart phone business heats up.

    Step 3: The Data Assessment
    Once you have the value drivers identified, the next step is collecting data on these variables, as a precursor for developing probability distributions. In developing the distributions, you can draw on the following:
    1. Past data: If the value driver is a macroeconomic variable, say interest rates or oil prices, you can draw on historical data going back in time. My favored site for all things macroeconomic is FRED, the Federal Reserve data site in St. Louis, a site that combines great data with an easy interface and is free. I have included data on interest rate, inflation, GDP growth and the weighted dollar for those of you interested in US data in the attached link. For data on other countries, currencies and markets, you can try the World Bank data base, not as friendly as FRED, but rich in its own way.
    2. Company history: For companies that have been in existence for a long time, you can mine the historical data to get a measure of how key company-specific variables (revenues, operating margin, tax rate) vary over time. 
    3. Sector data: You can also look at cross sectional differences in key variables across companies in a sector. Thus, to estimate the operating margin for Amazon, you could look at the distribution of margins across retail companies.: If the value driver is a macroeconomic variable, say interest rates or oil prices, you can draw on historical data going back in time. My favored site for all things macroeconomic is FRED, the Federal Reserve data site in St. Louis, a site that combines great data with an easy interface and is free. I have included data on interest rate, inflation, GDP growth and the weighted dollar for those of you interested in US data in the attached link. For data on other countries, currencies and markets, you can try the World Bank data base, not as friendly as FRED, but rich in its own way.
    In the case of Apple, I isolated my data assessment to three variables: revenue growth, operating margin and the cost of capital.  To get some perspective on the range and variability in revenue growth rates and operating margins, I started by looking at the values for these numbers annually from 1990 to 2015:


    This extended time period does distract from the profound changes wrought at Apple over the last decade by the iPhone. To takes a closer look at its effects, I looked at growth and margins at Apple for every quarter from 2005 to the first quarter of 2016 :
    Superimposed on this graph of gyrating revenue growth, I have traced the introduction of the different iPhone models that have been largely responsible for Apple's explosive growth over the last decade. There are a few interesting patterns in this graph. The first is that revenue growth is clearly driven by the iPhone cycle, peaking soon after each new model is introduced and fading in the quarters after. The second is that the effect of a new iPhone on revenue growth has declined with each new model, not surprising given the scaling up of revenues as a result of prior models. The third is that the operating margins have been steady through the iPhone cycles, with only a midl dip in the last cycle. There is good news and bad news in this graph for Apple optimists. The good news is that the iPhone 7 will deliver an accelerator to the growth but the bad news is that it will be milder that the prior versions; if the trend lines hold up, you are likely to see only a 10-15% revenue growth in the quarters right after its introduction. 

    To get some perspective on what the revenue growth would look like for Apple, if it's iPhone franchise fades, I looked at the compounded annual revenue growth for US technology firms older than 25 years that were still listed and publicly traded in 2016:

    Of the 343 firms in the sample, 26.2% saw their revenues decline over the last 10 years. There is a sampling bias inherent in this analysis, since the technology firms with the worst revenue growth declines over the period may not have survived until 2016. At the same time, there were a healthy subset of aging technology firms that were able to generate revenue growth in the double digits over a ten-year period. 

    Step 4: Distributional Assumptions
    There is no magic formula for converting the data that you have collected into probability distributions, and as with much else in valuation, you have to make your best judgments on three dimensions.
    1. Distribution Type: In the section above, I broadly categorized the uncertainties you face into discrete vs continuous, symmetric vs skewed and fat tail vs thin tail. At the risk of being tarred and feathered for bending statistical rules, I have summarized the distribution choices based on upon these categorizations. The picture is not comprehensive but it can provide a road map though the choices:
    2. Distribution Parameters: Once you have picked a distribution, you will have to input the parameters of the distribution. Thus, if you had the good luck to have a variable be normally distributed, you will only be asked for an expected value and a standard deviation. As you go to more complicated distributions, one way to assess your parameter choices to look at the full distribution, based upon your parameter choices, and pass it through the common sense test.
    In the case of Apple, I will use the historical data from the company, the cross sectional distribution of revenue growth across older technology companies as well as a healthy dose of subjective reasoning to pick a lognormal distribution, with parameters picked to yield values ranging from -4% on the downside to +10% on the upside. On the target operating margin, I will build my distribution around the 25% that I assumed in my base case and assume more symmetry in the outcomes; I will use a triangular distribution to prevent even the outside chance of infinite margins in either direction.
    Note the correlation between the two, which I will talk about in the next section.

    Step 5: Build in constraints and correlations
    There are two additional benefits that come with simulations. The first is that you can build in constraints that will affect the company's operations, and its value, that are either internally or externally imposed. For an example of an external constraint, consider a company with a large debt load. That does not apply to Apple but it would to Valeant. If the company's value drops below the debt due, you could set the equity value to zero, on the assumption that the company will be in default. As another example, assume that you are valuing a bank and that you model regulatory capital requirements as part of your valuation. If the regulatory capital drops below the minimum required, you can require the company to issue more shares (thus reducing the value of your equity).  The second advantage of a simulation is that you can build in correlations across variables, making it more real life. Thus, if  you believe that bad outcomes on margins (lower margins than expected) are more likely to go with bad outcomes on revenue growth (revenue growth lower than anticipated), you can build in a positive correlation between the variables. With Apple, I see few binding constraints that will affect the valuation. The company has little chance of default and is not covered by regulatory constraints on capital. I do see revenues and operating margins moving together and I build in this expectation by assuming a correlation of 0.50 (lower than the historical correlation of 0.61 between revenues and operating margin from 1989 to 2015 at Apple).

    Step 6: Run the simulations
    Using my base case valuation of Apple (which yielded the value per share of $126.47) as my starting point and inputting the distributional assumptions for revenue growth and operating margin, as well as the correlation between the two, I used Crystal Ball to run the simulations (leaving the number at the default of 100,000) and generated the following distribution for value:

    The percentiles of value and other key statistics are listed on the side. Could Apple be worth less than $93/share. Yes, but the probability is less than 10%, at least based on my assumptions. Having bought and sold Apple three times in the last six years (selling my shares last summer), this is undoubtedly getting old, but I am an Apple shareholder again. I am not a diehard believer in the margin of safety, but if I were, I could use this value distribution to create a more flexible version of it, increasing it for companies with volatile value distributions and reducing it for firms with more stable ones.

    The most serious concern that I have, as an investor, is that I am valuing cash , which at $232 billion is almost a third of my estimated value for Apple, as a neutral asset (with an expected tax liability of $28 billion). Some of you, who have visions of Apple disrupting new businesses with the iCar or the iPlane may feel that this is too pessimistic and that there should be a premium attached for these future disruptions. My concern is the opposite, i.e., that Apple will try to do too much with its cash, not too little. In my post on aging technology companies, I argued that, like aging movie stars in search of youth, some older tech companies throw money at bad growth possibilities. With the amount of money that Apple has to throw around, that could be deadly to its stockholders and I have to hope and pray that the company remains restrained, as it has been for much of the last decade.

    Conclusion
    Uncertainty is a fact of life in valuation and nothing is gained by denying its existence. Simulations offer you an opportunity to look uncertainty in the face, make your best judgments and examine the outcomes. Ironically, being more open about how wrong you can be in your value judgments  will make you feel more comfortable about dealing with uncertainty, not less. If staring into the abyss is what scares you, take a peek and you may be surprised at how much less scared you feel.

    YouTube video


    Attachments
    1. Paper on probability distributions
    2. Apple valuation - May 2016
    3. Link to Oracle Crystal Ball trial offer
    1. If you have a D(discount rate) and a CF (cash flow), you have a DCF.  
    2. A DCF is an exercise in modeling & number crunching. 
    3. You cannot do a DCF when there is too much uncertainty.
    4. The most critical input in a DCF is the discount rate and if you don’t believe in modern portfolio theory (or beta), you cannot use a DCF.
    5. If most of your value in a DCF comes from the terminal value, there is something wrong with your DCF.
    6. A DCF requires too many assumptions and can be manipulated to yield any value you want.
    7. A DCF cannot value brand name or other intangibles. 
    8. A DCF yields a conservative estimate of value. 
    9. If your DCF value changes significantly over time, there is something wrong with your valuation.
    10. A DCF is an academic exercise.



    DCF Myth 3.1: The Margin of Safety - Tool for Action or Excuse for Inaction?

    In my last post on dealing with uncertainty, I brought up the margin of safety, the tool that many value investors claim to use to protect themselves against uncertainty. While there are certainly some in the value investing community who have found a good way to incorporate MOS into their investing process, there are many more who seem to have misconceptions about what it does for them as well as the trade off from using it. 


    The Margin of Safety: Definition and Rationale

    While the margin of safety has always been around, in one form or another, in investing, it was Ben Graham who brought the term into value investing in The Intelligent Investor, when he argued that the secret of sound investment is to have a margin of safety, with the margin of safety defined as the difference between the value of an asset and its price. The definitive book on MOS was written by Seth Klarman, a value investing icon. Klarman’s book has acquired a cult following, partly because of its content and partly because it has been out of print now for years; a quick check of Amazon indicates a second-hand copy can be acquired for about $1600. Klarman’s take on margin of safety is similar in spirit to Graham’s measure, with an asset-based focus on value, which is captured in his argument that investors gain the margin of safety by “buying at a significant discount to underlying business value and giving preference to tangible assets over intangibles”.



    There are many reasons offered for maintaining a margin of safety. The first is that the value of an asset is always measured with error and investors, no matter how well versed they are in valuation techniques, have to recognize that they can be wrong in their judgments. The second is that the market price is determined by demand and supply and if it diverges from value, its pathway back is neither quick nor guaranteed. The proponents of margin of safety point to its benefits. By holding back on making investment decisions (buy or sell) until you feel that you have a margin of safety, they argue that you improve your odds of making successful investments. In addition, They also make the point that having a healthy margin of safety will reduce the potential downside on your investments and help protect and preserve your capital. 

    The Margin of Safety: Divergence across Investors
    As a concept, I not only understand the logic of the MOS, but also its allure, and I am sure that many investors adopt some variant of it in active investing, but there are differences in how it is employed:
    1. Valuation Basis: While MOS is often defined it as the difference between value and price, the way in which investors estimate value varies widely. The first approach is intrinsic value, either in its dividend discount model format or a more expansive DCF version. The second approach estimates value from accounting balance sheets, using either unadjusted book value or variants thereof (tangible book value, for instance). The third approach is to use a pricing multiple (PE, EV to EBITDA), in conjunction with peer group pricing, to estimate “a fair price” for the company. While I would contest even calling this number a value, it is still used by many investors as their estimated value.
    2. Magnitude and Variability: Among investors who use MOS in investing, there seems to be no consensus on what constitutes a sufficient margin. Even among investors who are explicit about their MOS, the follow up question becomes whether it should be a constant (say 15% for all investments) or whether it should be greater for some investments (say in risky sectors or growth stocks) than for others (utilities or MLPs).
    The bottom line is that a room full of investors who all claim to use margin of safety can contain a group with vast disagreements on how the MOS is computed, how large it should be and whether it should vary across investments and time.

    Myths about Margin of Safety
    When talking about value, I am often challenged by value investors on how I control for risk and asked why I don’t explicitly build in a MOS. Those are fair questions but I do think that some of the investors who are most enamored with the concept fundamentally misunderstand it. So, at the risk of provoking their wrath, here is my list of MOS misconceptions.

    Myth 1: Having a MOS is costless
    There are some investors who believe that their investment returns will always be improved by using a margin of safety on their investments and that using a larger margin of safety is costless. There are very few actions in investing that don’t create costs and benefits and MOS is not an exception. In fact, the best way to understand the trade off between costs and benefits is to think about type 1 and type 2 errors in statistical analysis. If type 1 errors refer to the fact that you have a false positive, type 2 errors reflect the opposite problem, where you have a false negative. Translating this proposition into investing, let’s categorize type 1 errors as buying an expensive stock, because you mistake it to be under valued, and type 2 errors as not buying a bargain-priced stock, because you perceive it wrongly to be over valued. Increasing your MOS will reduce your type 1 errors but will increase your type 2 errors. 

    Many risk averse value investors would accept this trade off but there is a cost to being too conservative and  if that cost exceeds the benefits of being careful in your investment choice, it will show up as sub-par returns on your portfolio over extended periods. So, will using a MOS yield a positive or negative payoff? I cannot answer that question for you, because each investor has to make his or her own judgment on the question, but there are simple tests that you can run on your own portfolios that will lead you to the truth (though you may not want to see it). If you find yourself consistently holding more of your overall portfolio in cash than your natural risk aversion and liquidity needs would lead you to, and/or you don't generate enough returns on your portfolio to beat what you would have earned investing passively (in index funds, for instance), your investment process, no matter what its pedigree, is generating net costs for you. The problems may be in any of the three steps in the process: your valuations may be badly off, your judgment on market catalysts can be wrong or you may be using too large a MOS.

    Myth 2: If you use a MOS, you can be sloppy in your valuations
    Value investors who spend all of their time coming up with the right MOS and little on valuation are doing themselves a disservice. If your valuations are incomplete, badly done or biased, having a MOS on that value will provide little protection and can only hurt you in the investment process (since you are creating type 2 errors, without the benefit of reducing type 1 errors). Given a choice between an investor with high quality valuations and no/little MOS and one with poorly done valuations and a sophisticated MOS, I would take the former over the latter every single time.

    I am also uncomfortable with investors who start with conservative estimates of value and then apply the MOS to that conservative value. In intrinsic valuation, conservative values will usually mean haircutting cash flows below expectations, using high discount rates and not counting in growth that is uncertain. In asset-based valuation, it can take the form of counting only some of the assets because they are tangible, liquid or both. Remember that you are already double counting risk, when you use MOS, even if your valuation is a fair value (and not a conservative estimate of value), because that value is computed on a risk-adjusted basis. If you are using a conservative value estimate, you may be triple or even quadruple counting the same risk when making investment decisions. If you are using this process, I am amazed that any investment manages to make it through your risk gauntlets to emerge as a good investment, and it does not surprise me that nothing in the market looks cheap to you.

    Myth 3: The MOS should be the same across all investments 
    I have always been puzzled by the notion that one MOS fits all investments. How can a 15% margin of safety be sufficient for both an investment in a regulated utility as well as a money-losing start-up? Perhaps, the defense that would be offered is that the investors who use MOS as their risk breakers would not look at companies like the latter, but I would still expect that even in the value investing spectrum, different investments would evoke different degrees of uncertainty (and different MOS).

    Myth 4: The MOS on your portfolio = MOS on individual investments in the portfolio
    I know that those who use MOS are skeptics when it comes to modern portfolio theory, but modern portfolio theory is built on the law of large numbers, and that law is robust. Put simply, you can aggregate a large number of risky investments to create a relatively safe portfolio, as long as the risks in the individual stocks are not perfectly correlated. In MOS terms, this would mean that an investor with a concentrated portfolio (who invests in three, four or five stocks) would need a much larger MOS on individual investments than one who spreads his or her bets across more investments, sectors and markets.

    Expanding on this point, using a MOS will create biases in your portfolio. Using the MOS to pick investment will then lead you away from investments that are more exposed to firm-specific risks, which loom large on an individual company basis but fade in your portfolio. Thus, biotechnology firms (where the primary risk lies in an FDA approval process) will never make your MOS cut, but food processing firms will, for all the wrong reasons. In the same vein, Valeant and Volkswagen will not make your MOS cut, even though the risk you face on either stock will be lowered if they are parts of larger portfolios. 

    Myth 5: The MOS is an alternative risk measure
    I know that many investors abhor betas, and believe it or not, I understand. In fact, I have long argued that there are replacements available for portfolio theory-based risk measures and that not only is intrinsic value robust enough to work with these alternative risk measures but that the discount rate is not (and should not) be the ultimate driver of value in most companies. That said, there are some in the value investing community who like to use their dislike of betas as a bludgeon against all financial theory and after they have beaten that straw horse to death, they will offer MOS as their alternative risk measure. That suggests a fundamental misunderstanding of MOS. To use MOS, you need an estimate of value and I am not aware of any intrinsic value model that does not require a risk adjustment to get to value. In other words, MOS is not an alternative to any existing risk measure used in valuation but an add-on, a way in which risk averse investors can add a second layer of risk protection.

    There is one possible way in which the MOS may be your primary risk adjustment mechanism and that is if you use a constant discount rate when doing valuation (a cost of capital of 8% for all companies or even a risk free rate) and then apply a MOS to that valuation to capture risk. If that is your approach, you should definitely be using different MOS for different investments (see Myth 3), with a larger MOS being used on riskier investments. I would also be curious about how exactly you make this MOS adjustment for risk, including what risks you bring in and how you make the conversion.

    Margin of Safety – Incorporating into a Strategy
    I would not put myself in the MOS camp but I recognize its use in investing and believe that it can be incorporated into a good investing strategy. To do so, though, you would need to do the following:
    1. Self examination: Even if you believe that MOS is a good way of picking investments, it is not for everyone. Before you adopt it, you have to assess not only your own standing (including how much you have to invest, how risk averse you are) but also your faith (in your valuation prowess and that markets correct their mistakes). Once you have adopted it, you still need the effects it has on your portfolio, including how often you choose not to invest (and hold cash instead) and whether it makes a material difference to the returns you generate on your portfolio.
    2. Sound Value Judgments: As I noted in the last section, a MOS is useful only if it is an addendum to sound valuations. This may be a reflection of my biases but I believe that this requires intrinsic valuation, though I am willing to concede that there are multiple ways of doing it right. Accounting valuations seem to be built on the twin presumptions that book value is an approximation of liquidation value and that accounting fair value actually means what it says, and I have little faith in either. As for passing of pricing as value, it strikes me as inconsistent to use the market to get your pricing number (by using multiples and comparable firms) and then argue that the same market misprices the asset in question.
    3. A Flexible MOS: Tailor the MOS to the investment that you are looking at: There are two reasons for using a MOS in the first place. The first is an acceptance that, no matter how hard you try, your estimate of value can be wrong and the second is that even if the value estimate is right, there is uncertainty about whether the market will correct its mistakes over your time horizon. If you buy into these two reasons, it follows that your MOS should vary across investments, with the following determinants.
    • Valuation Uncertainty: The more uncertain you are about your estimated value for an asset, other things remaining equal, the larger the MOS should be. Thus, you should use a smaller MOS when investing in mature businesses and during stable markets, than when putting your money in young, riskier business or in markets in crises.
    • Portfolio Tailoring: The MOS that you use should also be tailored to your portfolio choices. If you are a concentrated investor, who invests in a four or five companies, you should use a much higher MOS than an investor who has a more diversified portfolio, and if you the latter, perhaps even modify the MOS to be larger for companies that are exposed to macroeconomic risks (interest rates, inflation, commodity prices or economic cycles) than to company-specific risks (regulatory approval, legal jeopardy, management flux).
    • Market Efficiency: I know that these are fighting words to an active investor, red flags that call forth intemperate responses. The truth, though, is that even the most rabid critics of market efficiency ultimately believe in their own versions of market efficiency, since if markets never corrected their mistakes, you would never make money of even your canniest investments. Consequently, you should settle for a smaller MOS when investing in stocks in markets that you perceive to be more liquid and efficient than in assets, where the corrections will presumably happen more quickly than in inefficient, illiquid markets where the wait can be longer.
    • Pricing Catalysts: Since you make money from the price adjusting to value, the presence of catalysts that can lead to this adjustment will allow you to settle for a lower MOS. Thus, if you believe that a stock has been mispriced ahead of an earnings report, a regulatory finding or a legal judgment, you should demand a lower MOS than when you invest in a stock that you believe is misvalued but with no obvious pricing catalyst in sight. 
    Finally, if MOS is good enough to use when you buy a stock, it should be good enough to use when you sell that stock. Thus, if you need a stock to be under valued by at least 15%, to buy it, should you also not wait until it is at least 15% over valued, to sell it? This will require you to abandon another nostrum of value investing, which is that once you buy a great company, you should hold it forever, but that is not just unwise but is inconsistent with true value investing.
    Conclusion
    Would I prefer to buy a stock at a 50% discount on value rather than at just below fair value? Of course, and I would be even happier if you made that a 75% discount. Would I feel even more comfortable if you estimated value very conservatively. Yes and I would be delighted if all you counted was liquid assets. That said, I don't live in a  world where I see too many of these investments and when I do, it is usually the front for a scam rather than a legitimate bargain.  That is the reason that  I have never formally used a MOS in investing. I did buy Valeant at $32, because my valuation of the stock yielded $45 for the company. Would I have still bought the stock, if my value estimate had been only $35 or if it was a big chunk of my portfolio? Perhaps not, but I have bought stocks that were priced at my estimated fair value and have held back on investments that I have found to be under valued by 25% or more. Why? That has to wait for my coming post on simulations, since this one has run its course.

    YouTube Video


    Uncertainty Posts
    1. DCF Myth 3: You cannot do a valuation, when there is too much uncertainty
    2. The Margin of Safety: Excuse for Inaction or Tool for Action?
    3. Facing up to Uncertainty: Probabilities and Simulations
    DCF Myth Posts
    1. If you have a D(discount rate) and a CF (cash flow), you have a DCF.  
    2. A DCF is an exercise in modeling & number crunching. 
    3. You cannot do a DCF when there is too much uncertainty.
    4. It's all about D in the DCF (Myths 4.14.24.34.4 & 4.5)
    5. The Terminal Value: Elephant in the Room! (Myths 5.15.25.35.4 & 5.5)
    6. A DCF requires too many assumptions and can be manipulated to yield any value you want.
    7. A DCF cannot value brand name or other intangibles. 
    8. A DCF yields a conservative estimate of value. 
    9. If your DCF value changes significantly over time, there is something wrong with your valuation.
    10. A DCF is an academic exercise.



    DCF Myth 3: You cannot do a valuation, when there is too much uncertainty!

    Uncertainty, both imminent and resolved, has been on my mind these last two weeks. I posted my valuation of Valeant on April 20, making the argument that, at least based on my expectations on what could be revealed in the delayed financial filings, the stock was worth about $44, approximately $12 more than the prevailing stock price. Many of you were kind enough to comment on my valuation, and one of the more common refrains was there were too many unknowns on the stock to be taking a stand. In fact, one of the comments on the post was that "regardless of the valuation, a sufficient margin of safety does not exist (on the stock)". On April 21, we got news that Volkswagen had come to an agreement with US authorities on the compensation that they would offer buyers of their cars and a day later, the company announced that it would take an $18.2 billion charge to cover the costs of its emissions misrepresentations. It was a chance for me to revisit my valuation of Volkswagen, in the immediate aftermath of the scandal in October 2015, and take stock of how the the investment I made in the stock then looks, as the uncertainty gets slowly resolved. All through these last two weeks, there were signs that Yahoo's journey, that was starting to resemble the Bataan Death March lately, was nearing its end, as the company reviewed bids for its operating assets. Since it is a stock that I valued almost two years ago (and bought after the valuation) and labeled as a Walking Dead company, I am interested, both financially and intellectually, to see how this end game plays out. As I wrestle with the resolution of uncertainties from the past and struggle with uncertainties in the future on every one of my investments, I thought it would be a good time to look at good and bad ways of responding to I uncertainty in investing and valuation.

    The Uncertainty Principle
    Uncertainty has always been part of human existence, though it has transitioned from the physical uncertainty that characterized the caveman era to the economic uncertainty that is more typical of today, at least in developed markets. Each generation, though, seems to think that it lives in the age of the greatest uncertainty. That may be partially a reflection of a broader sense of "specialness" that afflicts each generation, where it is convinced that its music and movies were the very best and that it had to get through the biggest challenges to succeed. The other is a variation of hindsight bias, where we can look at the past and convince ourselves that what actually happened should have been obvious before it occurred. I am surprised at how many traders, investors and portfolio managers, who lived through the 2008 crisis, have convinced themselves that November 2008 was not that bad and that there was never a chance of a catastrophic ending.  That said, uncertainty not only ebbs and flows over time but also changes form, making enduring fixes and lessons tough to find. As investors bemoan the rise of uncertainty in today's markets, there are three reasons why they may feel more under siege now than in prior decades:
    1. Low Interest Rates: In my post on negative interest rates, I pointed to the fact that as interest rates in many of the leading currencies have dropped to historic lows, risk premiums have increased in both stock and bond markets. The expected return on the S&P 500 in early 2008, before the crisis, was 8% and it remains at about that level today, even though the treasury bond rate has dropped from 4% to less than 2%, but the equity risk premium has risen to compensate. Even though the expected return may be the same, the fact that more of it can be attributed to a risk premium will increase the market reaction to news, in both directions, adding to price volatility.
    2. Globalization: Globalization has not only changed how companies and investors make choices but has also had two consequences for risk. The first is that there seem to be no localized problems any more, with anyone's problem becoming everyone's problem. Thus, political instability in Brazil and too much local government borrowing to build infrastructure in China play out on a global stage, affecting stock prices in the rest of the world. The second is that the center of global economic power is shifting from the US and Europe to Asia, and as it does, Americans and Europeans are starting to bear more of world's economic risk than they used to.
    3. Media/Online Megaphones: As an early adopted of technology, I am far from being a Luddite but I do think that the speed with which information is transmitted around the world has allowed market risks to go viral. It is not just the talking heads on CNBC, Bloomberg and other financial news channels that are the transmitters of these news but also social media, as Twitter and Facebook become the place where investors go to get breaking investing news.
    I am sure that you can add other items to this list, such as the disruption being wrought by technology on established businesses, but I am not sure that these are either uncommon or unusual. Every decade has its own disruptive factors, wreaking havoc on existing business models and company values.

    The Natural Responses to Uncertainty
    Much of financial theory and a great deal of financial practice was developed in the United States in the second half of the last century and therein lies a problem. The United States was the giant of the global economy for much of this period, with an economy on an upward path. The stability that characterized the US economy during this period was unusual, if you look at long term history of economies and markets, and much as we would like to believe that this is because central bankers and policy makers learned their lessons from the great depression, there is the very real possibility that it was just an uncommonly predictable period. That would also mean that the bedrock of financial practice, built on extrapolating from past data and assuming mean reversion in all things financial, may be shaky, and that we have to reevaluate them for the economies that we operate in today. It is unfair to blame the way we deal with uncertainty entirely on the fact that our practices were honed in the United States. After all, it is well chronicled in both psychological annals and behavior studies that we, as human beings, deal with uncertainty in unhealthy ways, with the following being the most common responses:
    1. Paralysis and Inaction: The most common reaction to uncertainty, in my experience, is inaction. "There is too much uncertainty right now to act" becomes the refrain, with the promise that action will come when more of the facts are know. The consequences are predictable. I have friends who have almost entirely been invested in money market funds for decades now, waiting for that moment of clarity and certainty that never seems to come. I have also talked to investors who seem to view investing when uncertain as a violation of value investing edicts and have found themselves getting pushed into smaller and smaller corners of the market, seeking elusive comfort.
    2. Denial and Delusion: At the other end of the spectrum, the reaction that other investors have to uncertainty is go into denial, adopting one of two practices. The number crunchers fall back on false precision, where they add more detail to their forecasts and more decimals to their numbers, as a defense against uncertainty. The story tellers fall back on story telling, acting as if they have the power to write the endings to every uncertain narrative, when in fact they have little control over either the players or the outcome.
    3. Mental Accounting and Rules of Thumb: The brain may be a wondrous organ but it has its own set of tics that undercut investing, when uncertain. As Richard Thaler has so convincingly shown in his work on mental accounting, investors and analysts like to use rules of thumb, often with no basis in fact or reality, when making judgments. Thus, a venture capitalist who is quick to dismiss the use of intrinsic value in a young start-up as too fraught with estimation error, seems to have no qualms about forecasting earnings five years out for the same company and applying a price earnings ratio to those earnings to get an exit value.
    4. Outsourcing and Passing the Buck: When stumped for answers, we almost invariably turn to others that we view as more knowledgeable or better equipped than we are to come up with solutions. Cynically, you could argue that this allows us to avoid taking responsibility for investment mistakes, which we can now attribute to consultants, text book writers or that person you heard on CNBC. 
    5. Prayer and Divine Intervention: The oldest response to uncertainty is prayer and it has had remarkable staying power. There are large segments of the world where big investment and business decisions are preceded by prayers and divine intervention on your behalf. 
    If the first step in change is acceptance, I have come to accept that I am prone to do some or all of the above, when faced with uncertainty, but I have also discovered that these reactions can do damage to my portfolio. 
    Dealing with Uncertainty
    To reduce, if not eliminate, my unhealthy responses to uncertainty, I have developed my own coping mechanisms that will hopefully push me on to healthier tracks. I am not suggesting that these will work for you, but they have for me, and please feel free to modify, abandon or adjust them to your own needs.
    1. Have a narrative: As many of you who read this blog know, I have long believed that a company valuation without a story to bind it together is just numbers on a spreadsheet and a story that uses no numbers at all is a fairy tale. There is another advantage in having a narrative underlie your valuation and tying numbers to that narrative. When faced with uncertainty about specifics, the question that I ask is whether these specifics affect my narrative for the company and if yes, in what way. In my valuation of Volkswagen, right after the diesel emissions scandal, I did not find a catastrophic drop in value for the company because my underlying narrative for Volkswagen, that of a mature business with little to offer in terms of expansion or growth opportunities, was dented but largely unchanged as a result of the scandal. With Valeant, in my November 2015 valuation, I argued that the attention brought to the company by its drug pricing policies and connections to Philidor would result in it having to abandon its strategy of growth driven by acquisitions and growth and to shift to being a less exciting, lower growth pharmaceutical company. That shift in narrative drove the inputs into my valuation and my lower assessment of value. 
    2. Categorize uncertainty: Uncertainty can come from many sources and it is useful, when valuing a company in the face of multiple uncertainties, to classify them. Here are my groupings:


    Since it is easy to miss some uncertainties and double count others, I find it useful to keep them isolated in different parts of my valuation:


    Specifically, in my Volkswagen and Valeant valuations, it was micro risk that concerned me, with some of that risk being continuous (the effect of the diesel emissions scandal on Volkswagen car sales) and some being discrete (the fines levied by the EPA on Volkswagen and the risk of default in Valeant). That is why both companies, at least in my conventional valuations, have low costs of capital, notwithstanding the risky environment, but their values are then adjusted for the expected costs of the discrete events occurring.
    3. Keep it simple:  This may seem ironic but the more uncertainty there is, the simpler my valuation models become, with fewer inputs and less levers to move. One reason is that it allows me to focus on the variables that really drive value for the company and the other is that it reduces my need to estimate dozens of variables in the face of uncertainty. Thus, in my valuations of start-up companies, my focus is almost entirely on three variables: revenue growth, operating margins and the reinvestment needed to sustain that growth. 
    4. Make your best estimates: As I start making my estimates in the face of uncertainty, I hear the voice in the back of my mind pipe up, saying "You are going to be so wrong!" and I silence it by  reminding myself that I don't have to be right, just less wrong than everyone else, and that when uncertainty is rampant, most investors give up.
    5. Face up to uncertainty: Rather than cringe in the face of uncertainty and act like it is not there, I have found that it is freeing to admit that you are uncertain and then to take the next step and be explicit about that uncertainty. In my valuations of tech titans in February 2016, I used probability distributions for the inputs that I felt most shaky about and then reported the values as distributions. Since some of you have been curious about the mechanics of this process, I will take a lengthier journey through the process of running simulations in a companion piece to this post.
    6. Be willing to be wrong: If you don't like to be wrong, it is best not  to value companies in the face of uncertainty. However, if you think that Warren Buffet did not face uncertainty in his legendary investment in American Express after the salad oil scandal in 1964 or that John Paulson knew for sure that his bet against the housing bubble would pay off in 2008, you are guilty of revisionist history. There is a corollary to this point and it relates to diversification. As I have argued in my post on diversification, the more uncertain you feel about individual investments, the more you have to spread your bets. It is not an admission of weakness but a recognition of reality.

    If you are a value investor, you will notice that I have not mentioned one of value investors' favorite defenses against uncertainty, which is the margin of safety. Seth Klarman is one of my favorite investment thinkers but I am afraid that the margin of safety, at least as practiced by some in the investing community, has become an empty vessel, an excuse for inaction rather than a guide to action in risky times. I will come back to this measure as well in another post in this series.

    Conclusion
    If you are an active investor, you are constantly looking for an edge, something that you can bring to the table that most other investors cannot or will not, that you can exploit to earn higher returns. As the investing world gets flatter, with information freely accessible and available to almost all investors, and analytical tools that anyone can access, often at low cost, being comfortable with uncertainty may very well be the edge that separates success from failure in investing. There may be some who are born with that comfort level, but I am not one of them. Instead, my learning has come the hard way, by diving into companies when things are most uncertain and by valuing businesses in the midst of market crises, "by going where it is darkest". That journey is not always profitable (see my experiences with Vale as a precautionary note), sometimes makes me uncomfortable (as I have to make forecasts based upon little or bad information), but it is never boring. I am wrong a hefty percent of the time, but so what? It's only money! I am just glad that I am not a brain surgeon!

    YouTube Video


    Uncertainty Posts
    1. DCF Myth 3: You cannot do a valuation, when there is too much uncertainty
    2. The Margin of Safety: Excuse for Inaction or Tool for Action?
    3. Facing up to Uncertainty: Probabilities and Simulations
    DCF Myth Posts
    1. If you have a D(discount rate) and a CF (cash flow), you have a DCF.  
    2. A DCF is an exercise in modeling & number crunching. 
    3. You cannot do a DCF when there is too much uncertainty.
    4. It's all about D in the DCF (Myths 4.14.24.34.4 & 4.5)
    5. The Terminal Value: Elephant in the Room! (Myths 5.15.25.35.4 & 5.5)
    6. A DCF requires too many assumptions and can be manipulated to yield any value you want.
    7. A DCF cannot value brand name or other intangibles. 
    8. A DCF yields a conservative estimate of value. 
    9. If your DCF value changes significantly over time, there is something wrong with your valuation.
    10. A DCF is an academic exercise.



    The Brexit Effect: The Signals amidst the Noise


    There are few events that catch markets by complete surprise but the decision by British voters to leave the EU comes close. As markets struggle to adjust to the aftermath, analysts and experts are looking backward, likening the event to past crises and modeling their responses accordingly. There are some who see the seeds of a market meltdown, and believe that it is time to cash out of the market. There are others who argue that not only will markets bounce back but that it is a buying opportunity. Not finding much clarity in these arguments and suspicious of bias on both sides, I decided to open up my crisis survival kit, last in use in August 2015, in the midst of another market meltdown.

    The Pricing Effect
    I am sure that you have been bombarded with news stories about how the market has reacted to the Brexit vote and I won't bore you with the gory details. Suffice to say that, for the most part, it has followed the crisis rule book: Government bond rates in developed market currencies (the US, Germany, Japan and even the UK) have dropped, gold prices have risen, the price of risk has increased and equity markets have declined. The picture below captures the fallout of the vote:


    While most of the reactions are not surprising, there are some interesting aspects worth emphasizing. 
    1. Currency Wars: If this is a battle, the British Pound is on the front lines and taking heavy fire, down close to 10% over the last week against the US dollar and approaching three-decade lows, with the Euro seeing collateral damage against the US dollar and the Japanese Yen.
    2. Old EU, New EU and the Rest of the World : The damage is greatest in the EU, but even within the EU, it is the old EU countries (primarily West European, that joined the EU prior to 2000) that have borne the biggest pain, with sovereign CDS spreads rising and stock prices falling the most. The new EU countries (mostly East European) have been hurt less than Britain's other trading partners (US, Australia and Canada) and the damage has been muted in emerging markets. At least for the moment, this is more a European crisis first than a global one.
    3. Banking Problems? Though I have seen news stories suggesting that financial service companies are being hurt more than the rest of the market by Brexit and that smaller companies are feeling the pain more than larger ones, the evidence is not there for either proposition at the global level. At more localized levels, it is entirely possible that it does exist, especially in the UK, where the big banks (RBS, Barclays) have dropped by 30% or more and mid-cap stocks have done far worse than their  large-cap counterparts.
    While I did stop the assessment as of Friday (6/24), the first two days of this trading week have continued to be volatile, with a big down day on Monday (6/27) followed by an up day on Tuesday (6/28), with more surprises to come over the next few days.

    The Value Effect
    As markets make their moves, the advice that is being offered is contradictory. At one end of the spectrum, some are suggesting that Brexit could trigger a financial crisis similar to 2008, pulling markets further down and the global economy into a recession, and that investors should therefore reduce or eliminate their equity exposures and batten down the hatches. At the other end are those who feel that this is much ado about nothing, that Brexit will not happen or that the UK will renegotiate new terms to live with the EU and that investors should view the market drops as buying opportunities. Given how badly expert advice served us during the run-up to Brexit, I am loath to trust either side and decided to go back to basics to understand how the value of stocks could be affected by the event and perhaps pass judgment on whether the pricing effect is under or overstated. The value of stocks collectively can be written as a function of three key inputs: the cash flows from existing investment, the expected growth in earnings and cash flows and the required return on stocks (composed of a risk free rate and a price for risk). The following figure looks at the possible ways in which Brexit can affect value:

    Embedded in this picture are the most extreme arguments.  Those who believe that Brexit is Lehman-like are arguing that it will lead to systemic shocks that will lower global growth (not just growth in the UK and the EU) and increase the price of risk. In this story, these shocks will come from banking problems spilling over into the rest of the economy or an unraveling of the EU.  Those who believe that Brexit’s effects are more benign are making a case that while it may reduce UK or even EU growth in the short term, the effects of global growth are likely to be small and/or not persistent and that the risk effect will dissipate once investors feel more reassured. 

    I see the truth as falling somewhere in the middle.  I think that doomsayers who see this as another Lehman have to provide more tangible evidence of systemic risks that come from Brexit. At least at the moment, while UK banks are being hard hit, there is little evidence of the capital crises and market breakdowns that characterized 2008. It is true that Brexit may open the door to the unraveling of the EU, a bad sign given the size of that market but buffered by the fact that growth has been non-existent in the EU for much of the last six years. If the European experiment hits a wall, it accelerate the shift towards Asia that is already occurring in the global economy. I also think that those who believe that is just another tempest in a teapot are too sanguine. The UK may be only the fifth largest economy in the world but it has a punch that exceeds its weight because London is one of the world's financial centers. I think that this crisis has potential to slow an already anemic global economy further. If that slowdown happens, the central banks of the world, which already have pushed interest rates to zero and below in many currencies will run out of ammunition. Consequently, I see an extended period of political and economic confusion that will affect global growth and some banks, primarily in the UK and the US, will find their capital stretched by the crisis and their stock prices will react accordingly. 

    The Bigger Lessons
    It is easy to get caught up in the crisis of the moment but there are general lessons that I draw from Brexit that I hope to use in molding my investment strategies.
    1. Markets are not just counting machines: One of the oft-touted statements about markets is that they are counting machines, prone to mistakes but not to bias. If nothing else, the way markets behaved in the lead-up to Brexit is evidence that markets collectively can suffer from many of the biases that individual investors are exposed to. For most of the last few months, the British Pound operated as a quasi bet on Brexit, rising as optimism that Remain would prevail rose and falling as the Leave campaign looked like it was succeeding. There was a more direct bet that you would make on Brexit in a gamblers' market, where odds were constantly updated and probabilities could be computed from these odds. Since Brexit was also one of the most highly polled referendums in history, you would expect the gambling to be closely tied to the polling numbers, right? The graph below illustrates the divide.
      While the odds in the Betfair did move with the polls, the odds of the Leave camp winning never exceeded 40% in the betting market, even as the Leave camp acquired a small lead in the weeks leading up to the vote. In fact, the betting odds were so sticky that they did not shift to the Leave side until almost a third of the votes had been counted. So, why were markets so consistently wrong on this vote? One reason, as this story notes,  is that the big bets in these markets were being made by London-based investors tilting the odds in favor of Remain. It is possible that these investors so wanted the Remain vote to win and so separated from this with a different point of view that they were guilty of confirmation bias (looking for pieces of data or opinion that backed their view). In short, Brexit reminds us that markets are weighted, biased counting machines, where if big investors with biases can cause prices to deviate from fair value for extended periods, a lesson perhaps that we learned from value investors piling into Valeant Pharmaceuticals.
    2. No one listens to the experts (and deservedly so): I have never seen an event where the experts were all so collectively wrong in their predictions and so completely ignored by the public. Economists, policy experts and central banks all inveighed against exiting the EU, arguing that is would be catastrophic, and their warnings fell on deaf years as voters tuned them out. As someone who cringes when called a valuation expert, and finds some of them to be insufferably pompous,  I can see why experts have lost their cache. First, in almost every field including economics and finance, expertise has become narrower and more specialized than ever before, leading to prognosticators who are incapable of seeing the big picture. Second, while economic experts have always had a mixed track record on forecasting, their mistakes now are not only more visible but also more public than ever before. Third, the mistakes experts make have become bigger and more common as we have globalized, partly because the interconnections between economies means there are far more uncontrollable variables than in the past. Drawing a parallel to the investment world, even as experts get more forums to be public, their prognostications, predictions and recommendations are getting far less respect than they used to, and deservedly so.
    3. Narrative beats numbers: One of the themes for this blog for the last few years has been the importance of stories in a world where numbers have become more plentiful. In the Brexit debate, it seemed to me that the Leave side had the more compelling narrative (of a return to an an old Britain that some voters found appealing) and while the Remain side argued that this narrative was not plausible in today's world, its counter consisted mostly of numbers (the costs that Britain would face from Brexit). Looking ahead to similar referendums in other EU countries,  I am afraid that the same dynamic is going to play out, since few politicians in any EU country seem to want to make a full-throated defense of being Europeans first. 
    4. Democracy can disappoint (you): The parallels between political and corporate governance are plentiful and Brexit has brought to the surface the age-old debate about the merits of direct democracy. While some (mostly on the winning side) celebrate the power of free will, those who have never trusted people to make  reasoned judgments on their futures view the vote as vindication of their fears. In corporate governance, this tussle has been playing out for a while, with those who believe that shareholders, as the owners of public corporations, should control outcomes, at one end, and those who argue that incumbent managers and/or insiders are more knowledgeable about businesses and should therefore be allowed to operate unencumbered, at the other. I am sure that there are many in the corporate world who will look at the Brexit results and cheer for the Facebook/Google model of corporate governance, where shares with different voting rights give insiders control in perpetuity. As someone who has argued strongly for corporate democracy and against entrenching incumbent managers, it would be inconsistent of me to find fault with the British public for voting for Brexit.  In a democracy, you will get outcomes you do not like and throwing a tantrum (as some in the Remain camp are doing right now) or threatening to move (to Canada or Switzerland) are not grown-up responses.  You may not like the outcome, but as an American political consultant said after his candidate lost an election, "the people have spoken... the bastards".
    The End Game
    I have not bought or sold anything since the Brexit results for the simple reason that almost anything I do in the midst of a panic is more likely to be counter productive than helpful. To those who would argue that I should move my money away from Europe, the markets have already done that for me (by marking down my European stocks) and I see little to be gained by overdoing it. To those who assert that this is the time to buy, I am not a fan of blind contrarianism but I will be looking at UK-based companies that have significant non-European operating exposure in the hope that markets have knocked down their prices too much. Finally, to those who posit that this is a financial meltdown, I will keep a wary eye on the numbers, looking for early signs that the worst case scenario is playing out. In my view, bank stocks will be the canaries in the coal mine, and especially so if the damage spreads to non-UK banks, and I will continue to estimate equity risk premiums for the S&P 500 and perhaps add the UK and Germany to the list to get a measure of how equity markets are repricing risk.

    YouTube




    Icahn exits, Buffett enters, Whither Apple? Value and Price Effects of Big Name Investing

    In my last post, I looked at Apple, arguing, with a Monte Carlo simulation, that the stock was a good investment at the prevailing market price ($93 at the time of the analysis). I appreciate the many comments that I got on the analysis, some taking issue with the distributions that I used for profit margins and revenue growth and some taking me to task for ignoring the fact that big name investors were either entering and exiting the stock. Those who felt that my valuation was optimistic pointed out that Carl Icahn, a long time and very vocal investor in Apple, had decided to sell his stake in the company on April 28. Some who concurred with my value judgment on Apple pointed out that Berkshire Hathaway (and by extension, Warren Buffett or his proxies) had invested in the company on May 16.  Should Carl Icahn’s decision to sell Apple or Berkshire Hathaway’s choice to buy it change my assessments of value or views on its price? More generally, should the decisions by "big name" investors to buy or sell a specific company affect your investment judgments about that company? 

    Price versus Value: The Set Up
    To set up the discussion of whether, and if so how, the actions of other investors, especially those with big names and reputations to match, affect your investing choices, I will fall back on a device that I have used before, where I contrast the value and pricing processes.


    Put simply, the value process is driven by a company's fundamentals (cash flows, growth and risk) or at least your perception of those fundamentals, whereas  the pricing process is driven by demand and supply, with mood, momentum and liquidity all playing big roles in determining price. In an earlier post,  I argued that it these processes that separate investors from traders, with investors focused on the drivers of value and traders on the pricing process, and that the skills and tools that you need to be a successful trader are different from those that you need to be a successful investor. To understand how and why the entry of a big name investor may alter your assessments of value and price, I would suggest categorizing that investor into one of four types.
    1. An Insider, who is either part of management or has privileged access to management.
    2. An Activist, who plans to change the way the firm is run or financed.
    3. A Trader, whose skill lies in playing the pricing game, with the power to either reinforce or reverse price momentum
    4. A Value Investor, who has valued the company and is willing to take a position based upon that value, on the expectation that the pricing gap will close.
    Each type of big name investor has the potential to change how you view the dynamics of price and value, though the place where the change occurs will depend on the investor type.

    The entry (or exit) of a big name insider or big name activist can alter your estimate of value for a company, by either changing your perceptions of cash flows, growth and risk or by having the potential to change the company's operating and financing characteristics. As a trader, the entry or exit of a big name trader may cause you to move from one side of the pricing game to the other, i.e., shift you from being a buyer to a seller. Finally, as a long term value investor who believes that a stock is mis-priced but has little or no power to cause the pricing gap to close, the entry of a big name value investor can provide a catalyst for the correction.

    The Value Effect 
    If you asked a value purist whether the actions of other investors affect his or her value, the answer will almost always be "of course not". After all, the essence of intrinsic value is that it is determined not by what others think about the company but the company's capacity to generate cash flows  over time. That said, there are two ways that the investment action (to buy or sell) of a big name investor can change your assessment of value. 

    1. The first is if the big name investor has private information or is perceived as knowing more about the firm than you do. While that may walk awfully close to the insider trading line in the United States, it is entirely possible that the investor's information is diffuse enough to not be in violation of the law. In this case, it is entirely rational for you, as an investor, to reassess your cash flows and risk, based upon the insiders' actions. That is perhaps why we are so fascinated by insider trading, where the perception is that insider buying is value increasing and insider selling is value selling. In some emerging markets, where possessing proprietary information is neither illegal nor unusual, and the decision by an investor who is perceived as having this information (an insider, manager or family member) to buy (or sell) is an indicator that your value should be increased (decreased). 
    2. The other scenario is where the big name investor is an activist who plans to push for changes in the way the company operates, how it is financed or how much and how it returns cash to investors. The potential effects of these changes can be most easily seen using a financial balance sheet:

    To the extent that you believe that the company will have to respond to activist pressure, your assessment of value will change. An asset restructuring can alter he cash flows and risk characteristics of a business, changing your estimate of value, though the direction of the value change and its magnitude will depend on how you see these operating changes playing out in cash flows and growth.  Adding debt to your financing mix can add value to a firm (because of the tilt in the tax code towards debt) or destroy value (because it exposes companies to bankruptcy risk). If you are valuing a company, the entry of a big name activist investor in the ranks with a history of pushing for more debt could lead you to reassess your value estimate as well. Returning more cash to stockholders in special dividends or buybacks can change value either upwards (if the market is discounting the cash on the presumption that the company would waste the cash on bad investments/acquisitions) or downwards (if returning the cash will expose the firm to default risk or substantial financing costs in the future).

    The Pricing Effect
    In some cases, the big name investing in the stock is a trader, doing so on the expectation that momentum will either continue, sustaining the pricing trend, or that momentum will reverse, causing the trend to reverse as well. Since this trade is not motivated by either new information or the desire to change how the company is run, there is no value effect, but there can be a price effect for two reasons. 
    1. The volume effect: If the big name trader has enough money to back his or her trade, there will be a liquidity effect, where a buy will push the price up higher and a sell will push it lower. 
    2. The bandwagon effect: To the extent that there are some in the market who perceive the big name trader as better at perceiving momentum swings than the rest of us, they will follow the investor in buying or selling the stock. 
    In contrast to a value effect, which is long term and sustained, the pricing effect will have a shorter half life. To the extent that the big name trader's time horizon may be even shorter, he or she can still make money from the bandwagon effect. To get a measure of the pricing effect of a big name trade, you have to look at both the resources commanded by the trader as well as the liquidity/trading volume in the stock. A trader with billions under his control investing in a lightly traded and lightly followed stock will have a much bigger pricing effect than in a very liquid, large market capitalization company. 

    The Catalyst Effect
    It is an undeniable and frustrating truth about value investing that for most of us, it is not just enough to be right in your assessment of value but you have to get the market to correct its mistakes to make money on your investments. If you are a small investor, there is little that you can do to close the pricing gap because you have neither the money or the megaphone to close the gap. A big name value investor, though, may be more successful for two reasons: he or she can take a larger position in the stock and as with the big name trader, create a bandwagon effect where other value investors will follow into the stock.  Again, the magnitude of the catalyst effect will vary across both investors and companies. The extent of the impact on the pricing gap will depend in large part on the history of success that the big name investor brings into the investment, with sustained success in the past going with a larger impact. 

    Apple, Icahn and Buffett
    It has taken me a while to get to the point of this post, which was ostensibly about Apple and how Icahn’s exit and Buffett’s entry into the stock affect my thinking. At first sight, this graph shows how the market reacted to their actions:

    While it does look like Icahn's sale had a negative effect (albeit mild) and Berkshire's buy had a positive effect (almost as mild), I plan to use the framework of the last section to assess each of these investors and gauge how it should affect my thinking about the stock.

    Icahn, the Activist Trader
    Through much of his tenure, Carl Icahn has been labeled an activist investor but I will take issue with at least a portion of that label. It is true that Icahn is an activist, though he is much more active on the financing/dividend dimension (pushing companies to borrow money and return cash) than on the operating dimension. I do think that Icahn is more of a trader than an activist, more focused on momentum and pricing than on value and this is illustrated by the tools that brings to the assessment. When Icahn was asked why he invested in Lyft in 2015, his response was that it looked cheap relative to Uber, a classic pricing argument. With Apple, in his bullish days, Icahn argued that it was cheap, but consider how he justified his contention in May 2015, that Apple, then trading at $100, should really be trading at $240. In effect, he forecast out earnings per share in 2016 to be $12, applied a PE ratio of 18 and added the cash balance of $24.44/share. Not only is this definitely not an intrinsic valuation, it is at best "casual pricing", i.e., the type of pricing you would do on the back of an envelope after you have had a little too much to drink.

    Before you point out to me that Icahn is worth billions and I am not, let me hasten to add that there is nothing ignoble about trading and that Icahn has been an incredibly successful trader over the last few decades, testimonial to his targeting and trading skills. It does color how I viewed Icahn’s investment in Apple in January 2014, his push at Apple for more dividends and more debt during his days as a Apple investor and his decision to sell his holdings on April 2016. I was already an investor in Apple in January 2014, when Icahn bought his shares, and while I did not view his decision to buy the shares as vindication of my valuation, I welcomed him to the shareholder ranks both because Apple was badly in need of a momentum shift and Icahn was playing both an activist and a catalyst role. I am glad that he put pressure on Apple to get over its unwillingness to borrow money and to return more cash in dividends and buybacks. His decision to depart does tells me two things. First, Icahn has recognized the limitations of financing and dividend policy changes in driving Apple’s value and is moving on to companies where the payoff is greater from financial reengineering. Second, it is possible that Icahn’s momentum detector is telling him that while Apple’s stock price may not be going lower, it has little room to go higher either, at least in the short term, and given his trading track record, I would take that signal seriously,

    Buffett Buys In?
    The decision by Berkshire Hathaway to invest in Apple about three weeks after Icahn’s departure mollified some worried Apple investors, since there is no more desirable endorsement in all of value investment than Warren Buffett’s buy order. I am not privy to the inner workings in Omaha, but I have a feeling that this decision was made more by Todd Combs and Ted Wechsler, the co-heads that Buffett hired as his successors, than by Buffett, but let’s assume that they are following the Buffett playbook. What does that tell you about Apple stock? The good news is that the greatest value investor of this generation now considers Apple to be a value stock. The bad news is that this investor's biggest investment in a technology company has been in IBM, a company that delivers solid dividends and cash flows but has been liquidating itself gradually over the last ten years. If my value judgment on Apple had required substantial growth for value to be delivered, Buffett’s investment could very well have adversely affected my view on the company. In this case, though, I agree with his assessment that Apple is a mature company, with enough cash flows to cover dividends for a generation. 

    The Apple End Game
    In early May, when I analyzed Apple, I knew that Carl Icahn had already closed out his position and it had no impact on my value estimate or investment judgment. Icahn’s decision to sell was an indication to me that the price might not recover quickly and that momentum could work against me in the near term, but I was okay with that, since my time horizon was not constrained. Buffett’s decision (if it was his) to jump in, a couple of weeks later, may be an indication that the best days of Apple are behind it, but I had already made the same judgment in my valuation. If there is a silver lining, it is that Buffett's followers, with their large numbers and unquestioning, will imitate him and perhaps get the price gap to close. 

    The Dark Side of Big Name Investing
    While I am open to the possibility that the entry of a big name into a company has the potential to change the way I think about the company and perhaps my investment decisions, there are dangers embedded in doing so.
    1. Confirmation bias: It is a well-established fact that investors look for evidence that confirms decisions that they have already made and ignore evidence that contradicts it and big name investors feed into this bias. Thus, if you have bought a stock, you are far more likely to focus in on those big name investors who agree with you (and are either bullish on the stock or buy it) and screen out big name investors who do no.
    2. Mixed Motives: It is entirely possible that you (as an investor) may be misreading or misunderstanding the motives that caused the big name trade in the first place. In particular, the insider, who you assumed was trading because he or she had private information, may be selling the stock for tax or liquidity reasons. The activist, who you assumed was pushing for real changes in the company, may be more interested in collecting a payoff from the company to leave it alone. The trader, who you assumed had skills playing the momentum game, may himself be following the crowd rather than assessing momentum shifts. Finally, the value investor, who you assumed had valued the company and was pushing for the price/value gap to close, may be more trader than investor, quick to give up, if the stock moves in the wrong direction.
    There are some investors, including many institutional investors, whose entire investment strategy seems to be built around watching what big name investors do and imitating them. While imitation may be the best form of flattery, it is inauthentic and a poor basis for an investment philosophy, no matter who the big name investor that you are imitating is and how successful he or she has been. We are too quick to attribute investment success to skill and wisdom and that much of what passes for "smart" money is really "lucky" money. My advice is that if you have an investment thesis that leads you to buy the stock, do so and stop worrying about what the talking heads on CNBC or Bloomberg tell you about it. If you have so little faith in your reasoning that you doubt it and are ready to abandon it the moment it is contested by a big name, you should consider investing in index funds instead.

    YouTube Video



    May you live in "exciting" times! An Updated Picture of Country Risk

    About a year ago, I completed my first  update of a paper looking at all aspects of country risk, from political risk to default risk to equity risk, and wrote about my findings in three posts, one on how to incorporate risk in company value, the second on the pricing of country risk and the last one on decoding currencies. The twelve months since have been interesting, to say the least, and unsettling to many as markets were buffeted by crises. In August 2015, a month after my posts, we had questions about China, its economy and markets play out on the global arena, leading to this post with my China story. Towards the end of June 2016, we had UK voters choosing to exit the EU, and that too caused waves (or at least ripples) through markets, which I talked about in this post. It is a good time to update my global country risk database and the paper that goes with it, and in this post, I would like to focus on updating numbers and providing risk pictures of the world, as it looks today.

    Country Risk: Non-market measures
    This should go without saying, but since there is still resistance in some practitioner circles to this notion, I will say it anyway. Some countries are riskier to invest in, either as an investor or as a business, than others. The risk differences can be traced to a variety of factors including where the country is in the life cycle (growing, stable or declining?), the maturity of its political institutions (democracy or dictatorship?, smoothness of political transitions), the state of its legal system (in terms of both efficiency and fairness) and its exposure to violence. Not surprisingly, how you perceive risk differences will depend in large part on which dimension of risk you are looking at in a country.

    While I look at risk measures that look at threat of violence, degree of corruption, dependence of the economy on a commodity (or commodities) and protection of property rights individually in the full paper, I also report on a composite measure of risk that I obtain from Political Risk Services (PRS), a Europe-based service that measures country risk on a numerical scale, with lower (higher) numbers representing more (less) risk. The picture provides a heat map of the world using this measure as of July 2016. (The heat maps don't seem to show up on some browsers. So, I have replaced them with snapshots. If you click on the links below the snapshots, you should be able to see the heat maps.. I think).
    Link to heat map

    As we move from 2015 to 2016, it is interesting to see how much risk changed in countries, rather than the level of risk, and again using political risk score, the heat map above reports on changes in the PRS score over the last year (if you hover over a country, you should see it).

    Finally, there is an alternate and more widely used measure of country risk that focuses on country default risk, with sovereign ratings for countries from Moody's and Standard & Poors (among others) and the picture below provides these ratings, as of July 1, 2016, globally:
    Link to heat map
    I know that ratings agencies are much maligned after their failures during the 2008 crisis, but I do think that some of the abuse that they take is unwarranted. They often move in tandem and are generally slow to respond to big risk shifts, but I am glad that I have their snapshots of risk at my disposal, when I do valuation and corporate finance.

    Country Risk: Market Measures
    There are two problems with non-market measures like risk scores or sovereign ratings. The first is that they are neither intuitive nor standardized. Thus, a PRS score of 80 does not make a country twice as safe as one with a PRS score of 40. In fact, there are other services that measure country risk scores, where high numbers indicate high risk, reversing the PRS scoring. The second is that these non-market measures are static. Much as risk measurement services and ratings agencies try, they cannot keep up with the pace of real world developments. Thus, while markets reacted almost instantaneously to Brexit by knocking down the value of the British Pound and scaling down stock prices around the globe, changes in risk scores and ratings happened (if at all) more slowly.

    The first market measure of country risk that I would like to present is one that captures default risk changes in real time, the sovereign credit default swap (CDS) market. The heat map below captures sovereign CDS spreads globally, as of July 1, 2016:
    Link to heat map
    Note that the map, if you scroll across countries,  reports three numbers: the CDS spread as of July1, 2016, a CDS spread net of the US CDS (of 0.41%) as of July 1, 2016 and the in the sovereign CDS spread over the last twelve months. Reflecting the market's capacity to adjust quickly, the UK, for instance, saw a doubling in the market assessment of default risk over the last year. The limitation is that sovereign CDS spreads are available for only 64 countries, with more than half of the countries in the world, especially in Africa, uncovered.

    The second market measure of country risk is one that I have concocted that is based upon the default spread, but also incorporates the higher risk of equities, relative to government bonds, i.e., an equity risk premium (ERP) for each country. The process by which I estimate these equity risk premiums, which I build on top of a premium that I estimate every month for the S&P 500 (and by extension, use for all AAA ratted countries), is described more fully in this post from the start of the year. The updated ERPs for countries is captured in the heat map below.
    Link to heat map
    Note that as companies globalize, you need the entire map to estimate the equity risk premium  to value or analyze a multinational, since its risk does not come from where it is incorporated but where it does business.

    Conclusion
    I think that the way we think about and measure country risk is in its nascency and that we need richer and more dynamic measures of that risk. I don't claim to have all of the answers, or even most of the answers, but I will continue to learn from market behavior and make my equity risk premiums more closely reflective of the risk in each country. I will probably regret this resolution next July, but I plan to make my country risk premium an annual update, just as I have my work on equity risk premiums.

    Charts update: The charts don't seem to be working on some browsers. They seem to work on Safari.

    Papers
    1. Country Risk Premium: Determinants, Measures and Implications - The 2016 Update
    Data)
    1. Sovereign Ratings, by Country (July 2016)
    2. Sovereign CDS Spreads, by Country (July 2016)
    3. Equity Risk Premiums, by Country (July 2016)
    Last year's Posts on Country Risk




      Tesla: It's a story stock, but what's the story?

      The last few weeks have tested Tesla’s shareholders and frustrated short sellers in the stock. Shareholders have had to weather a series of bad news stories, ranging from a failure to meet its shipment targets in the last few months to a fatality with a driver using its autopilot function to a surprise acquisition of Solar City. While each of those stories has created pressure on the stock, the price has held up surprisingly well, frustrating long-time short sellers who have been waiting for a correction in what they see as an overhyped stock.
      Tesla Stock Price: Google Finance
      So, what gives here? Why has Tesla’s stock price not collapsed facing this adversity? I think that Tesla's price action illustrates the power of the “big story” and the sometimes difficult-to-understand market dynamics of story stocks.

      Story Stocks
      In earlier posts, I have made a case for valuation being a bridge between story and numbers, with every number telling a story and every story being captured in a number. Thus, while your final valuation may be composed of forecasts of revenue growth, profit margins and reinvestment, it is the story that binds together these numbers that represent the soul of the valuation.

      That said, the balance between stories and numbers can vary across companies and for the same company, can change across time. For most companies, it is the story that comes first, with numbers following, and for others, it is the numbers that tell the story. 

      There are some companies that I would classify as story stocks, where the story is so dominant in both how people price the stock and what determines its value that the numbers either fade into the background or have only a secondary effect. There are three characteristics that story stocks share:

      Amazon remains one of my longest-standing examples of a story stock, a company, with a CEO (Jeff Bezos) who was and continues to be clear about his ambitions to conquer big markets, told that story well and acted consistently with it. You can see why Tesla also has the makings of a story stock, going after a big market (automobiles and perhaps even clean energy), with an unconventional strategy for that market and a larger-than-life CEO in Elon Musk. With story stocks, it is the story that dominates how the market perceives the stock, and that has consequences:
      1. Story changes and information: it is shifts in the story that cause price and value changes. An earnings report that beats expectations (in either direction) or a news story of significance (good or bad) may not have any effect on either (value or price) if it does not change the story. Conversely, a shift in perceptions about the business story, triggered by minor news or even no news at all, can trigger major price changes. 
      2. Wider disagreements: When a company’s value is driven primarily by numbers, there is less room for disagreement among investors. Thus, when valuing a company in a market with steady revenue growth and sustainable profit margins, there will be less divergence in what investors think the stock is worth. In contrast, with a story stock, investor stories can span a much wider spectrum, leading to a much bigger range in values, as illustrated with Uber in this post
      The key to understanding story stocks is deciphering the story behind the company, then checking that story for reasonability and making it your own.

      The Tesla Story
      So, what is Tesla’s story? To structure the process, let me lay out the dimensions where investors can differ on the story and how these differences play out valuation. The first is Tesla's business, i.e., whether you see Tesla primarily as an automobile company that incorporates technology into its cars, a technology company that uses automobiles to deliver superior electronics (battery and software) or even a clean energy company with its focus on electric cars. The second is focus,  i.e., whether you believe that Tesla will cater more to the high end of whichever business you see it in or have mass market appeal. The third is the competitive edge that you see it bringing to the market, with the choices ranging from being first to the market, superior styling & brand name and superior (proprietary) technology. The fourth is the investment intensity needed to deliver your expected growth, with much higher reinvestment needed if you consider Tesla a conventional manufacturing company (like autos) than if you see it as a tech company. Finally, there is the risk in the company, with the auto story bringing with it the risks of cyclicality and high fixed costs and the tech story the risks of being rendered obsolete by new technologies and shorter life cycles.


      The value that you attach to Tesla will be very different if you consider it to be an automobile company, catering to a high-end clientele than if you view it as an electronics company with a superior technology (in electric batteries) and a mass market audience.

      My thinking on Tesla has changed over time. In my first valuation of the company in September 2013, I valued it as a high-end automobile company, which would use its competitive edges in branding and technology to generate high margins, with investment and risk characteristics more reflective of being an auto than a tech company. The resulting inputs into my valuation and valuation are summarized below:
      Download spreadsheet
      The value that I obtained for Tesla’s equity was $12.15 billion (with a value per share of $70) well below the market capitalization of $28 billion (and a stock price of $168.76) at the time.

      In July 2015 I took another look at Tesla, keeping in mind the developments since September 2013. The company had not only sent signals that it was moving towards offering vehicles with lower price tags (expanding towards the mass market) but also made waves with its plans for a $5 billion gigafactory to manufacture batteries. The focus on batteries suggested to me that I had understated the role that technology played in Tesla’s appeal and I incorporated it more strongly into my story. Tesla remained an automobile company, but with a much stronger technology component and wider market aspirations, which in turn led the following inputs into value:
      Download spreadsheet
      The value of equity based on these inputs was 19.5 billion (share price of $123), much higher than my September 2013 estimate, but still below the value of $33 billion (share price of $220) at the time.

      I took my third shot at valuing Tesla about two weeks ago,  just prior to its Solar City acquisition announcement, and I incorporated the news since my last valuation. The announcement of the Tesla 3 clearly reinforced my story line that it was moving towards being more of a mass market company. The unprecedented demand for the car, with close to 400,000 people putting down deposits for a vehicle that will not be delivered until 2018, indicates the hold that it has on its customer base. I have tweaked the inputs to reflect these changes:
      Download spreadsheet
      The value of equity that I obtained was $25.8 billion (with a share price of $151/share), climbing from my July 2015 valuation but the market capitalization stayed at $33 billion. Before I embark on looking at how the Solar City acquisition and Musk's master plan have on the narrative, it is worth looking at how the value changes as a function of revenues, reinvestment and profit margin:
      Download spreadsheet
      Note that there are pathways that lead to the value at or above the current stock price but they all require navigating a narrow path of building up sales, earning healthy profit margins and reinvesting more like a technology company than an automobile company.

      So, what effect does acquiring Solar City have on the story? If nothing else, it muddies up the waters substantially, a dangerous development for a story stock and that is perhaps even why even long-term Tesla bulls and nonplussed. The most optimistic read is that  Tesla is now a clean energy company, with a potentially much larger market, but the catch is that Solar City's products don't have the cache that Tesla cars have as well as the competitive nature of the solar power market will push margins down. If you add the debt burden and reinvestment needs that Solar City brings into the equation, Tesla, already stretched in terms of cash flows, may be over extending itself. The most pessimistic read is that talk of synergy notwithstanding, this acquisition is more about Musk using Tesla stockholder money to preserve his legacy and perhaps get back at short sellers in Solar City.

      The X Factor: Elon Musk
      The Solar City acquisition spotlighted how difficult it is to separate Tesla, the company, from Elon Musk. Musk's strengths, and there are many, are at the core of Tesla's success but his weaknesses may hamstring the company.
      • On the plus side, Musk clearly fits the visionary mode, dreaming big, convincing customers, employees and investor to buy into his dreams and, for the most part, working on making the dreams a reality. Like Bezos at Amazon and Steve Jobs at Apple, Musk had the audacity to challenge the status quo. 
      • On the minus side, Musk is less disciplined and focused than Bezos, whose story about Amazon has remained largely unchanged for almost 20 years, even as the company has expanded into new businesses and markets. In fact, as someone who has followed Apple for more than three decades, it seems to me that Musk shares more characteristics with Steve Jobs in his first iteration at Apple (which ended with him being fired) than he does with Steve Jobs in his second stint at the company. Musk is a large social media presence, but he does strike me as thin skinned, as his recent exchange with Fortune magazine about the autopilot fatality showed. 
      Your views on  what you think Tesla is worth will be a function of what you think about Elon Musk. If you believe, as some of his most fervent defenders do, that he is that rarest of combinations, a visionary genius who will deliver on this vision, you will find Tesla to be a good buy. At the other extreme, you consider him a modern version of P.T. Barnum, a showman who promises more than he can deliver, you will view Tesla as over valued. Wherever you fall in the Musk continuum, Tesla is approaching a key transition point in its life, a bar mitzvah moment so to speak, where the focus will shift from the story to execution, from master plans to supply chains, and we will find out whether Musk is as good at the latter as he is in the former.

      Can Musk the visionary become Musk the builder? He certainly has the capacity. After all, if you can get spaceships into outer space and back to earth safely, you should be able to build and deliver a few hundred thousand cars, right? Given Tesla's missteps on delivery and execution, though, Musk may not have the interest in the nitty gritty of operations, and if he does not, he may need someone who can take care of those details, replicating the role that Tim Cook played at Apple during Steve Job's last few years at the company.  

      Investment Direction
      Tesla is a company where there seems to be no middle ground. You are either for the company or against it, believe that it is on a pathway to being the next Apple or that it is worth nothing, a cheerleader or a doomsdayer. I think that both sides of this debate are over reaching. I don't buy the talk that Tesla is on its way to being the next trillion dollar company, especially since I have a tough time justifying its current valuation of $33 billion. Unlike some of the high-profile short sellers who seem to view Tesla as an over-hyped electric car company that is only a step away from tipping into default, I do believe that Tesla has a connection to its customers (and investors) that other auto companies would kill to possess, brings a technological edge to the game and has viable, albeit narrow, pathways to fair value.  I will choose to sit this investment out, letting others who are more nimble than I am or have more conviction than I do to take stronger positions in Tesla.

      YouTube Video
      1. Tesla (September 2013) valuation
      2. Tesla (July 2015) valuation
      3. Tesla (July 2016) valuation



      Mean Reversion: Gravitational Super Force or Dangerous Delusion?

      In my last post on the danger of using  single market metrics to time markets, I made the case that though the Shiller CAPE was high, relative to history, it was not a sufficient condition to conclude that US equities were over valued. In the comments that followed, many disagreed. While some took issue with measurement questions, noting that I should have looked at ten-year correlations, not five and one-year numbers, others argued that this metric was never meant for market timing and that the real message was that the expected returns on stocks over the next decade are likely to be low. I was surprised at how few brought up what I think is the central question, which is the assumption that the CAPE or any other market metric will move back to historic norms. This unstated belief that things revert back to the way they used to be is both deeply set, and at the heart of much of value investing, especially of the contrarian stripe. Thus, when you buy low PE stocks and or sell a stock because it has a high PE, you are implicitly assuming that the PE ratios for both will converge on an industry or market average. I am just as prone to this practice as anyone else, when I do intrinsic valuation, when I assume that operating margins and costs of capital for companies tend to converge on industry norms. That said, I continue to worry about how many of my valuation mistakes occur because I don’t question my assumptions about mean reversion enough. So, you should view this post as an attempt to be honest with myself, though I will use CAPE data as an illustrative example of both the allure and the dangers of assuming mean reversion.

      Mean Reversion: Basis and Push Back
      The notion of mean reversion is widely held and deeply adhered to not just in many disciplines but in every day life. In sports, whether it be baseball, basketball, football or soccer, we use mean reversion to explain why hot (and cold) streaks end. In investments, it is an even stronger force explaining why funds and investors that fly high come back to earth and why strategies that deliver above-average returns are  unable to sustain that momentum.

      In statistics, mean reversion is the term used to describe the phenomenon that if you get an extreme value (relative to the average) in a draw of a variable, the second draw from the same distribution is likely to be closer to the average. It was a British statistician, Francis Galton, who first made official note of this process when studying the height of children, noted that extreme characteristics on the part of parent (a really tall or short parent) were not passed on. Instead, he found that the heights reverted back to what he called a mediocre point, a value-laden word that he used to describe the average. In the process, he laid the foundations for linear regressions in statistics.

      In markets and in investing, mean reversion has not only taken on a much bigger role but has arguably had a greater impact than in any other discipline. Thus, Jeremy Siegel's argument for why "stocks win in the long term" is based upon his observation that over a very long time period (more than 200 years), stocks have earned higher returns than other asset classes and that there is no 20-year time period in his history where stocks have not outperformed the competition. Before we embark on on examination of the big questions in mean reversion, let's start by laying out two different versions of mean reversion that co-exist in markets.
      • In time series mean reversion, you assume that the value of a variable reverts back to a historical average. This, in a sense, is what you are using when looking at the CAPE today at 27.27 (in August 2016) and argue that stocks are over priced because the average CAPE between 1871 and 2016 is closer to 16.
      • In cross sectional mean reversion, you assume that the value of a variable reverts back to a cross sectional average. This is the basis for concluding that an oil stock with a  PE ratio of 30 is over priced, because the average PE across oil stocks is closer to 15. 
      At the risk of over generalization, much of market timing is built on time series mean reversion, whereas the bulk of stock selection is on the basis of cross sectional mean reversion. While both may draw their inspiration from the same intuition, they do make different underlying assumptions and may pose different dangers for investors.

      The nature of markets, though, is that every point of view has a counter, and it should come as no surprise that just as there are a plethora of strategies built around mean reversion, there are almost as many built on the presumption that it will not happen, at least during a specified time horizon. Many momentum-based strategies, such as buying stocks with high relative strength (that have gone up the most over a recent time period) or have had the highest earnings growth in the last few years, are effectively strategies that are betting against mean reversion in the near term. While it is easy to be an absolutist on this issue, the irony is that not only can both sides be right, even though their beliefs seem fundamentally opposed, but worse, both sides can be and often are wrong.

      Mean Reversion: The Questions
      You can critique mean reversion at two levels. At the level at which it is usually done, it is more about measurement than about process, with arguments centered around both how to compute the mean and the timing and form of the reversion process. There is a fundamental and perhaps more significant critique of the very basis of mean reversion, which is based on structural changes in the process being analyzed.

      The Measurement Critique
      Let’s say that both you and I both believe in mean reversion. Will we respond to data in the same way and behave the same way? I don't think so and that is because there are layers of judgments that lie under the words “mean” and “reversion”, where we can disagree. 
      • On the mean, the numbers that you arrive at can be different, depending upon the time period you look at (if it time series mean reversion) or the cross sectional sample (if it is a cross sectional mean reversion), and you can get very different values with the arithmetic average as opposed to the median. With cross sectional data, for instance, the oil company analysis may be altered depending on whether your sample is of all oil companies, just larger integrated oil companies or smaller, emerging market oil companies. For time series variations, consider the historical time series of CAPE and how different the "mean" looks depending on the time period used and how it was computed.
      • On the reversion part, there can be differences in judgment as well. First, even if we both agree that there is mean reversion, we can disagree on how quickly it will happen. That has profound consequences for investing, because there may be a time horizon threshold at which we may not be to devise an investment strategy to take advantage of the reversion. Second, we can disagree over how the metric in question will adjust. To illustrate, assume that the mean reversion metric is CAPE and that we both agree that  the CAPE of 27 should drop to the historic norm of 16 over the next decade. This can be accomplished by a drop in stock prices (a market crash) or by a surge in earnings (if you can make an argument that earnings are depressed and are due for recovery). The implications for investing can be very different.
      In summary, there is a lot more nuance to mean reversion than its strongest proponents let on. One reason that they try to make their case look stronger than it is may be because they are selling others on their investment thesis and hoping that if they can convince enough people to make it self fulfilling. The other, and perhaps more dangerous reason, is to convince themselves that they are right, as a precursor to action. 

      The Fundamental Critique
      The process of mean reversion is built on the presumption that the underlying distribution (whether it be a time series or cross sectional) is stationary and that while there may be big swings from year to year (or from company to company), the numbers revert back to a norm. That is the elephant in the room, the really big assumption, that drives all mean reversion and it is its weakest link. If there are structural changes that alter the underlying distribution, there is no quicker way to ruin that trusting in mean reversion. The types of structural changes that can cause distribution to go awry range the spectrum, and the following is a list, albeit not comprehensive, of why these changes in the context of mean reversion over time.
      • The first is aging, with the argument easiest to make with individual companies and more difficult with entire markets. As companies move through the life cycle, you will generally see the numbers for the company reflect that aging, rather moving to historic norms. That is especially true for growth rates, with growth rates decreasing as a company scales up and becomes more mature, but it is also true of both other operating numbers (margins, costs of capital) as well as pricing metrics (price earnings ratios and EV multiples). While markets, composed of portfolios of companies, are less susceptible to aging, you could argue that aging equity markets (the US, Japan and Europe) will exhibit different characteristics than they did when were younger and more vibrant. 
      • The second is technology and industry structure, shaking up both the product market structure and creating challenges for accountants. This is true clearly at the company level, as is the case with retailing, where Amazon's entry and subsequent growth has laid waste to historic norms for this sector, bringing down operating margins and changing reinvestment patterns. It is also true at the market level, where an increasing proportion of the equity market (say, the S&P 500) are service and technology stocks and the accounting for expenses in these sectors (with many capital expenses being treated as operating expenses) creating questions about whether the E in the PE for the S&P 500 is even comparable over time.
      • The third is changes in consumer and investor preferences, with the first affecting the numbers in product markets and the latter in financial markets. For instance, there is an argument to be made that the surge in index funds has altered how stocks are priced today, as opposed to two or three decades ago.
      In the context of CAPE, again, and using Shiller's entire database, which goes back to 1871, let's take a quick look at how much both the US economy has grown and changed since 1871 and how those changes have affected the composition of US stocks.

      In 1871, coming out of the civil war, the US was more emerging than developed market, with the growth and risk that goes with that characterization. In 1900, the US equity market had become the largest in the world, but 63% of its value came from railroad stocks, reflecting both their importance to the US economy then and their need for equity capital. For most of the next few decades, the US continued on its path as a growth market and economy, though the growth trend was brought to a stop by the great depression.  The Second World War firmly established the US as the center of the global economy and the period between 1945 and 2000 represents the golden age of mean reversion, a period where at least in the US, mean reversion worked like a charm not just across stocks but across time. It is worth noting that many of the now-accepted standard practices in both corporate finance and valuation, from using historical risk premiums for stocks to attaching premiums for expected returns to small-cap stocks to believing that value stocks beat growth stocks (with low PBV or low PE as a proxy for value) came from researchers poring over this abnormally mean-reverting financial history. I trace my awakening to the dangers of mean reversion to the 2008 crisis but I believe that the signs of structural change were around me for at least a decade prior. After all, the shift from a US-centric global economy to one that was more broadly based started occurring in the 1970s and continued, with fits and bounds, in the decades after. Similarly, the US dollar's reign as the global currency was challenged by the introduction of the Euro in 1999 and put under further strain by the growth in emerging market currencies.

      So, how did 2008 change my thinking about markets, investing and valuation? First, globalization is here to stay and while it has brought pluses, it has already brought some minuses. As I noted in my post on country risk, no investor or company can afford to stay localized any more, since not only do market crisis in one country quickly become global epidemics, but a company that depends on just its domestic market for operations (revenues and production) is now more the exception than the rule. Second, the fact that financial service firms were at the center of the crisis, has had long term consequences. Not only has it led to a loss of faith in banks as well-regulated entities, run by sensible (and risk averse) people, but it has increased the role of central bankers in economies, with perverse consequences. In their zeal to be saviors of the economy, central bankers (in my view) have contributed to an environment of low economic growth and higher risk premiums. Third, the low economic growth and low inflation has resulted in interest rates lower than they have been historically in most currencies and negative interest rates in some. I know that there are many who believe that I am over reacting and that it only a question of time before we revert back to more normal interest rates, higher economic growth and typical inflation but I am not convinced. 

      From Statistical Significance to Investment Return Payoff
      The standard approach to showing mean reversion is start with historical data and establish mean reversion with statistics. I will start with that basis, again using CAPE as my illustrative example, but will then build on it to show why, even if you believe in mean reversion and you base it on sound statistics, it is so difficult to convert statistical significance into market-beating returns.

      The statistics
      If you were looking at a data series, how would you go about showing mean reversion? There are three simple statistical devices that you can draw. The first is graphical, a scatter plot of the data that shows the mean reversion over time. In the context of CAPE, for instance, this is the graph that you saw in my last post:
      Historical data on Shiller CAPE
      The problem with this plot is that it is weak evidence for investing, since you don't make money from buying or selling PE but from buying and selling stocks. In fact, even in this plot, you can see that the CAPE case that stocks are over priced is weakened because I have used a 25-year median for comparison. A stronger graphical backing for mean reversion would then graph stock returns in subsequent time periods as  a function of the CAPE today, with a higher CAPE (relative to history) translating into lower returns in a future period. 

      Looking at this data, at least, the evidence seems strong that a high CAPE today goes with lower stock returns in future periods, with the mean reversion becoming stronger for longer time periods.

      The relationship between the market timing metric and returns can be quantified in one of two ways. You could compute the correlation between the metric and returns, with a more negative correlation indicating stronger mean reversion. Updating my CAPE/ returns correlation metric, with 10-year returns added to the mix, you can see again the basis for the market timing argument:

      You an build on these correlations and run regressions (linear or otherwise) where you regress returns in future periods against the value of the metric today. The results of those regressions, with CAPE as the market metric, are summarized below:
      What does this mean? If you buy into mean reversion and can live with the noise or error in your estimate (captured in the R-squared), these regressions back up the correlation findings, insofar as your CAPE-based predictions get more precise for longer time period returns. In fact, if you are one of those who lives and dies by statistics, using today's CAPE of 27.27 in this regression will yield a predicted annualized return of 4.30% on stocks for the next 10 years:
      Expected annualized return in next 10 years = 16.24% - 0.0044 (27.27) = 4.30%
      Scary, right? But before you over react, first recognize that this prediction comes with a standard error and range and second, please read on.

      The Investment Action
      If you have sat through a statistics class, you have probably heard the oft-repeated caution that "correlation is not causation", a good warning if you are a researcher trying to explain a phenomenon but not particularly relevant, if you are an investor. After all, if you can consistently make a lot of money from a strategy, do you really need to know why? The biggest challenge in investing is whether you can convert statistical significance ( a high correlation or a regression with impressive predictive power) into investment strategy. It is at this level that market timing metrics run into trouble, and using CAPE again, here are the two ways in which you can use the results from the data to change the way you invest.

      If you are willing to buy into the notion that the structural changes in the economy and markets have not changed the historical mean reversion tendencies in the CAPE, the most benign and defensible use of the data is to reset expectations. In other words, if you are an investor in stocks today, you should expect to make lower returns for the next 10 years than you have historically. This has consequences for how much investors should save for future retirement or how much states should set aside to cover future contractual obligations, with both set asides increasing because your expected returns are lower. 

      It is when you decide to use the CAPE findings to do market timing that the tests become more arduous and difficult to meet. To understand what this means, let's go back to the basic asset allocation decision that all investment begins with. Given your risk aversion (a function of both your psychological make-up and the environment you are in) and liquidity needs (a function of your age, wealth and dependents), there is a certain mix of stocks, bonds and cash that is right for you. With market timing, you will alter this mix to reflect your views on desirable (or under priced) markets and undesirable ones. Thus, your natural mix is 60% stocks, 30% bonds and 10% cash, and you believe (using whatever market timing metric you choose) that stocks are over priced, you would lower your allocation to stocks and increase your allocation to either bonds or cash. You could further refine this market timing algorithm for domestic stocks versus foreign stocks or bring in other asset classes such as collectibles and real estate. The test of a market timing strategy therefore requires more structure than the statistical analysis of checking for correlation or regression:
      1. Timing threshold: If you decide that you will time markets using a metric, you have to follow through with specifics. For instance, with CAPE as your market metric, and a high (low) CAPE being used as an indicator of an over valued (under valued) market, you have to indicate the trigger  that will initiate action. In other words, does the CAPE have to be 10% higher, 25% higher or 50% higher than the historic average for you to start moving money out of stocks?
      2. Asset class alternatives: If you decide to move money out of stocks, you have to also specify where the money will go and you have four choices. 
      3. Holding period: You will have to specify how long you plan to stay with the "market timed" allocation mix, with the answers ranging from a pre-specified time horizon (1 year, 2 years or 5 years) to until the market timing metric returns to safe territory. 
      4. Allocation Constraints (if any): The allocation that you have for an asset class can be floored at zero, if you are a long only investor, but can be negative, if you are willing to go short. The cap on what you can allocate to an asset class is 100%, if you cannot or choose not to borrow money, but can be greater than 100%, if you can. 
      Put simply, the lower your threshold, the more alternatives you have to investing in stocks, the shorter your holding period and the fewer your constraints, the more active you are as a market timer. It is in this context that I tried out different market timing strategies built around CAPE. The table below lists out the returns from a buy and hold strategy with a fixed mix of stocks, bonds and bills (60%, 30% and 10%) and contrasts it with returns over the same period from using a CAPE timing strategy of reducing the equity allocation to 40% if the CAPE is 25% higher than a 50-year median value and increasing the equity allocation to 80% if the CAPE is 25% lower than a 50-year median value. I report the numbers for the entire time period 1917-2016 and break it down into two fifty-year time periods (1917-1966, 1967-2016):
      Download market timing spreadsheet
      With this mix of timing choices (50-year median, 25% threshold and the given changes to equity allocation), the Shiller CAPE outperforms the buy and hold strategy for the 1917-2016 time period  but  under performs in the last fifty year time period. I know that your timing choices can be very different from mine and I have created options in this spreadsheet to let you change the choices to reflect your preferences to see if you can deliver better market timing results using CAPE. I did try a few variants and here is what I found.
      1. Time Period: With every variation of timing that I tried, the CAPE delivers a positive market timing payoff in the first half of the entire time period (from 1917 to 1966) and a negative one in the second half (1967-2016). In fact, I could not find a combination of timing devices that delivered positive payoff in the second time period.
      2. Choice of median: Using the lifetime median delivers better results during the "good" period (1917-1966) but worse results during the "bad" period (1967-2016). Using a shorter time periods for the median reduces the outperformance in the first half of the analysis period but improves it in the second half.
      3. Buy and Sell: The CAPE's timing payoff is greater when it is used as a buying metric than as a selling metric. In fact, you make a positive payoff from using a low CAPE as a buying indicator over the entire period but using it is a signal of over priced markets costs you money in both time period. 
      4. Market Timing magnitude: Increasing the degree to which you tilt towards or away from stocks, in reaction to the CAPE, just magnifies the return difference, positive or negative. Thus, in the first half of the century (1917-1966), changing your equity exposure more increases the payoff to market timing. In the second half, it makes the negative payoff worse.
      In many ways, this testing is tilted in favor of finding that the Shiller CAPE works. First, while I have been careful not to use ex-post data, I have acted as if I know what the earnings for the year will be, at the end of each year, when my market timing decision is made. In reality, on December 31, 2012, I would know only the earnings for the first three quarters of 2012 and not quite the full year. Second, I am ignoring the transactions costs and taxes due from shifting large amounts in and out of stocks in my timing years. Those will represent a significant drain on my returns as an investor. Finally, I am assuming that there have been no structural shifts large enough to cause the mean reversion to break down. In spite of all of this, I am hard pressed to explain why we are so swayed by arguments based on this metric.

      Conclusion
      These are dangerous times for those who believe in mean reversion, for two reasons. The first is that our access to historical data is getting broader and deeper, with mixed consequences. Having more data allows us to find out more about the underlying fundamentals but since that data goes back so far, much of what we find no longer has relevance. The second is that doing statistical analysis no longer requires either homework or effort, with tools at our fingertips and statistical results are only a click away. Both in academia and in practice, I see more and more use of statistical significance as proof that you can beat markets and my reason devising and testing out market timing strategies with CAPE were not meant to be an assault on CAPE but more a cautionary note that statistical correlation is not cash in the bank. This may also explain why there are so many ways to beat the market, on paper, and so few seem to be able to deliver those magical excess returns, in practice. 

      YouTube Video

      Datasets
      1. CAPE: 1881-2016 (Shiller Data)
      2. Stock, Bond and Bill Returns (1881-2016)
      3. Market Timing Spreadsheet



      Superman and Stocks: It's not the Cape (CAPE), it's the Kryptonite(Cash flow)!

      Just about a week ago, I was on a 13-hour plane trip from Tokyo to New York. I know that this will sound strange but I like long flights for two reasons. The first is that they give me extended stretches of time when I can work without interruption, no knocks on the door or email or phone calls. I readied my lecture notes for next semester and reviewed and edited a manuscript for one of my books in the first half on the trip. The second is that I can go on movie binges with my remaining time, watching movies that I would have neither the time nor the patience to watch otherwise. On this trip, however, I made the bad decision of watching Batman versus Superman, Dawn of Justice, a movie so bad that the only way that I was able to get through it was by letting my mind wander, a practice that I indulge in frequently and without apologies or guilt. I pondered whether Superman needed his suit or more importantly, his cape, to fly. After all, his powers come from his origins (that he was born in Krypton) and not from his outfit and the cape seems to be more of an aerodynamic drag than an augmentation. These deep thoughts about Superman's cape then led me to thinking about CAPE, the variant on PE ratios that Robert Shiller developed, and how many articles I have read over the last decade that have used this measure as the basis for warning me that stocks are headed for a fall. Finally, I started thinking about Kryptonite, the substance that renders Superman helpless, and what would be analogous to it in the stock market. I did tell you that I have a wandering mind and so, if you don't like Superman or stocks, consider yourself forewarned!

      The Stock Market’s CAPE
      As stocks hit one high after another, the stock market looks like Superman, soaring to new highs and possessed of super powers.

      There are many who warn us that stocks are overheating and that a fall is imminent. Some of this worrying is natural, given the market's rise over the last few years, but there are a few who seem to have surrendered entirely to the notion that stocks are in a bubble and that there is no rational explanation for why investors would invest in them. In a post from a couple of years ago, I titled these people as  bubblers and classified them into doomsday, knee jerk, conspiratorial, righteous and rational bubblers. The last group (rational bubblers) are generally sensible people, who having fallen in love with a market metric, are unable to distance themselves from it.

      One of the primary weapons that rational bubblers use to back up their case is the Cyclically Adjusted Price Earnings (CAPE), a measure developed and popularized by Robert Shiller, Nobel prize winner whose soothsaying credentials were amplified by his calls on the dot com and housing bubbles. For those who don’t quite grasp what the CAPE is, it is the conventional PE ratio for stocks, with two adjustments to the earnings. First, instead of using the most recent year’s earnings, it is computed as the average earnings over the prior ten years. Second, to allow for the effects of inflation, the earnings in prior years is adjusted for inflation.  The CAPE case against stocks is a simple one to make and it is best seen by graphing Shiller’s version of it over time.
      Shiller CAPE data (from his site)

      The current CAPE of 27.27 is well above the historic average of 16.06 and if you buy into the notion of mean reversion, the case makes itself, right? Not quite! As you can see, even within the CAPE story, there are holes, largely depending upon what time period you use for your averaging. Relative to the fully history, the CAPE looks high today, but relative to the last 20 years, the story is much weaker. Contrary to popular view, mean reversion is very much in the eyes of the beholder.

      The CAPE’s Weakest Links

      Robert Shiller has been a force in finance, forcing us to look at the consequences of investor behavior and chronicling the consequences of “irrational exuberance”. His work with Karl Case in developing a real estate index that is now widely followed has introduced discipline and accountability into real estate investing and his historical data series on stocks, which he so generously shares with us, is invaluable. You can almost see the “but” coming and I will not disappoint you. Of all of his creations, I find CAPE to be not only the least compelling but also potentially the most dangerous, in terms of how often it can lead investors astray. So, at the risk of angering those of you who are CAPE followers, here is my case against putting too much faith in this measure, with much of it representing updates of my post from two years ago.
      1. The CAPE is not that informative
      The notion that CAPE is a significant improvement on conventional PE is based on the two adjustments that it makes, first by replacing earnings in the most recent period with average earnings over ten years and the second by adjusting past earnings for inflation to make them comparable to current earnings. Both adjustments make intuitive sense but at least in the context of the overall market, I am not sure that either adjustment makes much of a difference. In the graph below, I show the trailing PE, normalized PE (using the average earnings over the last ten years) and CAPE for the S&P 500 from 1969 to 2016 (last twelve months). I also show Shiller's CAPE, which is based on a broader group of US stocks in the same graph.
      Download spreadsheet with PE ratios
      First, it is true that especially after boom periods (where earnings peak) or economic crises (where trailing earnings collapse), the CAPEs (both mine and Shiller's) yield different numbers than PE.  Second, and more important, the four measures move together most of the time, with the correlation matrix shown in the figure. Note that the correlation is close to one between the normalized PE and the CAPE, suggesting that the inflation adjustment does little or nothing in markets like the US and even the normalization makes only a marginal difference with a correlation of 0.86 between the unadjusted PE and the Shiller PE.

      2. The CAPE is not that predictive
      The question then becomes whether using the CAPE as a valuation metric yields judgments about stocks that are superior to those based upon just PE or normalized PE. To test this proposition, I looked at the correlation between the values of different metrics, including trailing PE, CAPE, the inverse of the dividend yield, earnings yield and the ratio of Shiller PE to the Bond PE) today and stock returns in the following year and the following five years:
      There is both good news and bad news for those who use the Shiller CAPE as their stock valuation metric. The good news is that the fundamental proposition that stocks are more likely to go down in future periods, if the Shiller CAPE is high today, seems to be backed up. The bad news is two fold. First, the relationship is noisy or in investment parlance, the predictive power is low, especially with one-year returns. Second, the trailing PE actually does a better job of predicting one-year returns than the CAPE and while CAPE becomes the better predictor than trailing PE over a five-year period, it is barely better than using a dividend yield indicator.  While I have not included these in the table, I will wager that any multiple (such as EV to EBITDA) would do as good (or as bad, depending on your perspective) a job as market timing.

      As a follow-up, I ran a simple test of the payoff to market timing, using the Shiller CAPE and actual stock returns from 1927 to 2016. At the start of every year, I first computed the median value of the Shiller CAPE over the previous fifty years and assumed an over priced threshold at 25% above the median (which you can change). If the actual CAPE was higher than the threshold, I assumed that you put all your money in treasury bills for the following year and that if the CAPE was lower than the threshold, that you invested all your money in equities. (You can alter these values as well). I computed how much $100 invested in the market in 1927 would have been worth in August of 2016, with and without the market timing based on the CAPE:

      Download spreadsheet and change parameters
      Note that as you trust CAPE more and more (using lower thresholds and adjusting your equity allocation more), you do more and more damage to the end-value of your portfolio. The bottom line is that it is tough to get a payoff from market timing, even when the pricing metric that you are using comes with impeccable credentials. 




      3. Investing is relative, not absolute
      Notwithstanding its weak spots, let’s take the CAPE as your measure of stock market valuation. Is a CAPE of 27.27 too high, especially when the historic norm is closer to 16? The answer to you may sound obvious, but before you do answer, you have to consider where you would put your money instead. If you choose not to buy stocks, your immediate option is to put your money in bonds and the base rate that drives the bond market is the yield on a riskless (or close to riskless) investment. Using the US treasury bond as a proxy for this riskless rate in the United States, I construct a bond PE ratio using that rate:
      Bond PE = 1/ Treasury Bond Rate
      Thus, if you invest in a treasury bond on August 22, with a yield of 1.54%, you are effectively paying 64.94 (1/.0154) times your earnings. In the graph below, I graph Shiller’s measures of the CAPE against this T.Bond PE from 1960 to 2016:
      Download T Bond Rate PE data

      I also compute a ratio of stock PE to T.Bond PE that will use as a measure of relative stock market pricing, with a low value indicating that stocks are cheap (relative to T.Bonds) and a high value suggesting the opposite. As you can see, bringing in the low treasury bond rates of the last decade into the analysis dramatically shifts the story line from stocks being over valued to stocks being under valued. The ratio is as 0.42 right now, well below the historical average over any of the time periods listed, and nowhere near the 1.91 that you saw in 2000, just before the dot com bust or  even the 1.04 just before the 2008 crisis. 

      4. Its cash flow, not earnings that drives stocks
      The old adage that it is cash flows, not earnings, that drives stocks is clearly being ignored when you look at any variant of PE ratios. To provide a sense of what stock prices look like, relative to cash flows, I computed a multiple of total cash returned to stockholders by companies (including buybacks) and compared these multiples to Shiller’s CAPE in the graph below:
      S&P 500 Earnings and Cash Payout
      Here again, there seems to be a disconnect. While the CAPE has risen for the market, from 20.52 in 2009 to 27.27 in 2016, as stocks soared during that period, the Price to CF ratio has remained stable over that period (at about 20), reflecting the rise in cash returned by US companies, primarily in buybacks over the period.

      Am I making the case that stocks are under valued? If I did, I would be just as guilty as those who use CAPE to make the opposite case. I am not a market timer, by nature, and any single pricing metric, no matter how well reasoned it may be, is too weak to capture the complexity of the market. Absolutism in market timing is a sign of either hubris or ignorance.



      The Market’s Kryptonite

      At this point, if you think that I am sanguine about stocks, you would be wrong, since the essence of investing in equities is that worry goes with it. If it’s not the high CAPE that is worrying me, what is? Here are my biggest concerns, the kryptonite that could drain the market of its strength and vitality.
      1. The Treasury Alternative (or how much are you afraid of your central bank?)  If the reason that you are in stocks is because the payoff for being in bonds is low, that equation could change if the bond payoff improves. If you are Fed-watcher, convinced that central banks are all-powerful arbiters of interest rates, your nightmares almost always will be related to a meeting of the Federal Open Market Committee (FOMC), and in those nightmares, the Fed will raise rates from 1.50% to 4% on a whim, destroying your entire basis for investing in stocks. As I have noted in these earlier posts, where I have characterized the Fed as the Wizard of Oz and argued that low rates are more a reflection of low inflation and anemic growth than the result of quantitative easing, I believe that any substantial rate rises will have to come from shifts in fundamentals, either an increase in inflation or a surge in real growth. Both of these fundamentals will play out in earnings as well, pushing up earnings growth and making the stock market effect ambiguous. In fact, I can see a scenario where strong economic growth pushes T. bond rates up to 3% or higher and stock markets actually increase as rates go up.
      2. The Earnings Hangover It is true that we saw a long stint of earnings improvement after the 2008 crisis and that the stronger dollar and a weaker global economy are starting to crimp earnings levels and growth. Earnings on the S&P 500 dropped in 2015 by 11.08% and are on a pathway to decline again this year and if the rate of decline accelerates, this could put stocks at risk. That said, you could make the case that the earnings decline has been surprisingly muted, given multiple crises, and that there is no reason to fear a fall off the cliff. No matter what your views, though, this will be more likely to be a slow-motion correction, offering chances for investors to get off the stock market ride, if they so desire.
      3. Cash flow Sustainability: My biggest concern, which I voiced at the start of the year, and continue to worry about is the sustainability of cash flows. Put bluntly, US companies cannot keep returning cash at the rate at which they are today and the table below provides the reason why:


      YearEarningsDividendsDividends + BuybacksDividend PayoutCash Payout
      200138.8515.7430.0840.52%77.43%
      200246.0416.0829.8334.93%64.78%
      200354.6917.8831.5832.69%57.74%
      200467.6819.40740.6028.67%59.99%
      200576.4522.3861.1729.27%80.01%
      200687.7225.0573.1628.56%83.40%
      200782.5427.7395.3633.60%115.53%
      200849.5128.0567.5256.66%136.37%
      200956.8622.3137.4339.24%65.82%
      201083.7723.1255.5327.60%66.28%
      201196.4426.0271.2826.98%73.91%
      201296.8230.4475.9031.44%78.39%
      2013107.336.2888.1333.81%82.13%
      2014113.0139.44101.9834.90%90.24%
      2015100.4843.16106.1042.95%105.59%
      2016 (LTM)98.6143.88110.6244.50%112.18%
      In 2015, companies in the S&P 500 collectively returned 105.59% of their earnings as cash flows. While this would not be surprising in a recession year, where earnings are depressed, it is strikingly high in a good earnings year. Through the first two quarters of 2016, companies have continued the torrid pace of buybacks, with the percent of cash returned rising to 112.18%. The debate about whether these buybacks make sense or not will have to be reserved for another post, but what is not debatable is this. Unless earnings show a dramatic growth (and there is no reason to believe that they will), companies will start revving down (or be forced to) their buyback engines and that will put the market under pressure. (For those of you who track my implied equity risk premium estimates, it was this concern about cash flow sustainability that led me to add the option of allowing cash flow payouts to adjust to sustainable levels in the long term).

      So, how do these worries play out in my portfolio? They don’t explicitly but they do implicitly affect my investment choices. I cannot do much about interest rates, other than react, and I will stay ready, especially if inflation pressures push up rates and the fixed income market offers me a better payoff. With earnings and cash flows, there may be concerns at the market level, but I bet on individual companies, not markets. With those companies, I can do my due diligence to make sure that they have the operating cash flows (not just dividends or buybacks) to justify their valuations. If that sounds like a pitch for intrinsic valuation, are you surprised?

      The Market Timing Mirage
      Will there be a market correction? Of course! When it does happen, don't be surprised to see a wave of “I told you so” coming from the bubblers. A clock that is stuck at 12 o'clock will be right twice every day and I would urge you to judge these market timers, not on their correction calls, which will look prescient, but on their overall record. Many of them, after all, have been suggesting that you stay out of stocks for the last five years or longer and it would have to be a large correction for you to make back what you lost from staying on the sidelines. Some of these pundits will be crowned as great market timers by the financial press and they will acquire followers. I hope that I don’t sound like a Cassandra but this much I know, from studying past history. Most of these great market timers usually get it right once, let that success get to their heads and proceed to let their hubris drive them to more and more extreme predictions in the next cycle. As an investor, my suggestion is that you save your money and your sanity by staying far away from market prognosticators.

      YouTube


      Datasets
      1. PE ratios from 1960-2016
      2. Shiller CAPE and T.Bond PE (1960-2016)
      3. S&P 500: Earnings, Dividends and Buybacks (2000-2016)
      4. CAPE Market Timing Test
















      The Bonfire of Venture Capital: The Good, Bad and Ugly Side of Cash Burn!

      In my last post on Uber, I noted that it was burning through cash and that this cash burn, by itself, is neither unexpected nor a bad sign. Since I got quite a few comments on what I said, I decided to make this post just about the causes and consequences of cash burn. In the process, I hope to dispel two myths held on opposite ends of the investing spectrum, the notion on the part of value investors, that a high cash burn signals a death spiral for a business and the equally strongly held belief, at the start-up investing end , that a cash burn is a sign of growth and vitality. 

      Cash Burn: The what?
      Since it is cash burn, not earnings burn, that concerns us, let’s start with the obvious. It is cash flow, not earnings, that is at the heart of a cash burn problem. While many money losing companies have cash burn problems, not all cash burn problems are money losing, and not all money losing companies have a cash burn problem. To understand cash burn, you have to start with a working definition of cash flows and my definition hews closely to what I use in the context of valuing businesses. The free cash flow to the firm is the cash left over after taxes have been paid and reinvestment needs (to maintain existing assets and generate future growth) have been met:

      For mature, going concerns, the after-tax operating income and free cash flow to the firm will be positive (at least on average) and that cash flow is used to service debt payments as well as to provide cash flows to equity in the form of dividends and stock buybacks. Any remaining cash flow, after debt payments and dividends/buybacks, augments the cash balance of the company.

      But what if the free cash flow to the firm is negative? That can happen either because a company has operating losses or because it has large reinvestment needs or both occur in tandem. If you have negative free cash flow to the firm, you can draw down an existing cash balance to cover that need and if that turns out to be insufficient, you will have to raise fresh capital, either in the form of new debt or new equity. If this negative cash flow is occasional and is interspersed with positive cash flows in other years, as is often the case with cyclical or commodity companies, you consider it to be a reflection of normal operations of the firm and it should cause few issues in valuation. If, on the other hand, a business has negative cash flows year in and year out, it is said to be burning through cash or having a “cash burn” problem.

      To measure the magnitude of the cash spending problem, analysts use a variety of measures. One is to compute the dollar cash spent in a time period, usually a month, and that is termed the Cash Burn rate. Another is to compute the Cash Runway, the time period that it will take for a company to run through its existing cash balance. Thus, a firm with a $1 billion cash balance and a negative cash flow of -$500 million a year has a 2-year Cash Runway. In contrast, another company with a $1 billion cash balance and a negative cash flow of -$ 2 billion a year has only a 6-month Cash Runway. 

      Cash Burn: The Why?
      Looking at the definition of cash flows should give you a quick sense of why you get high cash burn values (and ratios) at some companies. If your company is and has been losing money or generating very small earnings for an extended period and it sees high growth potential in the future (and invests accordingly), your cash flows will reflect that reality. 

      That combination of low operating income/operating losses and high reinvestment is what you should expect to see at many young companies and the resulting negative free cash flow to the firm will be the norm rather than the aberration. As the companies move through the life cycle, the benign perspective on cash burn is that this will cease to be a problem.

      As the company scales up, its operating income and margins should increase and as growth starts to scale down (in future years), the reinvestment should start dropping. 

      Cash Burn: The what next?
      The combination of higher operating margins and lower reinvestment should generate a cross over point where cash flows turn positive and these positive cash flow will carry the value. Rather than talking in abstractions, let me use the numbers in my August 2016 Uber valuation to illustrate. The story that I am telling in these numbers is of a going concern and success, with high revenue growth accompanied by improving operating margins as the first leg, followed by declining growth (and reinvestment) converting negative cash flows to positive cash flows in the second leg and a steady state of high earnings and cash flows reflected in a going concern value in the final phase.
      In my Uber forecasts, the cash flows are negative for the first six years, with losses in the first five years adding on to reinvestment in those years. The cash flows turn positive in year 7, just as growth starts to slow and accelerate in the final years of the forecasts.  Though these numbers are specific to Uber, the pattern of cash flows that you see in this figure is typical of the good cash burn story.

      The life cycle story that I have laid out is the benign one, where after its start-up pains, a young company turns the corner, starts generating profits and ultimately turns cash flows around. Before you buy into the fairy talk that I have told you, you should consider a more malignant version of this story. In this one, the firm starts off as a growth firm with negative margins and high reinvestment (and cash burn). As the revenues increase over time and the company scales up, the cost structure continues to spiral out-of-control and the margins become more negative over time, rather than less. In fact, with reinvestment creating an additional drain on the cash flows, your free cash flow will be negative for extended and very long time periods and you are on the pathway to venture capital hell. To illustrate what the cash flows would look like in this malignant version of cash burn, I revisited the Uber valuation and changed two numbers. I reduced the operating margin (targeted for year 10) from 20% down to 5% (making ride sharing a commoditized business) and increased reinvestment to match a typical US company (by setting the sales to capital ratio to two, instead of three). The effects on the cash flows are dramatic.
      The cash flows stay negative over the next ten years. In this scenario, it is very unlikely that Uber will make it to year 10 or even year 5, as capital providers will balk at feeding the cash burn machine?

      So, when is cash burn likely to be value destructive or fatal? If the company operates in a market place, where competition keeps pushing product prices down and the costs of delivering these products continue to rise, it is already on a course to report bigger and bigger losses, even before considering reinvestment. If this company reinvests for growth and the product market conditions do not change (i.e., price cutting and rising costs are expected to continue), it is likely that the reinvestment will not deliver the earnings required to justify that investment. Here, there is no light at the end of the tunnel, as negative cash flows will generally become more negative over time and even when they do turn positive, will be insufficient to cover the burden of negative cash flows in earlier time periods.

      Cash Burn: So what?
      Though stories about young companies and their cash burn problems abound, there are few that try to make the connection between cash burn and value other than to point to it as a survival risk. To make the connection more explicit, it is worth thinking about why and how cash burn affects the value of an enterprise. 
      1. Dilution Effect: A company has to raise cash to burn through it and if that cash is raised from fresh equity, as it inevitably has to be for young growth companies, the existing owners of the business will have to give up some of their ownership of the company. If you are an equity investor, the greater the cash burn in a company, the less of the company you will end up owning, even if it survives and prospers.
      2. Growth Effect: The dilution effect presumes that there are capital providers who will be supply the cash needed to keep the firm going through its cash burn days, but what if that presumption is incorrect? The best case scenario for the firm, when capital dries up, is that it is able to rein in discretionary spending (which will include all reinvestment for growth) until capital becomes available again. In the meantime, though, the company will have to scale back its growth plans.
      3. Distress Effect: The more dangerous consequence of capital drying up for a young firm with negative free cash flows Is that the firm’s survival is put at risk. This will be the case if the company is unable to meet its operating cash flow needs, even after cutting discretionary capital spending to zero. In this scenario, the firm will have to liquidate itself and given its standing, it will have to settle for a fraction of its value as a going concern.
      In intrinsic valuation, both of these effects can and should be captured in your intrinsic value. 
      1. The dilution effect manifests itself as negative cash flows in the early years and a drop in the present value of cash flows. For instance, in my Uber valuation, the present value of the expected cash flows for the first seven years, all negative, is $4.4 billion. While the positive cash flows thereafter more than compensate for this, I am in effect reducing the value of Uber by about 20% for these negative cash flows and this reduction can be viewed as a preemptive discounting of my equity stake in the company for future dilution.
      2. When I discount the negative cash flows back to today and assume that Uber has no chance of game-ending failure, I am assuming that Uber has and will continue to have access to capital, partly because of its size and partly because existing investors have too much to lose if the company goes into death throes. If you believe these assumptions to be too optimistic, you can adjust the valuation in two ways. The first is by putting a cap on how much new capital the firm can raise each year, which will also operate as a constraint on future growth. The other is by allowing for a probability that the firm will fail, either because capital markets shut down or cash flows are more negative than expected. In my Lyft valuation in September 2015, for instance, I allowed for a 10% probability of this occurring and assumed that equity investors would get close to nothing if it did, effectively reducing my valuation today.
      In pricing, how does it show up? In a young company, pricing usually involves forecasting revenues or earnings in a future time period, applying a multiple, at which you believe the company will be priced by a potential buyer or the market in an IPO, to these revenues and pricing and then discounting back that end price to today using a target rate of return.

      As you can see, there is no explicit adjustment for cash burn in this equation. While you could bring in the effect of negative cash flows, just as you did in intrinsic valuation, by discounting them back to today and netting out against the pricing, doing that removes one of the biggest reasons why investors and analysts like pricing, which is that it is simple. The only adjustment mechanism left is the target rate of return and, in my view, it becomes the mechanism that venture capitalists and investors use to deal with cash burn concerns. Given that these target rates of return also carry the weight of reflecting failure risk, it should come as no surprise that VC target rates of return for investment look high (at 30%, 40% or even 50%) relative to rates used for established companies.

      An Investor Checklist for Cash Burn
      If you are an investor in a company, public or private, that is burning through cash, you may be wondering at this point what you would look at to determine whether a company’s cash burn is benign or malignant and whether it is on a glide path to glory or a Hari Kari mission. Here are some things to consider:
      1. Understand why the company is burning through cash: Looking back at the constituents of free cash flows, there are multiple paths that can lead to negative free cash flows. The most benign scenario is one where a money making company reports negative cash flows because of large reinvestment. Not only is this negative cash flow a down payment for future growth but it is also discretionary, insofar as managers can scale back reinvestment if capital becomes scarce. The most dangerous combination is a money losing company that reinvests very little, since there is little potential for a growth payoff and management will be helpless if capital freezes up.
      2. Diagnose the operating business: While there is often a lot of noise around the numbers, you still have to make your best judgments about the profitability of the underlying business. In particular, you want to focus on the pricing power that your company has and the economies of scale in its cost structure. The most benign scenario on this dimension is one where the company has significant pricing power and a cost structure that benefits from scale, allowing for margin improvement over time.
      3. Gauge management skills: Managing a cash-burning company does require management to keep costs under control, while reinvesting to generate growth and to take care of short term cash flow problems, while mapping out a long term strategy. The best case scenario for investors is that the company is run by a management team that works within the cash flow constraints of today while mapping out pathways to profitability over time. The worst case scenario is that the company is managed by those who view negative cash flows as a badge of honor and a sign of growth rather than a temporary problem to overcome.
      4. Growth/Reinvestment trade off: Since reinvesting for future growth can be a big reason for negative cash flows, to assess the payoff in value terms, you have to both estimate how much growth will be created and its value effect. In its most value-creating form, reinvestment will generate high growth coupled with high returns and its most value-destructive form, reinvestment will drain cash flows while generating low growth and poor profits.
      5. Capital Market A firm with a cash burn problem is more depending upon capital markets for its survival, since a closing of these markets may be sufficient to put the firm into receivership. It is no surprise, therefore, that cash burning companies that have larger cash balances or more established capital providers are viewed more positively than cash burning companies that have less cash and have less access to capital.
      This checklist requires subjective judgments along the way and you will be wrong sometimes, in spite of your best efforts. That should not stop you from trying.

      The Bottom Line
      If you are an investor in a company that is burning through cash, don't panic! If your investments are in young companies, it is exactly what you should expect to see though you should do your due diligence, examining the reasons for the cash burn in and the soundness of the underlying business model. If you are an old-time value investor, weaned on large dividends, positive cash flows and margin of safety, you may find yourself avoiding companies that have these cash burn problems but be glad that there are investors who are less risk averse than you are and willing to bet on these companies.

      YouTube video


      Posts on valuing young companies

      1. Blood in the Shark Tank: Pre-money, Post-money and Play-money Valuations
      2. Billion Dollar Tech Babies: A Blessing of Unicorns or a Parcel of Hogs
      3. The Bonfire of Venture Capital: The Good, Bad and Ugly Side of Cash Burn





      The Ride Sharing Business: Is a Bar Mitzvah moment approaching?


      I did a series of three posts on the ride sharing business about a year ago, starting with a valuation of Uber, moving on to an assessment of Lyft, continuing with a global comparison of ride sharing companies and ending with a discussion of the future of the ride sharing business. In the last of those four posts, I looked at the ride sharing business model, argued that it was unsustainable as currently structured and laid our four possible ways in which it could be evolve: a winner-take-all, a losing game, collusion and a new player (from outside). While ride sharing continues its inexorable advance into new markets and new customers, the last few months has also brought a flurry of game-changing actions, culminating with Uber’s decision about a week ago to abandon China to arch-rival Didi Chuxing. It is a good time to take a look at the market again and perhaps map out where it stands now and what the future holds for it.

      The Face of Disruption
      While there is much to debate about the future of the ride sharing business, there are a few facts that are no longer debatable. 
      1. Ride sharing continues on its growth path: Ride sharing has grown faster, gone to more places and is used by more people than most people thought it would be able to, even a couple of years ago. The pace of growth is also picking up. Uber took six years before it reached a billion rides in December of 2015, but it took only six months for the company to get to two billion rides. For just the US, the number of users of ride sharing services is estimated to have increased from 8.2 million in 2014 to 20.4 million in 2020. 
        YearNumber of US ride sharers (in millions)% of US adult population
        2014
        8.20
        3.40%
        2015
        12.40
        5.00%
        2016
        15.00
        6.00%
        2017
        17.00
        6.70%
        2018
        18.20
        7.10%
        2019
        19.40
        7.50%
        2020
        20.40
        7.80%
      2. It is globalizing fast: In the same vein, ride sharing which started as a San Francisco experiment that grew into a US business has become global in just a short period, with Asia emerging as the epicenter for future growth. Didi Chuang, the Chinese ridesharing company, completed 1.43 billion rides just in 2015 and it now claims to have 250 million users in 360 Chinese cities. Ride sharing is also acquiring deep roots in both India and Malaysia, and is making advances in Europe and Latin America, despite regulatory pushback. 
      3. Expanding choices: The choices in ride sharing are becoming wider, to attract an even larger audience, from carpooling and private bus services to attract mass transit customers to luxury options for more upscale customers. In addition, ride sharing companies are experimenting with pre-scheduled rides and multiple stops on single trip gain to meet customer needs. 
      4. Devastating the status quo: All of this growth has been devastating for the status quo. Even hardliners in the taxicab and old time car service businesses recognize that ride sharing is not going away and that the ways of doing business have to change. The price of a New York city medallion which was in excess of $1.5 million before the advent of ride sharing continues its plunge, dropping to less than $500,000 in March 2016. The price of a Chicago cab medallion, which peaked at $357,000 in 2013, had dropped to $60,000 by July 2016.
      In short, there is no question that the car service business as we know it has been disrupted and that there is no going back to the old days. If you own a taxi cab or a car service business, the question is no longer whether you will lose business to ride sharing companies but how quickly, even with the regulatory authorities standing in as your defenders.

      A Flawed Business Model
      Disruption is easy but making money off disruption is difficult, and ride sharing companies would be exhibit 1 to back up the proposition. While the ride sharing option is here to stay and will continue to grow, ride sharing companies still have not figured out a way to convert ride sharing revenues in profits. In making this statement, though, I am relying on dribs and drabs of information that are coming out of the existing ride sharing companies, almost all of whom are private. Piecing together the information that we are getting from these unofficial and often selective leaked information, here is what seems clear:
      1. Raising capital at a hefty pace: In the last two years, the ride sharing companies have been active in raising capital, with Uber leading the way and Didi Chuxing close behding. In the graph below, I list the capital raised collectively by players in the ride sharing business over the last three years and the pricing attached to each company in its most recent capital round.
      2. Ride Sharing Company
        Amount Raised in last 12 months (in millions)
        Investor
        Company Priced at (in millions)
        Didi
        $7,300.00
        Apple, Alibaba, Softbank & Others
        $28,000
        Uber
        $3,500.00
        Saudi Arabian Sovereign Fund
        $62,500
        Lyft
        $500.00
        GM
        $5,500
        Ola
        $500.00
        Didi & Existing Investors
        $5,000
        Grabtaxi
        $350.00
        Didi & CIC
        $1,800
        Gett
        $300.00
        Volkswagen
        $2,000
        Via
        $100.00
        VC
        NA
        Scoop
        $5.10
        BMW
        NA
      3. At rich prices: As the table above indicates, the investors who are putting money in the ride sharing companies are willing to pay hefty prices for their holdings, with no signs of a significant pullback (yet). Uber, at its current pricing, is being priced higher than Ford or GM. Note that I use the word “pricing” to indicate what investors are attaching as numbers to these companies because I don’t believe that they have the interest or the stomach to actually value them. If you are confused about the contrast between “value” and “price”, please see my blog post on the topic.
      4. From unconventional capital providers: The capital coming into ride sharing companies is  coming less from the traditional providers to private businesses and more from public investors (Mutual funds, pension funds, wealth management arms of investment banks and sovereign funds). The reasons for the shift are simple on both sides. Public investors want to be invested in the ride sharing companies because they have visions of public offerings at much higher prices and are afraid to be left on the side lines, if that happens. The ride sharing companies are for it because some of them (Uber and Didi, in particular) are getting too big for venture capitalists to capitalize and perhaps because public investors are imposing less onerous constraints on them for providing capital.
      5. While burning through cash quickly: As quickly as the capital is being raised at ride sharing companies, it is being spent at astonishing rates. Uber admitted that it burned through more than a billion dollars in cash in 2015, with a significant portion of that coming from its attempts to increase market share in China. Its competitors are matching it, with Lyft estimated to be burning through about $50 million in cash each month ($600 million over a year) and Didi Chuxing's CEO, Jean Liu, openly admitting that “We wouldn’t be here today if it wasn’t for burning cash”. 
      The cash burn at ride sharing companies, by itself, is neither uncommon nor, by itself, troubling After all, to grow, you have to spend money, and a young start up often loses money because of infrastructure investments and fixed costs, and as revenues climb, margins should improve and reinvestment should scale down (at least on a proportional basis). The problem with ride sharing is companies in this business are losing money only partially because of their high growth. In fact, I believe that a significant portion of their expenses are associating with maintaining revenues rather than growing them (ride sharing discounts, driver deals and customer deals). I am afraid that I cannot back up that statement with anything more tangible than news stories about ride sharing wars for drivers, big discounts for customers and the leaked statistics from the ride sharing companies.  In effect, it looks like the business model that has brought these companies as far as they have in such a short time period are flawed, because what allowed these companies to grow incredibly fast is getting in the way of converting revenues to profits, since there are no moats to defend.

      If you are skeptical about my contention, here is a simple test of whether the cash burn is just a consequence of going for high growth or symptomatic of a business model problem. Assume that the growth ends in the ride sharing business tomorrow and that the ride sharing companies were to compete for existing riders. Do you think that the pieces are in place for these companies to generate profits? I don't think so, as ride prices keep dropping, new ride sharing businesses pop up and the costs continue to increase. 

      The Bar Mitzvah Moment
      In a post in November 2014 on Twitter’s struggles, I argued that every young growth company has a bar mitzvah moment, a time in its history when markets shift their attention away from surface measures of growth (number of users, in the case of Twitter) to more operating substance (evidence that the users are being monetized). I also argued that to get through these bar mitzvah moments successfully, young growth companies have to be managed on two levels, delivering the conventional metrics on one level while working on creating a business model to convert these metrics into more conventional measures of business success (revenues and earnings) on the other.

      This may be premature but I have sense that the bar mitzvah moment has arrived or will be arriving soon for ride sharing companies. After an initial life, where investors have been easily sated with reports of more ridesharing usage (number of cities served, rides, drivers etc.), these investors are starting to ask the tough questions about how ride sharing companies propose turning these impressive usage statistics into profits. What’s driving investor uneasiness?

      • The first factor is that the public investors who have put their money into the ride sharing companies operate under shorter time horizons than many VC investors and the fact that an IPO is not imminent in any of these companies adds to their impatience to see tangible results. 
      • The second factor is that the belief that there will be a winner-take-all, who can then proceed to charge what the market will bear, has receded, as all of the players in the market continue to attract capital. 
      • The third factor is that the possibility that big players like Apple and Google will enter the market is becoming a plausibility and perhaps even a probability and their technological edge and deep pockets could put existing ride sharing companies at a disadvantage.
      In my view, it is this perception that change is coming that is leading the flurry of activity that we have seen at ride sharing companies in the last few months. In conventional business terms, the ride sharing companies are trying to shore up their business models, generate pathways to profitability and build competitive advantages. Broadly speaking, these efforts include the following:
      1. Increased Switching costs: The ride sharing companies are working on ways to increase the costs of switching to their competitors, both among drivers (who I described in a prior post as uncontracted free agents) and customers. Uber’s partnership with Toyota, where Toyota will lease cars on favorable terms to Uber drivers, will benefit drivers but will also bind them more closely to Uber, and make it more difficult for them to threaten to go to Lyft for a few thousand dollars. GM’s agreement with Lyft is not as specific but seems to be directed at the same objective. 
      2. Cooperation/Collusion: In my ride sharing post in October 2015, I raised the possibility that the ride sharing companies would follow the route of the Mafia in the United States in the middle of the last century, where crime families divided the US into fiefdoms and agreed not to invade each other’s turf. Uber’s decision to abandon the Chinese market to Didi in return for a 20% ownership stake in that company, in particular, seems to be designed to accomplish this no-compete objective. Uber’s China move specifically seems to be designed to stop the mutually assured destruction that a free-for-all fight with Didi will create. 
      3. Higher Capital Intensity: Though there is little that is tangible that I can point to in support of this notion, I think that the ride sharing companies now recognize that their absence of tangible assets and infrastructure investment can now operate as an impediment to building a sustainable business. Consequently, I will not be surprised to see more investment by the ride sharing companies in self-driving cars, robots and other infrastructure as part of the phase of building up business moats.
      As we witness the breakneck pace of change in the ride sharing business, the big question if you are considering investing in these companies is whether these actions will work in laying the groundwork for profitability. Well, yes and no. If the ride sharing business were frozen to include only the current players, it is probable that they will come to an uneasy agreement that will allow them to generate profits. The problem, though, is that the existing structure of this business is anything but settled, with new ride sharing options popping up and large technology companies rumored to be on the cusp of jumping in. The unquestioned winners in the ride sharing game are car service customers, who have seen their car service costs go down while getting more care service options. . 

      Uber: An updated valuation
      In September 2015, I valued Uber at $23.4 billion, based upon my reading of the market then. In assessing this value, I incorporated what I saw as Uber’s strengths (its reach globally and across many different businesses) and its weaknesses (an out-of-control cost structure and the elimination of many of the insurance and regulatory loopholes that allowed ride sharing to gain such an advantage over conventional car service).  In the last year, as I see it, here is how the fundamental story has been impacted by developments in the last year: 

      1. Revenues: Uber’s growth continues, measured in cities and rides, though the rate of growth has started to slow down, not surprising given its size. Its decision to leave China, the largest ride sharing market in the world, even if it was the right one from the perspective of saving itself from a cash war, will reduce its potential revenues in the future.
      2. Competition: Before you over react to Uber's exit from China, there is good news in that decision. First,by removing the costs associated with going after the China market from the equation, it reduces the problem of cash burn, at least for the near future. Second, its peace treaty with Didi Chuxing puts the smaller players at risk. Lyft, Ola and Grabtaxi, all companies that Didi invested in to stop the Uber juggernaut, may now be left exposed to competition. Third, in return for its decision to leave the China market, Uber does get a 20% stake in Didi Chuxing.
      3. Costs: On the cost front, the ride sharing business continued to evolve, with most of the changes signaling higher costs for the ride sharing companies in the future. Seattle's decision to let Uber/Lyft drivers unionize may be the precursor of similar developments in other cities and higher costs for both companies. On the legal front, cities continue to throw up roadblocks for the ride sharing companies. Uber and Lyft abandoned Austin, after the city passed an ordinance requiring drivers for both services to pass background checks. One symptom of these higher costs is in the leaked financials from Uber, which suggested that the company lost more than a billion dollars in the first half of 2015. 
      4.  Imminent competition: The Silicon Valley gossip continues about Apple and Google preparing to enter the ride sharing market, with Google announcing that it has entered into a partnership with Fiat and that a top robocist had left the self-driving car unit a few days ago. Never one to hide in the shadows, Elon Musk added car sharing to his long list of to dos at Tesla in his Master Plan for the company. It seems clear that while the timing of the change remains up in the air, change is coming to this business.
      None of the changes are dramatic but tweaking my valuation to reflect those changes, as well as changes in the macro environment in the last year, my updated valuation for Uber is $28 billion, a little higher than my estimate last year of $23.4 billion. The loss of the China market reduces the total market size but it is offset by a higher market share of the remaining market and a 20% stake in Didi Chuxing. The pricing attached to this Didi stake is $7 billion, but since the same forces that have elevated Uber's pricing are at play across the ride sharing market, I have attached a value of $5 billion to the stake. The picture of the valuation is below:
      Download spreadsheet
      Clearly, the Saudi Sovereign fund, Goldman Sachs and Fidelity would disagree with me, since their estimated pricing for Uber is more than double my value. They could very well be right in their judgment and I could be wrong, but my valuation reflects my story about the company, which is perhaps not as expansive nor as optimistic as the stories that they might be telling.

      What's next?
      The ride sharing business is in a state of flux and the next few months will bring more experimentation on the part of companies. Some of these experiments will be with the services offered but more of them will be attempts to get business models that work at converting riders to profits. The ride sharing companies have clearly won the first phase of the disruption battle with the taxicab and car service companies and have been rewarded with high pricing and plentiful capital. The next phase will separate the winners from the losers song the ride sharing companies and it is definitely not going to be boring.

      Update:  To the many people who have commented about this valuation, I thank you, even if you vehemently disagree with me. To give you some sense of what the feedback has been across my blog, email and twitter, more of you seem to think that I am being too optimistic than pessimistic about Uber's future. Whatever your point of view, I don't claim to have a monopoly on the right story for each company that I value in this blog and the resulting valuation. However, rather than take issue with what you think is wrong with my story/valuation, I would suggest that you download the spreadsheet that is attached and make it your story/valuation. Thus, if you believe that my total market size is too low and/or that my judgment on profit margins too pessimistic, replace them with your own and you will have your own valuation of Uber. 

      YouTube Video


      Last year's posts on ride sharing
      1. On the Uber Rollercoaster: Narrative Tweaks, Twists and Turns
      2. Dream Big or Stay Focused? The Lyft Answer!
      3. The Future of Ride Sharing: Playing Pundit

      Uber Valuations
      1. June 2014
      2. September 2015
      3. August 2016




      Fairness Opinions: Fix them or Flush them!

      My post on the Tesla/SCTY deal about the ineptitude and laziness that Lazard and Evercore brought to the valuation process did not win me any friends in the banking M&A world. Not surprisingly, it drew some pushback, not so much from bankers, but from journalists and lawyers, taking me to task for not understanding the context for these valuations. As Matt Levine notes in his Bloomberg column, where he cites my post, "a fairness opinion is not a real valuation, not a pure effort to estimate the value of a company from first principles and independent research" (Trust me. No one is setting the bar that high. I was looking for biased efforts using flawed principles and haphazard research and these valuation could not even pass that standard)  and that "they (Lazard and Evercore) are just bankers; their expertise is in pitching and sourcing and negotiating and executing deals -- and in plugging in discount rates into preset spreadsheets -- not in knowing the future". (Bingo! So why are they doing these fairness opinions and charging millions of dollars for doing something that they are not good at doing? And there is a difference between knowing the future, which no one does, and estimating the future, which is the essence of valuation.) If Matt is right, the problems run deeper than the bankers in this deal, raising questions about what the purpose of a   "fairness opinion" is and whether it has outlived its usefulness (assuming that it was useful at some point).

      Fairness Opinions: The Rationale
      What is a fairness opinion? I am not a lawyer and I don't play intend to play one here, but it is perhaps best to revert back to the legal definition of the term. In an excellent article on the topic, Steven Davidoff defines a fairness opinion as an "opinion provided by an outsider that a transaction meets a threshold level of fairness from a financial perspective". Implicit in this definition are the assumptions that the outsider is qualified to pass this judgment and that there is some reasonable standard for fairness.  In corporate control transactions (acquisition, leveraged buyout etc.), as practiced today, the fairness opinion is delivered (orally) to the board at the time of the transaction, and that presentation is usually followed by a written letter that summarizes the transaction terms and the appraiser's assumptions and attests that the price paid is "fair from a financial point of view". That certainly sounds like something we should all favor, especially in deals that have obvious conflicts of interest, such as management-led leveraged buyouts or transactions like the Tesla/Solar City deal, where the interests of Elon Musk and the rest of Tesla 's stockholders may diverge.

      Note that while fairness opinions have become part and parcel of most corporate control transactions, they are not required either by regulation or law. As with so much of business law, especially relating to acquisitions, the basis for fairness opinions and their surge in usage can be traced back to Delaware Court judgments. In Smith vs Van Gorkom, a 1985 case, the court ruled against the board of directors of Trans Union Corporation, who voted for a leveraged buyout, and specifically took them to task for the absence of a fairness opinion from an independent appraiser. In effect, the case carved out a safe harbor for the companies by noting that “the liability could have been avoided had the directors elicited a fairness opinion from anyone in a position to know the firm’s value”.  I am sure that the judges who wrote these words did so with the best of intentions, expecting fairness opinions to become the bulwark against self-dealing in mergers and acquisitions. In the decades since, through a combination of bad banking practices, the nature of the legal process and confusion about the word "fairness", fairness opinions, in my view, have not just lost their power to protect those that they were intended to but have become a shield used by managers and boards of directors against serious questions being raised about deals. 

      Fairness Opinions: Current Practice?
      There are appraisers who take their mission seriously and evaluate the fairness of transactions in their opinions, but the Tesla/Solar City valuations reflect not only how far we have strayed from the original idea of fairness but also how much bankers have lowered the bar on what constitutes acceptable practice.  Consider the process that Lazard and Evercore used by  to arrive at their fairness opinions in the Tesla/Solar City deal, and if Matt is right, they are not alone:

      What about this process is fair, if bankers are allowed to concoct discount rates, and how is it an opinion, if the numbers are supplied by management? And who exactly is protected if the end result is a range of values so large that any price that is paid can be justified?  And finally, if the contention is that the bankers were just using professional judgment, in what way is it professional to argue that Tesla will become the global economy (as Evercore is doing in its valuation)? 

      To the extent that what you see in the Tesla/Solar City deal is more the rule than the exception, I would argue that fairness opinions are doing more harm than good. By checking off a legally required box, they have become a way in which a board of directors buy immunization against legal consequences. By providing the illusion of oversight and an independent assessment, they are making shareholders too sanguine that their rights are being protected. Finally, this is a process where the worst (and least) scrupulous appraisers, over time, will drive out the best (and most principled) ones, because managers (and boards that do their bidding) will shop around until they find someone who will attest to the fairness of their deal, no matter how unfair it is. My interest in the process is therefore as much professional, as it is personal. I believe the valuation practices that we see in many fairness opinions are horrendous and are spilling over into the other valuation practices.

      It is true that there are cases, where courts have been willing to challenge the "fairness" of fairness opinions, but they have been infrequent and  reserved for situations where there is an egregious conflict of interest. In an unusual twist, in a recent case involving the management buyout of Dell at $13.75 by Michael Dell and Silver Lake, Delaware Vice Chancellor Travis Lester ruled that the company should have been priced at $17.62, effectively throwing out the fairness opinion backing the deal. While the good news in Chancellor Lester's ruling is that he was willing to take on fairness opinions, the bad news is that he might have picked the wrong case to make his stand and the wrong basis (that markets are short term and under price companies after they have made big investments) for challenging fairness opinions.

      Fish or Cut Bait?
      Given that the fairness opinion, as practiced now, is more travesty than protection and an expensive one at that, the first option is to remove it from the acquisition valuation process. That will put the onus back on judges to decide whether shareholder interests are being protected in transactions. Given how difficult it is to change established legal practice, I don't think that this will happen. The second is to keep the fairness opinion and give it teeth. This will require two ingredients to work, judges that are willing to put fairness opinions to the test and punishment for those who consistently violate those fairness principles.

      A Judicial Check
      Many judges have allowed bankers to browbeat them into accepting the unacceptable in valuation, using the argument that what they are doing is standard practice and somehow professional valuation.  As someone who wanders across multiple valuation terrain, I am convinced that the valuation practices in fairness opinions are not just beyond the pale, they are unprofessional. To those judges, who would argue that they don't have the training or the tools to detect bad practices, I will make my pro bono contribution in the form of a questionnaire with flags (ranging from red for danger to green for acceptable) that may help them separate the good valuations from the bad ones.

      Question
      Green
      Red
      Who is paying you to do this valuation and how much? Is any of the payment contingent on the deal happening? (FINRA rule 2290 mandates disclosure on these)
      Payment reflects reasonable payment for valuation services rendered and none of the payment is contingent on outcome
      Payment is disproportionately large, relative to valuation services provided, and/or a large portion of it is contingent on deal occurring.
      Where are you getting the cash flows that you are using in this valuation?
      Appraiser estimates revenues, operating margins and cash flows, with input from management on investment and growth plans.
      Cash flows supplied by management/ board of company.
      Are the cash flows internally consistent?
      1.     Currency: Cash flows & discount rate are in same currency, with same inflation assumptions.
      2.     Claim holders: Cash flows are to equity (firm) and discount rate is cost of equity (capital).
      3.     Operations: Reinvestment, growth and risk assumptions matched up.
      No internal consistency tests run and/or DCF littered with inconsistencies, in currency and/or assumptions.
      -       High growth + Low reinvestment
      -       Low growth + High reinvestment
      -       High inflation in cash flows + Low inflation in discount rate
      What discount rate are you using in your valuation?
      A cost of equity (capital) that starts with a sector average and is within the bounds of what is reasonable for the sector and the market.
      A cost of equity (capital) that falls outside the normal range for a sector, with no credible explanation for difference.
      How are you applying closure in your valuation?
      A terminal value that is estimated with a perpetual growth rate < growth rate of the economy and reinvestment & risk to match.
      A terminal value based upon a perpetual growth rate > economy or a multiple (of earnings or revenues) that is not consistent with a healthy, mature firm.
      What valuation garnishes have you applied?
      None.
      A large dose of premiums (control, synergy etc.) pushing up value or a mess of discounts (illiquidity, small size etc.) pushing down value.
      What does your final judgment in value look like?
      A distribution of values, with a base case value and distributional statistics.
      A range of values so large that any price can be justified.

      If this sounds like too much work, there are four changes that courts can incorporate into the practice of fairness opinions that will make an immediate difference:
      1. Deal makers should not be deal analysts: It should go without saying that a deal making banker cannot be trusted to opine on the fairness of the deal, but the reason that I am saying it is that it does happen. I would go further and argue that deal makers should get entirely out of the fairness opinion business, since the banker who is asked to opine on the fairness of someone else's deal today will have to worry about his or her future deals being opined on by others.
      2. No deal-contingent fees: If bias is the biggest enemy of good valuation, there is no simpler way to introduce bias into fairness opinions than to tie appraisal fees to whether the deal goes through. I cannot think of a single good reason for this practice and lots of bad consequences. It should be banished.
      3. Valuing and Pricing: I think that appraisers should spend more time on pricing and less on valuation, since their focus is on whether the "price is fair" rather than on whether the transaction makes sense. That will require that appraisers be forced to justify their use of multiples (both in terms of the specific multiple used, as well as the value for that multiple) and their choice of comparable firms. If appraisers decide to go the valuation route, they should take ownership of the cash flows, use reasonable discount rates and not muddy up the waters with arbitrary premiums and discounts. And please, no more terminal values estimated from EBITDA multiples!
      4. Distributions, not ranges: In my experience, using a range of value for a publicly traded stock to determine whether a price is fair is useless. It is analogous to asking, "Is it possible that this price is fair?", a question not worth asking, since the answer is almost always "yes". Instead, the question that should be asked and answered is "Is it plausible that this price is a fair one?"  To answer this question, the appraiser has to replace the range of values with a distribution, where rather than treat all possible prices as equally likely, the appraiser specifies a probability distribution. To illustrate, I valued Apple in May 2016 and derived a distribution of its values:

      Let's assume that I had been asked to opine on whether a $160 stock price is a fair one for Apple. If I had presented this valuation as a range for Apple's value from $80.81 to $415.63, my answer would have to be yes, since it falls within the range. With a distribution, though, you can see that a $160 price falls at the 92nd percentile, possible, but neither plausible, nor probable.  To those who argue that this is too complex and requires more work, I would assume that this is at the minimum what you should be delivering, if you are being paid millions of dollars for an appraisal.

      Punishment
      The most disquieting aspect of the acquisition business is the absence of consequences for bad behavior, for any of the parties involved, as I noted in the aftermath of the disastrous HP/Autonomy merger. Thus, managers who overpay for a target are allowed to use the excuse of "we could not have seen that coming" and the deal makers who aided and abetted them in the process certainly don't return the advisory fees, for even the most abysmal advice. I think while mistakes are certainly part of business, bias and tilting the scales of fairness are not and there have to be consequences:
      1. For the appraisers: If the fairness opinion is to have any heft, the courts should reject fairness opinions that don't meet the fairness test and remove the bankers involved  from the transaction, forcing them to return all fees paid. I would go further and create a Hall of Shame for those who are repeat offenders, with perhaps even a public listing of their most extreme offenses. 
      2. For directors and managers: The boards of directors and the top management of the firms involved should also face sanctions, with any resulting fines or fees coming out of the pockets of directors and managers, rather than the shareholders involved.
      I know that your reaction to these punitive suggestions is that they will have a chilling effect on deal making. Good! I believe that much as strategists, managers and bankers like to tell us otherwise, there are more bad deals than good ones and that shareholders in companies collectively will only gain from crimping the process.

      YouTube Video


      Attachments
      1. The Fairness Questionnaire (as a word file, which you are free to add to or adapt)



      Keystone Kop Valuations: Lazard, Evercore and the TSLA/SCTY Deal

      It is get easy to get outraged by events around you, but I have learned, through hard experience, that writing when outraged is dangerous. After all, once you have climbed onto your high horse, it is easy to find fault with others and wallow in self-righteousness. It is for that reason that I have deliberately avoided taking issue with investment banking valuations of specific companies, much as I may disagree with the practices used in many of them. I understand that bankers make money on transactions and that their valuations are more sales tools than assessments of fair value and that asking them to pay attention to valuation first principles may be asking too much. Once in a while, though, I do come across a valuation so egregiously bad that I cannot restrain myself and reading through the prospectus filed by Tesla for their Solar City acquisition/merger was such an occasion. My first reaction as I read through the descriptions of how the bankers in this deal (Evercore for Tesla and Lazard for Solar City) valued the two companies was "You must be kidding me!".

      The Tesla/Solar City Deal
      In June 2016, Tesla announced that it intended to acquire Solar City in a stock swap, a surprise to almost everyone involved, except for Elon Musk. By August 1, the specifics of the deal had been ironed out and the broad contours of the deal are captured in the picture below:


      At the time of the deal, Mr. Musk contended that the deal made sense for stockholders in both companies, arguing that it was a "no-brainer" that would allow Tesla to expand its reach and become a clean energy company. While Mr. Musk has a history of big claims and perhaps the smarts and charisma to deliver on them, this deal attracted attention because of its optics. Mr. Musk was the lead stockholder in both companies and CEO of Tesla and his cousin, Lyndon Rive, was the CEO of Solar City. Even Mr. Musk's strongest supporters could not contest the notion that he was in effective control at both companies, creating, at the very least. the potential for conflicts of interests. Those questions have not gone away in the months since and the market concerns have been reflected in the trend lines in the stock prices of the two companies, with Solar City down about 24% and Tesla's stock price dropping about 8%.

      The board of directors at Tesla has recognized the potential for a legal backlash and as this New York Times article suggests, they have been careful to create at least the appearance of an open process, with Tesla's board hiring Evercore Partners, an investment bank, to review the deal and Solar City's board calling in Lazard as their deal assessor. Conspicuously missing is Goldman Sachs, the investment banker on Tesla's recent stock offering, but more about that later.

      The Banking Challenge in a Friendly Merger
      In any friendly merger, the bankers on the two sides of the deal face, what at first sight, looks like an impossible challenge. The banker for the acquiring company has to convince the stockholders of the acquiring company that they are getting a good deal, i.e., that they are acquiring the target company at a price, which while higher that the prevailing market price, is lower than the fair value for the company. At the same time, the banker for the target company has to convince the stockholders of the target company that they too are getting a good deal, i.e., that they are being acquired at is higher than their fair value. If you are a reasonably clever banking team, you discover very quickly that the only way you can straddle this divide is by bringing in what I call the two magic merger words, synergy and control. Synergy in particular is magical because it allows both sides to declare victory and control adds to the allure because it comes with the promise of unspecified changes that will be made at the target company and a 20% premium:


      In the Tesla/Solar City deal, the bankers faced a particularly difficult challenge. Finding synergy in this merger of an electric car company and a solar cell company, one of which (Tesla) has brand name draw and potentially high margins and the other of which is a commodity business (Solar City) with pencil thin margins) is tough to do. Arguing that the companies will be better managed as one company is tricky when both companies have effectively been controlled by the same person(Musk) before the merger. In fact, it is far easier to make the case for reverse synergy here, since adding a debt-laden company with a questionable operating business (Solar City) to one that has promise but will need cash to deliver seems to be asking for trouble. The bankers could of course have come back and told the management of both companies (or just Elon Musk) that the deal does not make sense and especially so for the stockholders of Tesla but who can blame them for not doing so? After all, they are paid based upon whether the deal gets done and if asked to justify themselves, they would argue that Musk would have found other bankers who would have gone along. Consequently, I am not surprised that both banks found value in the deal and managed to justify it.

      The Valuations
      It is with this perspective in mind that I opened up the prospectus, expecting to see two bankers doing what I call Kabuki valuations, elaborately constructed DCFs where the final result is never in doubt, but you play with the numbers to make it look like you were valuing the company. Put differently, I was willing to cut a lot of slack on specifics, but what I found failed even the minimal tests of adequacy in valuation. Summarizing what the banks did, at least based upon the prospectus (lest I am accused of making up stuff):
      Tesla Prospectus
      Conveniently, these number provide backing for the Musk acquisition story, with Evercore reassuring Tesla stockholders that they are getting a good deal and Lazard doing the same with Solar City stockholders, while shamelessly setting value ranges so wide that they get legal cover, in case they get sued.  Note also not only how much money paid to these bankers for their skills at plugging in discount rates into spreadsheets but that both bankers get an additional payoff, if the merger goes through, with Evercore pocketing an extra $5.25 million and Lazard getting 0.4% of the equity value of Solar City.  There are many parts of these valuations that I can take issue with, but in the interests of fairness, I will start with what I term run-of-the-mill banking malpractice, i.e., bad practices that many bankers are guilty of.
      1. No internal checks for consistency: There is almost a cavalier disregard for the connection between growth, risk and reinvestment. Thus, when both banks use ranges of growth for their perpetual value estimates, it looks like neither adjusts the cash flows as growth rates change. (Thus, when Lazard moves its perpetual growth rate for Solar City from 1.5% to 3%, it looks like the cash flow stays unchanged, a version of magical growth that can happen only on a spreadsheet).
      2. Discount Rates: Both companies pay lip service to standard estimation technology (with talk of the CAPM and cost of capital), and I will give both bankers the benefit of the doubt and attribute the differences in their costs of capital to estimation differences, rather than to bias.  The bigger question, though, is why the discount rates don't change as you move through time to 2021, where both Tesla and Solar City are described as slower growth, money making companies.
      3. Pricing and Valuation: I have posted extensively on the difference between pricing an asset/business and valuing it and how mixing the two can yield a incoherent mishmash. Both investment banks move back and forth between intrinsic valuation (in their use of cash flows from 2016-2020) and pricing, with Lazard estimating the terminal value of Tesla using a multiple of EBITDA. (See my post on dysfunctional DCFS, in general, and Trojan Horse DCFs, in particular).
      There are two aspects of these valuations that are the over-the-top, even by banking valuation standards:
      1. Outsourcing of cash flows: It looks like both bankers used cash flow forecasts provided to them by the management. In the case of Tesla, the expected cash flows for 2016-2020 were generated by Goldman Sachs Equity Research (GSER, See Page 99 of prospectus) and for Solar City, the cash flows for that same period were provided by Solar City, conveniently under two scenarios, one with a liquidity crunch and one without. Perhaps, Lazard and Evercore need reminders that if the CF in a DCF is supplied to you by someone else,  you are not valuing the company, and charging millions for plugging in discount rates into preset spreadsheets is outlandish. 
      2. Terminal Value Hijinks: The terminal value is, by far, the biggest single number in a DCF and it is also the number where the most mischief is done in valuation. While some evade these mistakes by using pricing, there is only one consistent way to get terminal value in a DCF and that is to assume perpetual growth. While there are a multitude of estimation issues that plague perpetual growth based terminal value, from not adjusting the cost of capital to reflect mature company status to not modifying the reinvestment to reflect stable growth, there is one mistake that is deadly, and that is assuming a growth rate that is higher than that of the economy forever. With that context, consider these clippings from the prospectus on the assumptions about growth forever made by Evercore in their terminal value calculations:
        Tesla Prospectus
        I follow a rule of keeping the growth rate at or below the risk free rate but I am willing to accept the Lazard growth range of 1.5-3% as within the realm of possibility, but my reaction to the Evercore assumption of 6-8% growth forever in the Tesla valuation or even the 3-5% growth forever with the Solar City valuation cannot be repeated in polite company. 
      Not content with creating one set of questionable valuations, both banks doubled down with a number of  of other pricing/valuations, including sum-of-the-parts valuations, pricing and transaction premiums, using a "throw everything at the fan and hope something sticks" strategy.

      Now what? 
      I don't think that Tesla's Solar City acquisition passes neither the smell test (for conflict of interest) nor the common sense test (of creating value), but I am not a shareholder in either Tesla or Solar City and I don't get a vote. When Tesla shareholders vote, given that owning the stock is by itself an admission that they buy into the Musk vision, I would not be surprised if they go along with his recommendations. Tesla shareholders and Elon Musk are a match made in market heaven and I wish them the best of luck in their life together.

      As for the bankers involved in this deal, Lazard's primary sin is laziness, accepting an assignment where they are reduced to plugging in discount rates into someone else's cash flow forecasts and getting paid $2 million plus for that service. In fact, that laziness may also explain the $400 million debt double counting error made by Lazard on this valuation,. Evercore's problems go deeper. The Evercore valuation section of the prospectus is a horror story of bad assumptions piled on impossible ones, painting a picture of ignorance and incompetence. Finally, there is a third investment bank (Goldman Sachs), mentioned only in passing (in the cash flow forecasts provided by their equity research team), whose absence on this deal is a story by itself. Goldman's behavior all through this year, relating to Tesla, has been rife with conflicts of interest, highlighted perhaps by the Goldman equity research report touting Tesla as a buy, just before the Tesla stock offering. It is possible that they decided that their involvement on this deal would be the kiss of death for it, but I am curious about (a) whether Goldman had any input into the choice of Evercore and Lazard as deal bankers, (b) whether Goldman had any role in the estimation of Solar City cash flows, with and without liquidity constraints, and (c) how the Goldman Sachs Equity Research forecast became the basis for the Tesla valuations. Suspicious minds want to know! As investors, the good news is that you have a choice of investment bankers but the bad news is that you are choosing between the lazy, the incompetent and the ethically challenged.

      If there were any justice in the world, you would like to see retribution against these banks in the form of legal sanctions and loss of business, but I will not hold my breath waiting for that to happen. The courts have tended to give too much respect for precedence and expert witnesses, even when the precedent or expert testimony fails common sense tests and it is possible that these valuations, while abysmal, will pass the legally defensible test. As for loss of business, my experience in valuation is that rather than being punished for doing bad valuations, bankers are rewarded for their deal-making prowess. So, for the many companies that do bad deals and need an investment banking sign-off on that deal (in the form of a fairness opinion), you will have no trouble finding a banker who will accommodate you.

      If this post comes across as a diatribe against investment banking, I am sorry and I am not part of the "Blame the Banks for all our problems" school. In fact, I have long argued that bankers are the lubricants of a market economy, working through kinks in the system and filling in capital market needs and defended banking against its most virulent critics. That said, the banking work done on deals like the this one vindicate everyone's worst perceptions of bankers as a hired guns who cannot shoot straight, more Keystone Kops than Wyatt Earps!

      YouTube Video


      Attachments
      1. Tesla Prospectus for Solar City Deal



      The School Bell Rings! It's Time for Class!

      As most teachers do, I mark time in academic rather than in calendar years and as September dawns, it is New Year's eve for me and a new class is set to begin. In just under a week, on September 7, 2016, I will walk into a classroom and face up to a roomful of students, not quite ready for summer to end, and start teaching, as I have every year since 1984. This semester, I will be back to teaching Valuation to MBAs at Stern, and as I have in semesters past, I invite you to join me on this journey, as we look at the mix of art, science and magic that makes valuation such a fascinating discipline.

      Class Philosophy
      I have always believe that to teach a class well, you have to start with a story and that the class is an extended serialization of the story. I also believe that to teach well, you have to, at least over time, make that story your own and mold the class to reflect it. In fact, the valuation class that I will be teaching this Fall has its seeds in the very first valuation class that I taught in 1986, but the differences reflect not only how much the world has changed since then, but also how my own thinking on valuation has evolved. The class remains a work in progress, where each time I teach it, I learn something new as well as recognize how much I have left to learn.

      I could give you an extended essay on what this class is about, but I would repeating what I said at the start of the Fall 2015 semester in this post. In short, I said this class is not an extended accounting class (where you forecast entire financial statements for extended periods), or a modeling class (where you become an Excel Ninja) or a theory class (since there is so little of it in  valuation to begin with). Instead, here are the broad themes that underlie this class, all captured in the picture below:

      If you find this picture a little daunting, I did do a Google talk that encapsulated these themes into about an hour-long session. 


      In particular, this class is less about the tools and techniques of valuation and more about developing a foundation that you can use to build your own investment philosophy. I know that faith is a word that is seldom used and often viewed with suspicion by many in the valuation community, but it is at the heart of this class, both in terms of how you build up faith in your own capacity to value assets and businesses and how you hold on to that faith when the market price moves away from your value.  Since I still struggle on both of these fronts, I cannot give you a template for success but I will be open about my own insecurities both about my own valuations and about markets.

      Class Structure
      Since my objective in the class is that by the end of it, you should be able to attach a number to just about any asset, I will roam the spectrum. I will start with the basics of intrinsic value, partly because it is where I am most comfortable and partly because it provides me with ways of dealing with other approach. The mechanics of estimating discount rates, cash flows, growth and terminal value are not just simple, but easily mechanized. It is the specifics that we will wrestle with in this class:

      • On risk free rates, usually the least troublesome and more easily obtained input in valuation, we will talk about why risk free rates vary across currencies, what to do about currencies that have negative risk free rates and whether normalizing risk free rates (as many practitioners have taken to doing) is a good idea or a bad one.
      • On risk premiums and discount rates, we will wrestle with questions of what risks should and should not be incorporated into discount rates and the different methods of bringing them in. In the process, we will examine how best to estimate equity risk premiums and default spreads, and why even if you don't like betas or portfolio theory, you should should still be able to estimate discount rates and do intrinsic valuation.  
      • On cash flows, we will focus on why accounting inconsistencies (on dealing with R&D, leases and other items) can lead to misstated earnings and how to fix those inconsistencies, examine what should and should not be included in reinvestment (capital expenditures and working capital) and what to do about stock based compensation.
      • On growth, we will start with the easy cases (where historical earnings growth is a good predictor of future growth) but quickly move on to more difficult cases (of companies in transition) and to what some view as impossible cases (like estimating growth in a start-up)>
      • On terminal value, the big number in every DCF,  that can very quickly hijack otherwise well-done valuations, we will develop simple rules for keeping the number in check and put to sleep many myths surrounding it.
      We will apply intrinsic valuation to value companies across the life cycle, in different sectors and across different markets. We will value small and large companies, private and public, developed and emerging and discuss how to value movie franchises (like Star Wars), phenomena (Pokemon Go) and sports teams. We will talk about why start ups can and should be valued in the face of daunting uncertainty and how probabilistic tools (simulations and decision trees) can help.

      About half way through the class, we will turn our attention to pricing assets/businesses, where rather than build up to a value from a company's fundamentals, we price it, based on how the market is pricing similar companies. Put simply, we will shine a light on the practice of using pricing multiples (PE, EV/EBITDA, EV/Sales) and comparable companies not with the intent of improving how it is done. We will also talk about why, even when you are careful and take care of the details, your pricing of a company can be very different form its value.

      In the last segment of the class, we will stretch our valuation muscles by talking about how option pricing models can sometime be used to estimate the additional value in a business, such as undeveloped reserves for a natural resource company or expansion potential for a young growth firm, and sometimes to value equity in deeply distressed companies. We will close by looking at acquisition valuation, where good sense seems to be in short supply, and how understanding value can be critical to corporate managers.

      Want to sit in?
      If you are intrigued or interested, you are welcome to sit in on the class (online and unofficially). While my immediate attention will be reserved for the Stern MBAs who will be registered in this class, you will have access to all of the resources that they do, starting with the lectures but also extending to lecture notes, quizzes/exams and even emails. The bad news is that I will be unable to grade your work or give you a certificate of completion. The good news is that the price is right. There are three ways in which you can join the class:

      1. My website: The most comprehensive and most updated center of all things related to this class at this link. You will find the webcasts, lecture notes, past exams, reading and even the emails I send on this class here.
      2. iTunes U: Just as I am not an Excel Ninja, my capacity to deal with html is primitive and my website's design reflects that lack of sophistication. If you prefer more polish, you can try the iTunes U app in the Apple app store. It is a free app that you can download and install on your Apple device. Once you have it installed, click on the add course and enter the enroll code FER-SFJ-AKA. Like magic, the class should pop up on your shelf. If you don't have an Apple device, you can get to the course on your computer using this link. If you have an Android device, you can use a workaround by downloading this app first. Like all things Apple, the set up is amazing and easy to work with.
      3. YouTube: The problem with the first two choices is that they presuppose that you don't have a broadband constraint, perhaps a phone internet connection or worse. My suggestion is that you use the YouTube playlist that I have created for this class at this link. The nice thing about YouTube is that it adjusts the image quality to your connection speed. So, it should work in almost any setting.
      Since I have made this offer for almost 20 years now, predating the MOOC boom and bust, I can offer some suggestions. First, it is a lot of work to watch two 80-minute lectures a week, try your hand out at working through actual valuations and finish the class in fifteen weeks, if you have other things going on in your life (and who does not?). My suggestion is that you cut yourself some slack and take more time, since the materials will stay up for at least a year after the class ends. Second, watching a lecture online for almost an hour and a half can be painful and for those of you who find the pain unbearable, I do have an alternative. A couple of years ago, I created an online version of this class, shrinking each 80-minute session into 10-15 minute sessions and this class is also available on my website at this link, on iTunes U at this link and on YouTube. Third, whichever version of the class you take will stick more if you pick a company and value it and even more, if you keep doing it. 

      The End Game
      I would love to tell you that I live a life of serenity and that I am sharing for noble reasons, but that would not be true. I am sharing my class for the most selfish of all reasons. I am a performer (and every teacher is) and what performer does not wish for a bigger audience? If I am going to prepare and deliver a class, would I not rather have thirty thousand people watch the class than three hundred. If you get something of value from this class, and you feel the urge to repay me, I will make the same suggestion that I did last year. Learning is one of those rare resources that is never diminished by sharing. So, please pass it on to someone else! See you in class!

      Links
      1. Entry Page for the Valuation Spring 2016 (on my website)
      2. Webpage for the Valuation Spring 2016 class webcasts (on my website)
      3. iTunes U for the Valuation Spring 2016 class (Enroll code on device: FER-SFJ-AKA)
      4. YouTube Playlist for the Valuation Spring 2016 class
      5. Webpage for Valuation Online class (short sessions)
      6. iTunes U for the Valuation Online class (short sessions)
      7. YouTube for the Valuation Online class (short sessions)



      Deutsche Bank: A Greek Tragedy at a German Institution?

      This may be a stereotype, but the Germans are a precise people and while that precision often gets in the way of more creative pursuits (like cooking and valuation), it lends itself well to engineering and banking. For decades until the introduction of the Euro and the creation of the European Central Bank, there was no central bank in the world that matched the Bundesbank for solidity and reliability. Thus, investors and regulators around the world, I am sure, are looking at the travails of Deutsche Bank in the last few weeksand wondering how the world got turned upside down. I am sure that there are quite a few institutions in Greece, Spain, Portugal and Italy who are secretly enjoying watching a German entity be at the center of a market crisis. Talk about schadenfreude!

      Deutsche Bank's Journey to Banking Hell
      There are others who have told the story about how Deutsche Bank got into the troubles it is in, much more creatively and more fully than I will be able to do so. Consequently, I will stick with the numbers and start by tracing Deutsche Bank’s net income over the last 28 years, in conjunction with the return on equity generated each year.

      If Deutsche Bank was reluctant to follow more daring competitors into risky businesses for much of the last century, it threw caution to the winds in the early part of the last decade, as it grew its investment banking and trading businesses and was rewarded handsomely with higher earnings from 2000 to 2007. Like almost every other bank on earth, the crisis in 2008 had a devastating impact on earnings at Deutsche, but the bank seemed to be on a recovery path in 2009, before it relapsed. Some of its recent problems reflect Deutsche’s well chronicled pain in investment banking, some come from its exposure to the EU problem zone (Greece, Spain, Portugal) and some from slow growth in the European economy. Whatever the reasons, in 2014 and 2015, Deutsche reported cumulative losses of close to $16 billion, leading to a management change, with a promise that things would turn around under new management. The other dimension where this crisis unfolded was in Deutsche’s regulatory capital, and as that number dropped in 2015, Deutsche Bank's troubles moved front and center. This is best seen in the graph below of regulatory capital (Tier 1 Capital) from 1998 to 2015, with the ratio of the Tier 1 capital to risk adjusted assets each year super imposed on the graph. 


      The ratio of regulatory capital to risk adjusted assets at the end of 2015 was 14.65%, lower than it was in 2014, but much higher than capital ratios in the pre-2008 time-period. That said, with the tightening of regulatory capital constraints after the crisis, Deutsche was already viewed as being under-capitalized in late 2015, relative to other large banks early this year. The tipping point for the current crisis came from the decision by the US Department of Justice to levy a $14 billion fine on Deutsche Bank for transgressions related to the pricing of mortgage backed securities a decade ago. As rumors swirled in the last few weeks, Deutsche Bank found itself in the midst of a storm, since the perception that a bank is in trouble often precipitates more trouble, as rumors replace facts and regulators panic. The market has, not surprisingly, reacted to these stories by marking up the default risk in the bank and marking down the stock price, most strikingly over the last two weeks, but also over a much longer period. 

      At close of trading on October 4, 2016, the stock was trading at $13.33 as share, yielding a market capitalization of $17.99 billion, down more than 80% from its pre-2008 levels and 50% from 2012 levels. Reflecting more immediate fears of default, the Deutsche CDS and CoCo bonds also have dropped in price, and not surprisingly, hedge funds sensing weakness have moved in to short the stock. 

      Revaluing Deutsche Bank
      When a stock is down more than 50% over a year, as Deutsche is, it is often irresistible to many contrarian investors, but knee jerk contrarian investing, i.e., investing in a stock just because it has dropped a lot, is a dangerous strategy. While it is true that Deutsche Banks has lost a large portion of its market capitalization in the last five years, it is also true that the fundamentals for the company have deteriorated, with lower earnings and hits to regulatory capital. To make an assessment of whether Deutsche is now “cheap”, you have to revalue the company with these new realities built in, to see if the market has over reacted, under reacted or reacted correctly to the news. (I will do the entire valuation in US dollars, simply for convenience, and it is straightforward to redo the entire analysis in Euros, if that is your preferred currency).

      a. Profitability 
      As you can see from the graph of Deutsche’s profits and return on equity, the last twelve months have delivered blow after blow to the company, but that drop has been a long time coming. The bank has had trouble finding a pathway to make sustainable profits, as it is torn between the desire of some at the bank to return to its commercial banking roots and the push by others to explore the more profitable aspects of trading and investment banking. The questions in valuation are not only about whether profits will bounce back but also what they will bounce back to. To make this judgment, I computed the returns on equity of all publicly traded banks globally and the distribution is below: 
      Global Bank Data
      I will assume that given the headwinds that Deutsche faces, it will not be able to improve its returns on equity to the industry median or even its own cost of equity in the near term. I will target a return on equity of 5.85%, at the 25th percentile of all banks, as Deutsche’s return on equity in year 5, and assume that the bank will be able to claw back to earning its cost of equity of 9.44% (see risk section below) in year 10. The estimated return on equity, with my estimates of common equity each year (see section of regulatory capital) deliver the following projected net income numbers. 
      YearCommon EquityROEExpected Net Income
      Base$64,609 -13.70%$(8,851)
      1$71,161 -7.18%$(5,111)
      2$72,754 -2.84%$(2,065)
      3$74,372 0.06%$43
      4$76,017 1.99%$1,512
      5$77,688 5.85%$4,545
      6$79,386 6.57%$5,214
      7$81,111 7.29%$5,910
      8$82,864 8.00%$6,632
      9$84,644 8.72%$7,383
      10$86,453 9.44%$8,161
      Terminal Year$87,326 9.44%$8,244
      I am assuming that the path back to profitability will be rocky, with losses expected for the next two years, before the company is able to turn its operations around. Note also that these expected losses are in addition to the $10 billion fine that I have estimated for the DOJ.

      b. Regulatory Capital 
      Deutsche Bank’s has seen a drop in it Tier 1 capital ratios over time but it now faces the possibility of being further reduced as Deutsche Bank will have to draw on it to pay the US DOJ government fine. While the DOJ has asserted a fine of $14 billion, Deutsche will negotiate to reduce it to a lower number and it is assessing its expected payment to be closer to $6 billion. I have assumed a total capital drop of $ 10 billion, leaving me with and adjusted regulatory capital of $55.28 billion and a Tier 1 capital ratio of 12.41%. Over the next few years, the bank will come under pressure from both regulators and investors to increase its capitalization, but to what level? To make that judgment, I look at Tier 1 capital ratios across all publicly traded banks globally: 
      Global Bank Data
      I will assume that Deutsche Bank will try to increase its regulatory capital ratio to the average (13.74%) by next year and then push on towards the 75th percentile value of 15.67%. As the capital ratio grows, the firm will have to increase regulatory capital over the next few years and that can be seen in the table below: 

      YearNet IncomeRisk-Adjusted AssetsTier 1 Capital/ Risk Adjusted AssetsTier 1 CapitalChange in Tier 1 CapitalFCFE = Net Income - Change in Tier 1
      Base$(8,851)$445,570 12.41%$55,282
      1$(5,111)$450,026 13.74%$61,834 $6,552 $(11,663)
      2$(2,065)$454,526 13.95%$63,427 $1,593 $(3,658)
      3$43 $459,071 14.17%$65,045 $1,619 $(1,576)
      4$1,512 $463,662 14.38%$66,690 $1,645 $(133)
      5$4,545 $468,299 14.60%$68,361 $1,671 $2,874
      6$5,214 $472,982 14.81%$70,059 $1,698 $3,516
      7$5,910 $477,711 15.03%$71,784 $1,725 $4,185
      8$6,632 $482,488 15.24%$73,537 $1,753 $4,880
      9$7,383 $487,313 15.46%$75,317 $1,780 $5,602
      10$8,161 $492,186 15.67%$77,126 $1,809 $6,352
      Terminal Year$8,244 $497,108 15.67%$77,897 $771 $7,472
      The negative free cash flows to equity in the first three years will have to be covered with new capital that meets the Tier 1 capital criteria. By incorporating these negative free cash flows to equity in my valuation, I am in effect reducing my value per share today for future dilution, a point that I made in a different context when talking about cash burn

      c. Risk
      Rather than follow the well-trodden path of using risk free rates, betas and risk premiums, I am going to adopt a short cut that you can think of as a model-agnostic way of computing the cost of equity for a sector. To illustrate the process, consider the median bank in October 2016, trading at a price to book ratio of 1.06 and generating a return on equity of 9.91%. Since the median bank is likely to be mature, I will use a stable growth model to derive its price to book ratio: 
      Plugging in the median bank’s numbers into this equation and using a nominal growth rate set equal to the risk free rate of 1.60% (in US dollars), I estimate a US $ cost of equity for the median bank to be 9.44% in 2016. 

      Using the same approach, I arrive at estimates of 7.76% for the banks that are at the 25th percentile of risk and 10.20% for banks at the 75th percentile.  In valuing Deutsche Bank, I will start the valuation by assuming that the bank is at the 75th percentile of all banks in terms of risk and give it a cost of equity of 10.20%. As the bank finds its legs on profitability and improves its regulatory capital levels, I will assume that the cost of equity moves to the median of 9.44%. 

      The Valuation 
      Starting with net income from part a, adjusting for reinvestment in the form of regulatory capital in part b and adjusting for risk in part c, we obtain the following table of numbers for Deutsche Bank. 

      YearFCFETerminal ValueCost of equity Cumulative Cost of EquityPV
      1$(11,663)10.20%1.1020$(10,583.40)
      2$(3,658)10.20%1.2144$(3,012.36)
      3$(1,576)10.20%1.3383$(1,177.54)
      4$(133)10.20%1.4748$(90.34)
      5$2,874 10.20%1.6252$1,768.16
      6$3,516 10.05%1.7885$1,965.99
      7$4,185 9.90%1.9655$2,129.10
      8$4,880 9.74%2.1570$2,262.34
      9$5,602 9.59%2.3639$2,369.91
      10$6,352 $87,317 9.44%2.5871$36,206.88
      Total value of equity $31,838.74
      Value per share =$22.97
      Note that the big number as the terminal value in year 10 reflects the expectation that Deutsche will grow at the inflation rate (1% in US dollar terms) in perpetuity while earning its cost of equity. Note also that since the cost of equity is expected to change over time, the cumulated cost of equity has to be computed as the discount factor. The discounted present value of the cash flows is $31.84 billion, which when divided by the number of shares (1,386 million) yields a value of $22.97 per share. There is one final adjustment that I will make and it reflects the special peril that banks face, when in crisis mode. There is the possibility that the perception that the bank is in trouble could make it impossible to function normally and that the government will have to step in to bail it out (since the option of letting it default is not on the table). I may be over optimistic but I attach only a 10% chance to this occurring and assume that my equity will be completely wiped out, if it occurs. My adjusted value is: 
      Expected Value per share = $22.97(.9) + $0.00 (.1) = $20.67 
      Given my many assumptions, the value per share that I get for Deutsche Bank is $20.67. To illustrate how much the regulatory capital shortfall (and the resulting equity issues/dilution) and overhang of a catastrophic loss affect this value, I have deconstructed the value per share into its constituent effects: 

      Unadjusted Equity Value =$33.63
      - Dilution Effect from new equity issues$(10.66)
      - Expected cost of equity wipeout$(2.30)
      Value of equity per share today =$20.67

      Note that the dilution effect, captured by taking the present value of the negative FCFE in the first four years, reduces the value of equity by 31.69% and the possibility of a catastrophic loss of equity lowers the value another 6.83%. The entire valuation is pictured below:
      Download Spreadsheet
      I know that you will disagree with some or perhaps all of my assumptions. To accommodate those differences, I have set up my valuation spreadsheet to allow for you to replace my assumptions with yours. If you are so inclined, please do enter your numbers into the shared Google spreadsheet that I have created for this purpose and let's get a crowd valuation going!

      Time for action or Excuse for inaction? 
      At the current stock price of $13.33 (at close of trading on October 4), the stock looks undervalued by about 36%, given my estimated value, and I did buy the stock at the start of trading yesterday. Like everyone else in the market, I am uncertain, but waiting for the uncertainty to resolve itself is not a winning strategy. Either the uncertainty will be resolved (in good or bad ways) and everyone will have clarity on what Deutsche is worth, and the price and value will adjust, or the uncertainty will not resolve itself in the near future and you will be sitting on the side lines. For those of you who have been reading my blog over time, you know that I have played this game before, with mixed results. My bets on JP Morgan (after its massive trading loss in 2012) and Volkswagen (after the emissions scandal) paid off well but my investment in Valeant (after its multiple scandals) has lost me 15% so far (but I am still holding and hoping). I am hoping that my Deutsche Bank investment does better, but I strapped in for a rocky ride!

      YouTube Videos


      Attachments

      1. My valuation of Deutsche Bank
      2. Global Banks - Data
      3. Google Shared Spreadsheet: Crowd Valuation of Deutsche Bank



      Venture Capital: It is a pricing, not a value, game!

      Venture capitalists (VCs) don’t value companies, they price them! Before you explode, implode or respond with righteous indignation, this is not a critique of what venture capitalists do, but a recognition of reality. In fact, not only is pricing exactly what you should expect from VCs but it lies at the heart of what separates the elite from the average venture capitalist. I was reminded of this when I read a response from Scott Kupor of Andreessen Horowitz, to a Wall Street Journal article about Andreessen, that suggested that the returns earned by the firm on its funds were not as good as those earned at other elite funds. While Scott’s intent was to show that the Wall Street Journal reporter erred in trusting total returns as a measure of VC performance, I think that he, perhaps unintentionally, opened a Pandora’s box when he talked about how VCs attach numbers to companies and how these numbers get updated, and how we (investors, founders and VCs) should read them, as a consequence.

      The WSJ versus the VC: A Recap
      Let’s start with the Wall Street Journal article that triggered the Kupor response. With the provocative title of “Andreessen Horowitz’s returns trail venture capital elite”, it had all the ingredients for click bait, since a big name (Andreessen Horowitz) failing (“trail venture capital elite”) is always going to attract attention. I must confess that I fell for the bait and read the article and walked away unimpressed. In effect, Rolfe Winkler, the Journal reporter, took the three VC funds run by Andreessen and computed an IRR based upon the realized and unrealized gains at these funds. I have reproduced his graph below:

      While the title of the story is technically correct, I am not sure that there is much of a story here. Even if you take the Journal’s estimates of returns at face value, if I were an investor in any of the three Andreessen funds, I would not be complaining about annual returns of 25%-42%, depending on the fund that I invested in. Arguing that I could have done better by investing in a fund in the top 5% of the VC universe would be the equivalent of claiming that Kevin Durant did not having a good NBA season last year, because Lebron James and Stephen Curry had better seasons.

      In the hyper-competitive business of venture capital, though, the article must have drawn blood, since it drew Scott Kupor's attention and a response. Scott focused attention specifically on what he believed was the weakest link in the Journal article, the combining of realized and unrealized gains to estimate an internal rate of return. Unlike investments in public equities, where the unrealized returns are based upon observed market prices for traded stocks and can be converted to realized returns relatively painlessly, Scott noted that unrealized returns at venture capital funds are based upon estimates and that these estimates are themselves based upon opaque VC investments in other companies in the space and not easily monetized. Implicitly, he seemed to be saying that not only are unrealized returns at VC funds subject to estimation error, but also to bias, and should thus be viewed as softer than realized returns. I agree, though I think it is disingenuous to go on to argue that unrealized returns should not be considered when evaluating venture capital performance, since VCs seem to have qualms about using them in sales pitches when they serve their purpose.

      The VC Game
      The Kupor response has been picked in the VC space, with some commenters augmenting legitimate points about return measurement but many more using the WSJ article to restate their view that non-VC people should stop opining about the VC business, because they don’t understand how it works. Having been on the receiving end of this critique at times in the past, you would think I would know better than to butt in, but I just can’t help myself. I may not be qualified to talk about the inner workings of the venture capital business, but I do believe that I am on firmer ground on the specific topic of how VCs attach numbers to the companies that they invest in.

      VCs price businesses, not value them!
      I have made the distinction between value and price so many times before that I sound like a broken record, but I will make it again. You can value an asset, based upon its fundamentals (cash flows, growth and risk) or price it, based upon what others are paying for similar assets, and the two can yield different numbers.

      In public investing, I have argued that this plays out in whether you choose to play the value game (invest in assets where the price < value and hope that the market corrects) or the pricing game (where you trade assets, buying at a lower price and hoping to sell at a higher).  I would be glad to be offered evidence to the contrary but based upon the many VC "valuations" that I have seen, VCs almost always play the pricing game, when attaching numbers to companies, and there are four ways in which they seem to do it:
      1. Recent pricing of the same company: In the most limited version of this game, a prospective or existing investor in a private business looks at what investors in the most recent prior round have priced the company to gauge whether they are getting a reasonable price. Thus, for an Uber, this would imply that a pricing close to the $62.5 billion that the Saudi Sovereign fund priced the company at, when it invested $3.5 billion in June 2016, will become your benchmark for a reasonable price, if you are investing close to that date. The dangers in doing this are numerous and include not only the possibility of a pricing mistake (a new investor who over or under prices the company) spiraling up and down the chain, but also the problems with extrapolating to the value of a company from a VC investment in it.
      2. Pricing of “similar” private companies: In a slightly more expanded version of this process, you would look at what investors are paying for similar companies in the “same space” (with all of the subjective judgments of what comprises “similar” and “same space”), scale this price to revenues, or lacking that, a common metric for that space, and price your company. Staying in the ride sharing space, you could price Lyft, based upon the most recent Uber transaction, by scaling the pricing of the company to its revenues (relative to Uber) or to rides or number of cities served.
      3. Pricing of public companies, with post-value adjustments: In the rare cases where a private business has enough operating substance today, in the form of revenues or even earnings, in a space where there are public companies, you could use the pricing of public companies as your basis for pricing private businesses. Thus, if your private business is in the gaming business and has $100 million in revenues and publicly traded companies in that business trade at 2.5 times revenues, your estimated value would be $250 million. That value, though, assumes that you are liquid (as publicly companies tend to be) and held by investors who can spread their risks (across portfolios). Consequently, a discount for lack of liquidity and perhaps diversification is applied, though the magnitude (20%, 30% or more) is one of the tougher numbers to estimate and justify in practice.
      4. Forward pricing: The problem with young start-ups is that operating metrics (even raw ones like riders, users or downloads) are often either non-existent or too small to be base a pricing. To get numbers of any substance, you often have to forecast out the metrics two, three or five years out and then apply a pricing multiple to these numbers. The forecasted metric can be earnings, or if that still is ephermal, it can be revenues, and the pricing multiple can be obtained not just from private transactions but from the public market (by looking at companies that have gone public). That forward value has to be brought back to today and to do so, venture capitalists use a target rate of return. While this target rate of return plays the same mechanical role that a discount rate in a DCF does, that is where the resemblance ends. Unlike a discount rate, a number designed to incorporate the risk in the expected cash flows for a going concern, a target rate of return incorporates not just conventional going-concern risk but also survival risk (since many young companies don’t make it) and the fear of dilution (a logical consequence of the cash burn at young companies), while also playing role as a negotiating tool. Even the occasional VC intrinsic value (taking the form of a DCF) is a forward pricing in disguise, with the terminal value being estimated using a multiple on that year's earnings or revenues.

      At the time of a VC investment, the VC wants to push today’s pricing for the company lower, so that he or she can get a greater share of the equity for a given investment in the company. Subsequent to the investment, the VC will want the pricing to go higher for two reasons. First, it makes the unrealized returns on the VC portfolio a much more attractive number. Second, it also means that any subsequent equity capital raised will dilute the VC’s ownership stake less. If you reading this as a criticism of how venture capitalists attach numbers to companies, you are misreading it because I think that this is exactly what venture capitalists should be doing, given how success is measured in the business. This is a business where success is measured less on the quality of the companies that you build (in terms of the cash flows and profits they generate) and more on the price you paid to get into the business and the price at which you exit this business, with that exit coming from either an IPO or a sale. Consequently, how much you are willing to pay for something becomes a process of judging what you will get when you exit and working backwards.

      But Venture Capitalists have a data problem
      It is not just venture capitalists who play the pricing game. As I have argued before, most investors in public markets (including many who call themselves value investors) are also in the pricing game, though they use pricing metrics of longer standing (from PE to EV/EBITDA) and have larger samples of public traded firms as comparable firms. The challenges with adapting this pricing game to venture capital investments are primarily statistical:
      1. Small Samples: If your pricing is based upon other private company investments, your sample sizes will tend to be much smaller, if you are a VC than if you a public company investor. Thus, as an investor in a publicly traded oil company, I can draw on 351 publicly traded firms in the US or even the 1029 publicly traded companies globally, when making relative value or pricing judgments. A VC investor pricing a ride sharing company is drawing on a sample of less than ten ride sharing firms globally.
      2. With Infrequent Updating: The small sample problem is exacerbated by the fact that unlike public companies, where trading is frequent and prices get updated for most of the companies in my sample almost continuously, private company transactions are few and far between. In many ways, the VC pricing problem is closer to the real estate pricing than conventional stock pricing, where you have to price a property based upon similar properties that have sold in the recent past.
      3. And Opaque transactions: There is a third problem that makes VC pricing complicated. Unlike public equities, where a share of stock is (for the most part) like any other share of stock and the total market value is the share price times number of shares outstanding, extrapolating from a VC investment for a share in a company to the overall value of equity can be and often is complicated. Why? As I noted in an earlier post on unicorn valuations, the VC investment at each stage of capital-raising is structured differently, with a myriad of options embedded in it, some designed for protection (against dilution and future equity rounds) and some for opportunity (allowing future investments at favorable prices). As I noted in that post, a start-up with a "true" value of $750 million can structure an investment, where the VC pays $50 million (instead of $37.5 million) for 5% of the company, by adding enough optionality to the investment. I may be misreading Scott's section on using option pricing to price VC investments, but if I am reading it right, I think Scott is saying that Andreessen uses option pricing models to clean up for the add-on options in VC investments to get to the fair value. Put differently, Andreessen would put a value of $750 million on this company rather than the $1 billion that you would get from extrapolating from the $50 million for 5%.
      I am sure that nothing that I have said here is new to venture capitalists, founders and those close to the VC process, but it is the subtle differences that throw off those whose primary experience is in the public markets. That is one reason that public investors should take the numbers that are often bandied about as valuations of private companies (like Palantir, Uber and Airbnb) with a grain of salt.  It is also why I think that public investors like mutual funds and university endowment funds should either tread lightly or not all in the space. Even within the VC business, it is sometimes easy, especially in buoyant times to forget how much the entire pricing edifice rests as much on momentum and mood, as it does on the underlying fundamentals.

      With Predictable Consequences
      So, let’s see. VCs price companies and that pricing is often based upon really small samples with infrequently updated and tough-to-read data. The consequences are predictable.
      1. The pricing estimates will have more noise (error) attached to them. The pricing that I obtain for Lyft, based upon the pricing of Uber, Didi Chuxing and GrabTaxi, will have a larger band around the estimate and there is a greater chance that I will be wrong. 
      2. The pricing will be more subjective, since you have the freedom to choose your comparable firms and often can use discretion to adjust for the infrequent data updating and the complexity of equity investments. While that may seem to just be a restatement of the first critique, there is also a much greater potential for bias to enter into the process. Not surprisingly, therefore, not all VC returns are created equal, especially when it comes to the unrealized portion, with more aggressive VCs reporting “higher” returns than less aggressive VCs. That is perhaps the point being made by Scott about realized versus unrealized returns.
      3. The pricing will lag the market: It is a well-established fact that the capital coming into the VC business ebbs and flows across time, with the number of transactions increasing in up markets and dropping in down markets. When there is a severe correction (say, just after the dot-com bust), transactions can come to a standstill, making repricing difficult, if not impossible. If VCs hold off on full repricing until transactions pick up again, there can be a significant lag between when prices drop at young companies and those price drops getting reflected in returns at VC firms.
      4. There is a price feedback loop: Since VC pricing is based upon small samples with infrequent transactions, it is susceptible to feedback loops, where one badly priced transaction (in either direction) can trigger many more badly priced transactions. 
      5. And a time horizon issue: The lack of liquidity and small samples that get in the way of pricing holdings also introduce a constraint into the pricing game. Unlike public market investors, where the pricing game can be played in minutes or even fractions of a minute on liquid stocks, private market pricing requires patience and more of it, the younger a company is. Put differently, winning at the VC pricing game may require that you take a position in a young start up and bide your time until you build it up and find someone who will find it attractive enough to offer you a much higher price for it. This is perhaps what Scott was talking about, in his response, when he talked about this being VC investing being a "long" game.
      There is one final point that also needs to be made. Much as we like to talk about the VC market and the public market as separate, populated by different species, they are linked at the hip. To the extent that a venture capitalist has to plot an exit, either in an initial public offering or by selling to a publicity traded company, if the public market catches a cold, the venture capital market will get pneumonia, though the diagnosis may come much later.
      The VC Edge
      If I were to summarize the entire post in a couple of sentences, here is what it would say. Venture capitalists price the companies they invest in, base that pricing on small samples of opaque transactions and the pricing is therefore more likely to be wrong and lag reality. That sounds pretty damning, but I think that these features work to the advantage of venture capitalists, or at least the very best among them. That may sound contradictory, but here is my basis for making that statement.
      1. The average VC does better than the average public market active investor: Both VC and public market investors play the pricing game, with the latter having the advantage of more and better data, but over time, venture capitalists seem to deliver better results than public market investors, as seen in the graph below. These are raw returns and I do realize that you have to adjust for risk, but some of the biggest risks in venture capital (failure risk) have already been incorporated into long term returns. 
        Source: Cambridge Associates
      2. The Elite: The most successful VCs not only earn higher returns than the top public market investors but that there seems to be more consistency in the VC business, insofar as the best of the VCs are able to generate higher returns across longer time periods. That would suggest that venture capitalists bring more durable competitive advantages to the investing game than public market investors.
      How do I reconcile my argument that the VC pricing game is inherently more error-prone and noisy with the fact that VCs seem to make money at it? I think that the very factors that make it so difficult to price and profit of a VC investment are what allow VCs collectively to earn excess returns and the very best VCs to set themselves apart from the rest. In particular, the best in the business set themselves apart from the rest on three dimensions:
      1. They are better pricers (relatively): As Scott notes in his piece, the price that you can attach to a VC investment can vary widely across investors and he uses the example of how Andreessen's option pricing approach can yield a lower pricing for the same company than an alternative approach. While all of these prices are undoubtedly wrong (because they are estimates), some of them are less wrong than others. Repeating a statement that I have made before, you don't have to be right to make money, you just have to be less wrong than everyone else and the chances of you doing that are greater in the VC pricing game.  
      2. They can influence the pricing game: Unlike public market investors, who for the most part can observe company metrics but not change them, venture capitalists can take a more active role in the companies that they invest in, from informally advising managers to more formal roles as board members, helping these companies decide what metrics to focus on, how to improve these metrics and how (and when) to cash in on them (from an IPO or a sale).
      3. They have better timing: The pricing game is all about timing, and the VC pricing game is more emphatically so. To be successful, you not only have to time your entry into a business right but even more critically, time your exit from it. 
      If you are an investor in a VC fund, therefore, you should of course look at both realized returns and unrealized returns, but you should also look at how the fund measures its unrealized returns and how it has generated its returns. A realized return that comes primarily from one big hit is clearly less indicative of skill than a return that reflects multiple hits over longer time periods. After all, if separating luck from skill is difficult in the public marketplace, it can become even more so in the venture capital business.

      YouTube Video



      Myth 5.5: The Terminal Value ate my DCF!

      When you complete a discounted cash flow valuation of a company with a growth window and a terminal value at the end, it is natural to consider how much of your value today comes from your terminal value but it is easy to interpret this number incorrectly. First, there is a perception that if the terminal value is a high proportion of your value today, the DCF is inherently unreliable, perhaps a reflection of old value investing roots. Second, following up on the realization that a high percentage of your current value comes from your terminal value, you may start believing that the assumptions that you make about high growth therefore don't matter as much as the assumptions you make in your terminal valuation. Neither presumption is correct but they are deeply held!

      If the terminal value is a high percent of value, your DCF is flawed!
      To understand why the terminal value is such a high proportion of the current value, it is perhaps best to deconstruct a discounted cash flow valuation in the form of the return that you make from investing in the equity of a business. For simplicity, let’s assume that you are discounting cash flows to equity (dividends of free cash flow to equity) to arrive at a value of equity today:

      Note that if you were to invest at the current value and hold through the end of your growth period, your returns will take the form of annual cash flows (yield) for the first five years and an expected price appreciation, captured as the difference between the terminal value and the value today. So what? Consider how investors have historically made money on stocks, decomposing US stock returns from 1928 through 2015 in the graph below:

      1-Year Horizon5-Year Horizon10-year Horizon
      1928-2015
      67.09%
      67.57%
      70.09%
      1966-2015
      72.43%
      73.42%
      75.10%
      1996-2015
      81.51%
      84.11%
      85.28%
      Note that no matter what time period you use in your assessment, the bulk of your return has taken the form of price appreciation and not dividends. Consequently, you should not be surprised to see the bulk of your value in a DCF come from your terminal value. In fact, it is when it does not account for the bulk of the value that you should be wary of a DCF!

      Determinants of Terminal Value Proportion
      While the terminal value will be a high proportion of the current value for all companies, the proportion of value that is explained by the terminal value will vary across companies. When you buy a mature company, you will get larger and more positive cash flows up front, and not surprisingly, if you put a 5-year or a 10-year growth window, you will get a smaller percentage of your value today from the terminal value than for a growth company, which is likely to have low (or even negative0 cash flows in the early years (because of reinvestment needs) before you can collect your terminal value. This can be seen numerically in the table below, where I estimate the percentage of current equity value that is explained by the terminal equity value for a firm with a high growth period of 5 years, varying the expected growth over the next 5 years and the efficiency with which that growth is delivered (through the return on equity):

      Excess Growth Rate (next 5 years)ROE = COE -2%ROE = COEROE = COE +2%
      0%
      75.14%
      75.14%
      75.14%
      2%
      86.30%
      82.53%
      80.86%
      4%
      100.00%
      90.76%
      86.75%
      6%
      117.24%
      100.00%
      93.15%
      8%
      139.59%
      110.44%
      100.00%
      10%
      169.71%
      122.33%
      107.35%
      In fact, if the reinvestment needs are large enough or the company is not quite ready to make profits, you can get more than 100% of your value today  from the terminal value. While that sounds patently absurd, it reflects the reality that when your cash flows are negative in the early years (as a result of high growth and reinvestment), your equity holding may get diluted in those years as the company raises new equity (by issuing shares). Note that to the extent that the cash flows come in as anticipated, with high growth and low/negative cash flows, you will not have to wait until the terminal year to cash out, since the price adjustment will lead the cash flows turning positive. (You can download the spreadsheet and try your own numbers)

      If your terminal value accounts for most of your value, your growth assumptions don’t matter
      If you accept the premise that the terminal value, in any well-done DCF, will account for a big proportion of the current value of the firm and that proportion will get higher, as growth increases, it seems logical to conclude that you should spend most of your time in a DCF finessing your assumptions about terminal value and very little on the assumptions that you make during the high growth period. Not only is this a dangerous leap of logic, but it is also not true. To see why, let me take the simple example of a firm with after-tax operating income of $100 million in the most recent year, a five-year high growth period , after which earnings will grow at 2% a year forever, with a 8% cost of equity. Holding the terminal growth rate fixed, I varied the growth rate in the high growth period and the return on equity. The resulting terminal values are reported in the table below:

      Excess Growth Rate (next 5 years)ROE = COE -2%ROE = COEROE = COE +2%
      0%
      $1,227.00
      $1,380.00
      $1,472.00
      2%
      $1,326.00
      $1,491.00
      $1,591.00
      4%
      $1,431.00
      $1,610.00
      $1,717.00
      6%
      $1,542.00
      $1,734.00
      $1,850.00
      8%
      $1,659.00
      $1,864.00
      $1,991.00
      10%
      $1,783.00
      $2,006.00
      $2,140.00
      Note that assuming a much higher growth rate and return on equity in the first five years has a large impact on my terminal value, even though the terminal growth rate remains unchanged. This effect will get larger for high growth firms and for longer growth periods. The conclusion that I would draw is ironic: as the terminal value accounts for a larger and larger percent of my current value, I should be paying more attention to the assumptions I make about my high growth period, not less!

      Conclusion
      If you are valuing equity in a going concern with a long life, you should not be surprised to see the terminal value in your DCF account for a high percentage of value. Contrary to what some may tell you, this is not a flaw in your valuation but a reflection of how investors make money from equity investments, i.e., predominantly from capital gains or price appreciation. You should also be aware of the fact that even though the terminal value will be a high proportion of current value, you should still pay attention to your assumptions about cash flows and growth during your high growth period, since your terminal value will be determined largely by these assumptions.

      YouTube Video



      Attachments
      1. Returns on US Stocks: Dividends and Capital Gains
      2. Spreadsheet to compute effect of growth assumptions on terminal value
      DCF Myth Posts
      1. If you have a D(discount rate) and a CF (cash flow), you have a DCF.  
      2. A DCF is an exercise in modeling & number crunching. 
      3. You cannot do a DCF when there is too much uncertainty.
      4. It's all about D in the DCF (Myths 4.14.24.34.4 & 4.5)
      5. The Terminal Value: Elephant in the Room! (Myths 5.15.25.35.4 & 5.5)
      6. A DCF requires too many assumptions and can be manipulated to yield any value you want.
      7. A DCF cannot value brand name or other intangibles. 
      8. A DCF yields a conservative estimate of value. 
      9. If your DCF value changes significantly over time, there is something wrong with your valuation.
      10. A DCF is an academic exercise.




      Myth 5.4: Negative Growth Rates forever? Impossible!


      As you peruse discounted cash flow valuations, it is striking how infrequently you see projections of negative growth into the future, even for companies where the trend lines in revenues and earnings have been anything but positive. Furthermore, you almost never see a terminal value calculation, where the analyst assumes a negative growth rate in perpetuity. In fact, when you bring up the possibility, the first reaction that you get is that it is impossible to estimate terminal value with a negative growth rate. In this post, I will present evidence that negative growth is neither uncommon nor unnatural and that the best course, from a value perspective, for some firms is to shrink rather than grow.

      Negative Growth Rates: More common than you think!
      The belief that most firms have positive growth over time is perhaps nurtured by the belief that it is unnatural for firms to have negative growth and that while companies may have a year or two of negative growth, they bounce back to positive growth sooner rather than later. To evaluate whether this belief has a basis in fact, I looked at compounded annual growth rate (CAGR) in revenues in the most recent calendar year (2015), the last five calendar years  (2011-2015)and the last ten calendar years (2006-2015) for both US and global companies and computed the percent of all companies (my sample size is 46,814 companies) that have had negative growth over each of those time periods:

      RegionNumber of firms% with negative revenue growth in 2015% with negative CAGR in revenues: 2011-2015% with negative CAGR in revenues: 2006-2015
      Australia, NZ and Canada
      5014
      41.44%
      36.73%
      28.20%
      Developed Europe
      7082
      33.42%
      30.03%
      24.25%
      Emerging Markets
      21196
      43.06%
      29.35%
      21.50%
      Japan
      3698
      33.41%
      20.76%
      31.80%
      United States
      9823
      39.69%
      26.76%
      28.10%
      Grand Total
      46814
      39.86%
      28.64%
      24.69%
      Note that almost 40% of all companies, in both the US and globally, saw revenues decline in 2015 and that 25% of all companies (and 27% of US companies) saw revenues decline (on a CAGR basis) between 2006 and 2015. (If you are interested in a break down by country, you can download the spreadsheet by clicking here.) Digging a little deeper, while there are company-specific reasons for revenue declines, there are also clearly sector effects, with companies in some sectors more likely to see revenues shrink than others. In the table below, I list the ten non-financial sectors with the highest percentage of companies (I excluded financial service companies because revenues are difficult to define, not because of any built-in bias):

      Industry GroupingNumber of firms% Negative in 2015% with Negative CAGR from 2011-2015% with Negative CAGR  from 20106-2015
      Publshing & Newspapers
      346
      53.77%
      48.44%
      45.69%
      Computers/Peripherals
      327
      43.30%
      42.12%
      45.65%
      Electronics (Consumer & Office)
      152
      43.70%
      47.11%
      44.44%
      Homebuilding
      164
      31.51%
      22.69%
      35.87%
      Oil/Gas (Production and Exploration)
      959
      79.22%
      43.75%
      35.40%
      Food Wholesalers
      126
      37.00%
      30.59%
      33.33%
      Office Equipment & Services
      160
      40.58%
      32.54%
      33.33%
      Real Estate (General/Diversified)
      418
      41.33%
      32.72%
      32.52%
      Telecom. Equipment
      473
      43.00%
      37.36%
      32.43%
      Steel
      757
      73.23%
      50.65%
      32.08%
      So what? For some of these sectors (like real estate and homebuilding), the negative revenue growth may just be a reflection of long cycles playing out but for others, it may be an indication that the business is shrinking. If you are valuing a company in one of these sectors, you should be more open to the possibility that growth in the long term could be negative. (If you interested in downloading the full list, click on this link.)

      Negative Growth Rates: A Corporate Life Cycle Perspective
      One framework that I find useful for understanding both corporate finance and valuation issues is the corporate life cycle, where I trace a company’s life from birth (as a start-up) to decline and connect it to expectations about revenue growth and profit margins:
      If you buy into this notion of a life cycle, you can already see that valuation, at least as taught in classes/books and practiced, is not in keeping with the concept. After all, if you apply a positive growth rate in perpetuity to every firm that you value, the life cycle that is more in keeping with this view of the world is the following:

      The problem with this life cycle perspective is that the global market place is not big enough to accommodate these ever-expanding behemoths. It follows, therefore, that there have to be companies (and a significant number at that) where the future holds shrinkage rather than growth. Fitting this perspective back into the corporate life cycle, you should be using a negative growth rate in revenues and perhaps declining margins to go with those shrinking revenues in your valuation, if your company is already in decline. If you are valuing a company that is mature right now (with positive but very low growth) but the overall market is stagnant or starting to decline, you should be open to the possibility that growth could become negative at the end of your forecast horizon.

      There is an extension of the corporate life cycle that may also have implications for valuation. In an earlier post, I noted that tech companies age in dog years and often have compressed life cycles, growing faster, reaping benefits for shorter time periods and declining more precipitously than non-tech companies. When valuing tech companies, it may behoove us to reflect these characteristics in shorter (and more exuberant) growth periods, fewer years of stable growth and terminal growth periods with negative growth rates.

      Negative Growth Rates: The Mechanics
      As I noted in my last post, the growth rate in perpetuity cannot exceed the growth rate of the economy but it can be lower and that lower number can be negative. It is entirely possible that once you get to your terminal year, that your cash flows have peaked and will drop 2% a year in perpetuity thereafter. Mathematically, the perpetual growth model still holds:
      If you do assume negative growth, though, you have to examine whether as the firm shrinks, it will be able to divest assets and collect cash. If the answer is no, the effect of negative growth is unambiguously negative and the terminal value will decline as growth gets more negative. If the answer is yes, the effect of negative growth in value will depend upon how much you will get from divesting assets.

      To illustrate, consider the example of the firm with $100 million in expected after-tax operating income next year, that is in perpetual growth and let’s assume a perpetual growth rate of -5% a year forever. If you assume that as the firm shrinks, there will be no cash flows from selling or liquidating assets, the terminal value with a 10% cost of capital is:
      Terminal value = $100/ (.10-(-.05)) = $666.67
      If you assume that there are assets that are being liquidated as the firm shrinks, you have to estimate the return on capital on these assets and compute a reinvestment rate. If the assets that you are liquidating, for instance, have a 7.5% return on invested capital, the reinvestment rate will be -66.67%.
      Reinvestment rate = -5%/7.5% = 66.67%
      If you are puzzled by a negative reinvestment rate, it as the cash inflow that you are generating from asset sales, and your terminal value will then be:
      Terminal value = $100 (1-(-0.6667))/ (.10 – (-.05)) = $1,111.33
      Put simply, the same rule that governs whether the terminal value will increase if you increase the growth rate, i.e., whether the return on capital is greater than the cost of capital, works in reverse when you have negative growth. As long as you can get more for divesting assets than as continuing investments (present value of cash flows), liquidating them will increase your terminal value. 

      Negative Growth: Managerial Implications
      Our unwillingness to consider using negative growth in valuation has turned the game over to growth advocates. Not surprisingly, there are many in academia and practice who argue that the essence of good management is to grow businesses and that the end game for companies is corporate sustainability. That's nonsense! If you are a firm in a declining business where new investments consistently generate less than the cost of capital, your attempts to sustain and grow yourself can only destroy value rather than increase it. It is with this, in mind, that I argued in an earlier post that the qualities that we look for in a CEO or top manager will be different for companies at different stages of the life cycle: 

      A visionary at the helm is a huge plus early in corporate life, but it is skill as a business builder that allows young companies to scale up and become successful growth companies. As growth companies get larger, the skill set shifts again towards opportunism, the capacity to find growth in new places, and then again at mature companies, where it management’s ability to defend moats and competitive advantages that allow companies to harvest cash flows for longer periods. In decline, it is not vision that you value but pragmatism and mercantilism, one reason that I chose Larry the Liquidator as the role model. It is worth noting, though, that the way we honor and reward managers follows the growth advocate rule book, with those CEOs who grow their companies being put on a much higher pedestal (with books written by and about them and movies on their lives) than those less ambitious souls who presided over the gradual liquidation of the companies under their command. 

      Conclusion
      I believe that the primary reason that we continue to stay with positive growth rates in valuation is behavioral. It seems unnatural and even unfair to assume that the firm that you are valuing will see shrinking revenues and declining margins, even if that is the truth. There are two things worth remembering here. The first is that your valuation should be your attempt to try to reflect reality and refusing to deal with that reality (if it is pessimistic) will bias your valuation. The second is that assuming a company will shrink may be good for that company's value, if the business it is in has deteriorated. I must confess that I don't use negative growth rates often enough in my own valuations and I should draw on them more often not only when I value companies like brick and mortar retail companies, facing daunting competition, but also when I value technology companies like GoPro, where the product life cycle is short and it is difficult to keep revitalizing your business model.


      YouTube Video


      Attachments
      1. Percent of negative revenue growth companies, by sector
      2. Percent of negative revenue growth companies, by country and region
      DCF Myth Posts
      1. If you have a D(discount rate) and a CF (cash flow), you have a DCF.  
      2. A DCF is an exercise in modeling & number crunching. 
      3. You cannot do a DCF when there is too much uncertainty.
      4. It's all about D in the DCF (Myths 4.14.24.34.4 & 4.5)
      5. The Terminal Value: Elephant in the Room! (Myths 5.15.25.35.4 & 5.5)
      6. A DCF requires too many assumptions and can be manipulated to yield any value you want.
      7. A DCF cannot value brand name or other intangibles. 
      8. A DCF yields a conservative estimate of value. 
      9. If your DCF value changes significantly over time, there is something wrong with your valuation.
      10. A DCF is an academic exercise.



      Myth 5.3: Growth is good, more growth is better!

      The perils of holding all else constant in perpetual growth equations and playing with individual inputs, not only leads to the use of impossibly high growth rates but also inflates the importance of growth in the terminal value estimation. Growth is not free and it has to be paid for with reinvestment and in the terminal value equation, this effectively means that you cannot leave cash flows fixed and change the growth rate. As the growth rate increases, even within reasonable bounds, the company will have to reinvest more to deliver that growth, leading to lower cash flows, thus making the effect on value unpredictable.

      Paying for Growth
      To make this relationship explicit, let us start by defining the two fundamental drivers of growth, a measure of how much the company reinvests (reinvestment rate) and how well it reinvests (Return on invested capital)
      In stable growth, the expected growth rate has to be a product of these two numbers
      Growth rate = Reinvestment Rate (RR) * Return on Invested Capital (ROIC)
      Over finite time periods, the growth rate for a company can be higher or lower than this "sustainable" growth rate, as profit margins and operating efficiency change, but once you get to the terminal value, where you are looking at forever, there is no evading its reach. Isolating the reinvestment rate in the equation and plugging back into the terminal value equation, here is what we get:
      Thus, as g changes, both the numerator and denominator change. For a firm that expects to generate $100 million in after-tax operating income next year, with a cost of capital of 10%, the terminal value can be estimated as a function of the ROIC it earns on its marginal investments in perpetuity. With a growth rate of 3% and a return on capital is 12%, for instance, the terminal value is:
      Changing the growth rate will have two effects: it will change the cash flow (by altering reinvestment) and change the denominator, and it is the net effect that determines whether and how much value will change.

      The Excess Return Effect
      Tying growth to reinvestment leads us to a simple conclusion. It is not the growth rate per se, but the excess returns (the difference between return on invested capital and the cost of capital) that drives value. In the table below, I take much of the hypothetical example from above (a company with expected operating income of $100 million next year and a cost of capital of 10%) and examine the effects of changing growth rate on value, for a range of returns on capital.
      Note that as you increase the growth rate in perpetuity from 0% to 3%, the effect on the terminal value is unpredictable, decreasing when the return on invested capital < cost of capital, unchanged when the ROIC = Cost of capital and increasing when the ROIC> Cost of capital. In fact, you an just as easily construct an equity version of the terminal value and show that the growth rate in equity earnings can affect equity value only if the ROE that you assume in perpetuity is different from your cost of equity.

      There are a few valuation purists who argue that the only assumption that is consistent with a mature, stable growth company is that it earns zero excess returns, since no company can have competitive advantages that last forever. If you make that assumption, you might as well dispense with estimating a stable growth rate and estimate a terminal value with a zero growth rate. While I see a basis for the argument, it runs into a reality check, i.e., that excess returns seem to last far longer than high growth rates do. Thus, your high growth period has to be extended to cover the entire excess return period, which may be twenty, thirty or forty years long, defeating the point of computing terminal value. It is for this reason that I adopt the practice of assuming that excess returns will move towards zero in stable growth and giving myself discretion on how much, with zero excess return being my choice for firms with few or no sustainable competitive advantages, a positive excess return for firms with strong and sustainable competitive advantages and even negative excess return for badly managed firms with entrenched management.

      Two Dangerous Practices
      If you follow the practice of tying growth to reinvestment, you will be well-armed against some of the more dangerous practices in terminal value estimation.
      1. Grow the nth year's cash flow: If you consider the perpetual growth equation in its simplest form, it looks as follows:
      The sheer simplicity of the equation can lull you into a false sense of complacency. After all, if you have projected the free cash flows for the your high growth period of 5 years, i.e, the cash flows after taxes and reinvestment, and you want to estimate your terminal value at the end of year 5, it seems to follow that you can grow your free cash flow in year 5 one more year at the stable growth rate to get your numerator for the terminal value calculation. The danger with doing is that you have effectively locked in whatever your reinvestment rate was in year 5 now into perpetuity and to the extent that this reinvestment rate is no longer compatible with your stable growth rate, you will misvalue your firm. For example, assume that you have a firm with $100 million in after-tax operating earnings that you expect to grow 10% a year for the next five years, with a reinvestment rate of 66.67%% and a return on investment of 15% backing up the growth; after year 5, assume that the expected growth rate will drop to 3%, with a cost of capital of 10%. In the table below, I illustrate the effect on value today of using the "just grow the year 5 free cash flow" and contrast it with the value that you would obtain if you recomputed your terminal year's cash flow, with a reinvestment rate of 20%, compatible with your stable growth rate and return on capital
      Note that just growing out the FCFF yields a value today of only $605 million, about half of the (right) value that you get with a recomputed FCFF.
      2. Stable Growth firms don't need to reinvest: I am not sure what the roots of this absurd practice are but they are deep. Analysts seems to be willing to assume that when you get to stable growth, you can set capital expenditures = depreciation, ignore working capital changes and effectively make the reinvestment rate zero, while allowing the firm to continue growing at a stable growth rate. That argument fails at two levels. The first is that if you reinvest nothing, your invested capital stays constant during your stable growth period, and as operating income rises, your return on invested capital will approach infinity. The second is that even if you assume a growth rate = inflation rate, you will have to replace your existing productive assets as they age and the same inflation that aids you on your revenues will cause the capital expenditures to exceed depreciation.

      Conclusion
      It is conventional wisdom that it is the growth rate in the perpetual growth equation that is the most significant driver of the resulting value. That may be true if you hold all else constant and change only the growth rate, but it is not, if you recognize that growth is never free and that changing the growth rate has consequences for your cash flows. Specifically, it is not the growth rate per se that determines value but how efficiently you generate that growth, and that efficiency is captured in the excess returns earned by your firm.

      YouTube Video


      Attachments
      1. Terminal Value Diagnostic Spreadsheet
      DCF Myth Posts
      1. If you have a D(discount rate) and a CF (cash flow), you have a DCF.  
      2. A DCF is an exercise in modeling & number crunching. 
      3. You cannot do a DCF when there is too much uncertainty.
      4. It's all about D in the DCF (Myths 4.14.24.34.4 & 4.5)
      5. The Terminal Value: Elephant in the Room! (Myths 5.15.25.35.4 & 5.5)
      6. A DCF requires too many assumptions and can be manipulated to yield any value you want.
      7. A DCF cannot value brand name or other intangibles. 
      8. A DCF yields a conservative estimate of value. 
      9. If your DCF value changes significantly over time, there is something wrong with your valuation.
      10. A DCF is an academic exercise.




      Myth 5.2: As g-> r...To Infinity and Beyond!

      In my last post, I started off by providing a rationale for a terminal value and presented alternatives to the perpetual growth model. That said, most DCFs are built with the the perpetual growth equation, setting up for a potential valuation disaster. Mathematically, the denominator is a powder keg waiting to blow, since as you increase g, holding the cash flow and r constant, your value will approach infinity before turning negative, leading to what I call “Buzz Lightyear” valuations.

      The Growth Cap
      If you want to draw on the perpetual growth equation, either because you believe your business will last forever or for convenience, the growth rate that you can use in it is constrained to be less than or equal to the growth rate of the economy in which you operate. This is not a debatable assumption, since it is mathematical, not one that owes its presence to economic theory. Within this statement, though, there are estimation choices that you will have to face about how to define the growth cap.
      1. Domestic versus Global: As a cap, you can use the growth in the domestic economy (if your company will remain a purely domestic operator) or growth in the global economy, and the economy’s growth rate has to be computed in the same terms that you are using for the rest of your valuation. That may seem to give you license to use high growth rates for emerging market companies but I would suggest caution, since emerging market economies as they get bigger will tend to see their growth rates move towards a global growth rate. Thus, while it is true that the Indian and Chinese economies have higher real growth rates than the global economy in the near term (5-10 years), they will see their growth rates converge on the global average (closer to 2%) sooner rather than later. 
      2. Real versus Nominal: In an earlier post, I argued that one of the hallmarks of a well-done DCF is consistency in how cash flows are defined and discount rates are computed. Specifically, you can choose to estimate your cash flows in real terms or nominal terms, with the former reflecting growth without the helping hand of inflation and the latter inclusive of it. If your valuation is in real terms, the cap on your growth rate will be the real growth rate in the economy, and if in nominal terms, it will be the nominal growth rate. 
      3. Currency: If you choose to do your valuation in nominal terms, you have to pick a currency to denominate your cash flows in, and that currency will have an expected inflation component attached to it. The nominal growth rate cap will have to be defined consistently, with the same expected inflation built into it as well. Thus, if you are valuing your company in a high-inflation currency, your nominal growth rate forever can be much higher than if you value it in a low-inflation currency.
      What if your company is in a high growth sector or a high growth market? The answer lies in the "forever", since no sector or market, no matter how high its growth is right now, can continue to grow at a rate faster than the overall economy forever. One of the greatest perils in valuation is ignoring the growth cap, either because you forget the mathematical basis for why it exists in the first place or because you have mismatched your cash flows and your discount rate, perhaps estimating the former in a high inflation currency and the latter in a low-inflation one or vice versa.

      A Risk Free Rate Proxy?
      If you accept the rationale that growth is capped at the growth rate of the economy, you are now confronted with a daunting and perhaps impossible task, i.e., to value an individual company, you will now have to estimate expected growth rate in the economy (domestic or global) and expected inflation in the currency of your choice. I, for one, want no part of this estimation challenge, for two reasons. The first is that I find long term macroeconomic forecasting to be a futile exercise and have absolutely no faith in either myself or the institutional entities that claim to be good at this task. The second is that any time I spend on these macroeconomic forecasts is time that I am not spending on understanding my company and its business, key to valuing that company. Consequently, I use a simpler and more easily observable number as a cap on stable growth: the risk free rate that I have used in the valuation. Not only does this take into account the currency automatically (since higher inflation currencies have higher risk free rates) but it is reasonable to argue that it is a good proxy for the nominal growth rate in the economy.  Since it is the component of my valuations that I am taken to task most frequently about, I have three arguments to offer and while none standing alone may be persuasive, you may perhaps accept a combination of them.

      1. An Empirical Argument:
      To understand the link between the risk free rate (a nominal interest rate) and nominal economic growth rates, consider the following decompositions of both:
      Risk free rate = Expected Inflation + Expected real interest rate
      Nominal economic growth = Expected Inflation + Expected real growth rate
      The table below the risk free rate in US dollars (measured with a ten-year treasury bond rate) and nominal economic growth (the sum of expected inflation and real GDP growth) from 1954 to 2015 in the United States, broken into two sub-periods.

      Period10-Year T.Bond RateInflation RateReal GDP GrowthNominal GDP growth rateNominal GDP - T.Bond Rate
      1954-2015
      5.93%
      3.61%
      3.06%
      6.67%
      0.74%
      1954-1980
      5.83%
      4.49%
      3.50%
      7.98%
      2.15%
      1981-2008
      6.88%
      3.26%
      3.04%
      6.30%
      -0.58%
      The nominal GDP growth rate was about 0.74% higher than the risk free rate over the entire period (1954-2015), but it has lagged the risk free rate by 0.58% since 1981. I know this table, by itself,  proves nothing, but there is reason to heed to the link. In the last sixty years in the United States,  nominal interest rates and nominal growth have been closely tied to each other, with an increase in one tied to an increase in the other. It is true that there is evidence in the data, especially in the 1954-1980 time period, that real growth can exceed real interest rates for extended periods, and economic intuition provides a rationale for why. If those who take no risk earn the riskfree rate, the economy, at least on average and over long time periods, has to deliver a little bit more to reward the risk takers. However, not only can that differential not be a large number but it is also worth remembering that the nominal growth rate is the growth rate in the entire economy, composed of both mature and growth companies. If you allow every mature company to grow at the rate at which the economy is growing, where does the growth come to sustain the growth companies in the economies? Put differently, setting the growth rate for mature companies below the growth rate of the economy cannot hurt you but setting it above that of the economy can cause valuations to implode. I'll take my chances on the former!

      2. A Consistency Rationale 
      If you are not convinced by this reasoning, I will offer another reason for tying the two numbers together. When you use a riskfree rate in a valuation, you are implicitly making assumptions about economic growth and inflation in the future and if you want your valuation to be consistent, you should make similar assumptions in estimating your cash flows. Thus, if you believe, the risk free rate today is too low or even negative (because the central banks have kept it so), and you use that risk free rate to come up with your discount rates, you have to keep your growth rate in perpetuity very low or negative to keep your valuation from imploding. That is the point that I was making in my post on negative interest rates. In the last decade, as interest rates have hit historic lows, the danger of this mismatch has become greater. Analysts have been quick to shift to using lower risk free rates (to 2% or lower) in their discount rate calculations while continuing to use nominal growth in the US economy (5-6%) as the cap on their growth rates. That is a recipe for disaster!

      3. A Self-Control Basis
      There is a third and final reason and this may reflect my personal weaknesses. When I value companies, I know that I fight my preconceptions and the urges I feel to tweak the numbers to deliver the result that I want to see. There is no number that can have more consequence for value than the growth rate in the terminal value and having a cap on that number removes the most potent vehicle for bias in valuation.

      In sum, you may or may not be convinced by my arguments for capping the perpetual growth rate at the risk free rate, but I would strongly recommend that you create your own cap on growth and tie that cap to the risk free rate in your valuation. Thus, you may decide a looser version of my cap, allowing your perpetual growth rate to be as much as (but not more than) one percent higher than the risk free rate.

      Conclusion
      The perpetual growth model is a powerful device for applying closure in a discounted cash flow valuation but it is a mathematical honey trap, with the growth rate in the denominator acting as the lure for analysts who are inclined by bias or ignorance to play with it. If you are tempted, it is worth also remembering that it is the first place that that people who are well versed in valuation look to check for valuation ineptitude, since there are far more subtle ways to bias your valuations than playing with the growth rate.

      YouTube Video


      DCF Myth Posts
      1. If you have a D(discount rate) and a CF (cash flow), you have a DCF.  
      2. A DCF is an exercise in modeling & number crunching. 
      3. You cannot do a DCF when there is too much uncertainty.
      4. It's all about D in the DCF (Myths 4.14.24.34.4 & 4.5)
      5. The Terminal Value: Elephant in the Room! (Myths 5.15.25.35.4 & 5.5)
      6. A DCF requires too many assumptions and can be manipulated to yield any value you want.
      7. A DCF cannot value brand name or other intangibles. 
      8. A DCF yields a conservative estimate of value. 
      9. If your DCF value changes significantly over time, there is something wrong with your valuation.
      10. A DCF is an academic exercise.




      Active Investing: Seeking the Elusive Edge!

      In my last post, I pointed to the shift towards passive investing that has accelerated over the last decade and argued that much of that shift can be explained by the sub-par performance of active investors. I ended the post on a contradictory note by explaining why I remained an active investor, though the reasons I gave were more personal than professional. I was taken to task on two fronts. The first was that I should have spent less time describing the problem (poor performance of active investors) and more time diagnosing the problem (the reasons for that poor performance). The second was that my rationale for being an active investor, i.e., that I enjoyed investing enough that I would be okay not earning excess returns, could never be used if I sought to manage other people's money and that a defense of active investing would have to be based on something more substantial. Both are fair critiques and I hope to address them in this post.

      The Roots of the Active Investing Malaise
      There is no denying the facts. Active investing has a problem not only because it collectively under performs passive investing (which is a mathematical given) but also because the drag on returns (from transactions costs costs and management fees) seems to be getting worse over time.  Even those few strands of active investing that historically have outperformed the market have come under siege in the last decade. While there are many reasons that you can point to for this phenomenon, here are some that I would highlight:
      1. A "Flatter" Investment Word: The investment world is getting flatter, as the differences across active investors rapidly dissipate. From information to processing models to trading platforms, professionals at the active investing game (including mutual funds and hedge funds) and individual investors are on a much more even playing field than ever before. As an individual investor, I have access to much of the information that an analyst working at Merrill Lynch or Fidelity has, whether it be financial statements or market rumors. I am not naive enough to believe that, SEC rules against selective information disclosure notwithstanding,  there are no channels for analysts to get "inside" information but much of that information is either too biased or too noisy to be useful. I have almost as much processing power on my personal computer as these analysts do on theirs and can perhaps even put it to better use. In fact, the only area where institutions (or at least some of them) may have an advantage over me is in being able to access information on trading data in real time and investing instantaneously and in large quantities on that information, leading to breast beating about the unfairness of it all. If history is any guide, the returns to these strategies fade quickly, as other large players with just as much trading power are drawn into the game. In fact, while much ink was spilt on flash trading and how it has put those who cannot partake at a disadvantage, it is worth noting that the returns to flash trading, while lucrative at first, have faded, while attracting smaller players into the game. In summary, if the edge that institutional active investors have had over individual active investors was rooted in information and processing power, it has almost disappeared in the United States and has eroded in much of the rest of the world.
      2. No Core Philosophy: There is an old saying that if you don't stand for something, you will fall for anything, and it applies to much of active investing. Successful investing starts with an investment philosophy, a set of core beliefs about market behavior that give birth to investment strategies. Too many active investors, when asked to characterize their investment philosophies, will describe themselves as "value investors" (the most mushy of all investment descriptions, since it can mean almost anything you want it to mean), "just like Warren Buffett" (a give away of lack of authenticity) or "investors in low PE stocks" (confusing an investment strategy with a philosophy). The absence of a core philosophy has two predictable consequences: (a) a lack of consistency, where active investors veer from one strategy to another, often drawn to whatever strategy worked best during the last time period and (b) me-tooism, as they chase momentum stocks to keep up with the rest. The evidence for both can be seen in the graph below, which looks at the percentages of funds in each style group who remain in that group three and five years later and finds that about half of all US funds change styles within the next five years.
        Source: SPIVA
      3. Bloated Cost Structures: If there is a core lesson that comes from looking at the performance of active investors, it is that the larger the drag on returns from the costs of being active, the more difficult it is to beat passive counterparts. One component of these costs is trading costs, and the absence of a core investment philosophy, referenced above, leads to more trading/turnover, as fund managers undo entire portfolios and redo them to match their latest active investing avatars. Another is the overhead cost of maintaining an active investing infrastructure that was built for a different market in a different era. The third cost is that of active management fees, set at levels that are not justified by either the services provided or by the returns delivered by that management team. Active money managers are feeling the pressure to cut costs, as can be seen in expense ratios declining over time, and the fund flows away from active money managers has been greatest at highest cost funds. I can only speak for myself but there is not one active investor (nope, not even him, and not even if he was forty years younger) in the world that I have enough reverence for that I would pay 2% (or even .5%) of my portfolio and 20% (or 5%) of my excess returns every year, no matter what his or her track record may be. To those who would counter that this is the price you have to pay for smart money, my response is that the smart money does not stay smart for very long, as evidenced by how quickly hedge fund returns have come back to earth. 
      4. Career Protection: Active money managers are human and it should come as no surprise  that they act in ways that increase their compensation and reduce their chances of losing their jobs. First, to the extent that their income is a function of assets under management (AUM), it is very difficult, if not impossible, to fight the urge to scale up a strategy to accommodate new inflows, even if it is not scaleable. Second, if you are a money manager running an established fund, it is far less risky (from a career perspective) to adopt a strategy of sustained, low-level mediocrity than one that tries to beat the market by substantial amounts, with the always present chance that you could end up failing badly. In institutional investing, this has led some of the largest funds to quasi-index, where their holdings deviate only mildly from the index, with predictable results: these funds deliver returns that match the index, prior to transactions costs, and systematically under perform true index funds, after transactions costs, but not by enough for managers to be fired. Third, at the other end of the spectrum, if you are a small, active money manager trying to make a name for yourself, you will naturally be drawn to high-risk, high-payoff strategies, even if they are bad bets on an expected value basis. In effect, you are treating investing as a lottery, where if you win, more money will flow into your funds and if you do not, it is other people's money anyway.
      There are macroeconomic factors that may also explain why active investing has had more trouble  in the last decade, but it is not low interest rates or central banks that are the culprits. It is that the global economy is going through a structural shift, where the old order (with a clear line of demarcation between developed & emerging markets) is being replaced with a new one (with new power centers and shifting risks), upending historical relationships and patterns. Given how much of active money management is built on mean reversion and lessons learned by poring over US market data from the last century, it should come as no surprise that the payoff to screening stocks (for low PE ratios or high dividend yield) or following rigid investing rules (whether they be centered on CAPE or interest rates) has declined.  In all of this discussion, I have focused on the faults of active institutional investors, be they hedge funds or mutual funds, but I believe that their clients bear just as much responsibility for the state of affairs. They (clients) let greed override good sense (knowing that those past returns are too good to be true, but not asking questions), claim to be long term (while demanding to see positive performance every three months), complain about quasi indexing (while using tracking error to make sure that deviations from the index get punished) and refuse to take responsibility for their own financial affairs (blaming their financial advisors for all that goes bad). In effect, clients get the active money managers they deserve.

      A Pathway to Active Investing Success
      If you accept even some of my explanation of why active investing is failing, at least collectively, there is a kernel of good news in that description. Specifically, the pathway to being a successful active investor lies in exploiting the weakness of the active investment community, especially large institutional investors. Here are my ingredients for active investing success, though I will add the necessary caveat that having all these ingredients will not guarantee an investment payoff.
      1. Have a core investment philosophy: In my book on investment philosophies, I argued that there is no best investment philosophy that fits all investors. The best investment philosophy for you is the one that best fits you as an investor, in sync not only with your views about markets but with your personal makeup (in terms of patience, liquidity needs and skill sets). Thus, if you have a long time horizon, believe that value is grounded in fundamentals and  that markets under estimate the value of assets in place, old-time value investing may very well be your best choice. In contrast, if your time horizon is short, believe that momentum, not value, drives stock prices, your investment philosophy may be built around technical analysis, centered on gauging price momentum and shifts in it.
      2. Balance faith with feedback: In a post on Valeant, I argued that investing requires balancing faith with feedback, faith in your core market beliefs with enough of an acceptance that you can be wrong on the details, to allow for feedback that can modify your investing decisions. In practice, walking this tightrope is exceedingly difficult to do, as many investors sacrifice one at the expense of the other. At one extreme, you have investors whose faith is so absolute that there is no room for feedback and positions once taken can never be reversed. At the other extreme, you have investors who  have no faith and whose decisions change constantly, as they observe market prices.   
      3. Find your investing edge: It has always been my contention that you have to bring something uncommon to the investment table to be able to take something away. Drawing on the language of competitive advantages and moats, what sets you apart does not have to be unique but it does have to be scarce and not easily replicable. That is why I am unmoved by talk of big data in investing and the coming onslaught of successful quant strategies, unless that big data comes with exclusivity (you and only you can exploit it). Here are four potential edges (and I am sure that there others that I might be missing): (a) In sync with client(s): I was not being facetious when I argued that one of my big advantages as an investor is that I invest my own money and hence have a freedom that most active institutional investors cannot have. If you are managing other peoples money, this suggests that your most consequential decision will be the screening your clients, turning money away from those who are not suited to your investment philosophy (b) Sell Liquidity: To be able to sell liquidity to investors seeking it, especially in the midst of a crisis, is perhaps one of investing's few remaining solid bets. That is possible, though, only if you, as an investor, value liquidity less than the rest of the market, a function of both your financial security.  (c) Tax Play: Investor price assets to generate after-tax returns and that effectively implies that assets that generate high-tax income (dividends, for instance) will be priced lower than assets that generate low-tax or no-tax income. If you are an investor with a different tax profile, paying either no or low taxes, you will be able to capture some of the return differential. Before you dismiss this as impossible or illegal, recognize that there is a portion of each of our portfolios, perhaps in IRAs or pension funds, where we are taxed differently and may be able to use it to our advantage. (d) Big Picture Perspective: As we become a world of specialists, each engrossed in his or her corner of the investment universe, there is an opening for "big picture" investors, those who can see the forest for the trees and retain perspective by looking across markets and across time. 
      If you are considering actively investing your money, you should be clear about what your own investment philosophy is, and why you hold on to it, and identify the scarce resource that you are bringing to the investment table. If you are considering paying someone else to actively manage your money, my suggestion is that while you should consider that person's track record, it is even more critical that you examine whether that track record is grounded in a consistent investment philosophy and backed up by a sustainable edge. 
      Conclusion
      There is much that I still do not know about investing but here are the lessons that I learn, unlearn and relearn every day. First, an investment cannot be a sure-bet and risky at the same time, and you can count me among the skeptical when presented with the next easy way of beating the market. Second, when I believe that I own the high ground in any investment debate, it is a sure sign that I have let hubris get the better of me and that my arguments are far weaker than I think they are. Third, much as I hate to be wrong on my investment choices,  I learn more when I concede that "I am wrong" than when I contend that "I am right".  For now, I will continue to invest actively, holding true to my investment philosophy centered on intrinsic value, while nurturing the small edges that I have over institutional investors. 



      Active Investing: Rest in Peace or Resurgent Force?

      I was a doctoral student at UCLA, in 1983 and 1984, when I was assigned to be research assistant to  Professor Eugene Fama, who wisely abandoned the University of Chicago during the cold winters for the beaches and tennis courts of Southern California. Professor Fama won the Nobel Prize for Economics in 2013, primarily for laying the foundations for efficient markets in this paper and refining them in his work in the decades after. The debate between passive and active investing that he and others at the University of Chicago initiated has been part of the landscape for more than four decades, with passionate advocates on both sides, but even the most ardent promoters of active investing have to admit that passive investing is winning the battle. In fact, the mutual fund industry seems to have realized that they face an existential threat not just to their growth but to their very existence and many of them are responding by cutting fees and offering passive investment choices.

      Passive Investing is winning!
      When Jack Bogle started the Vanguard 500 Index fund in 1975, I am sure that even he could not have foreseen how successful it would become in changing the way we invest. Not only have index funds become an increasing part of the landscape, but exchange traded funds have also added to the passive investing mix and index-based investing has expanded well beyond the S&P 500 to cover almost every traded asset market in the world. Today, you can put together a portfolio composed of index funds and ETFs to create any market exposure that you want in stocks, bonds or commodities. The growth of passive investing can be seen in the graph below, where I plot the proportion of the US equity market held by passive investors (in the form of ETFs and index funds) and active investors from 2005 to 2016:
      Source: Morningstar
      In 2016, passive investing accounted for approximately 40% of all institutional money in the equity market, more than doubling its share since 2005. Since 2008, the flight away from active investing has accelerated and the fund flows to active and passive investing during the last decade tell the story.
      The question is no longer whether passive investing is growing but how quickly and at what expense to active investing. The answer will have profound consequences not only for our investment choices going forward, but also for the many employed, from portfolio managers to sales people to financial advisors, in the active investing business. 

      Aided and Abetted by Active Investing
      To understand the shift to passive investing and why it has accelerated in recent years, we have to look no further than the investment reports that millions of investors get each year from their brokerage houses or financial advisors, chronicling the damage done to their portfolios during the course of the year by frenetic activity. Put bluntly, investors are more aware than ever before that they are often paying active money managers to lose money for them and that they now have the option to do something about this disservice.

      1. Collectively, active investing cannot beat passive investing (ever)!
      Before you attack me for being a dyed-in-the-wool efficient marketer, there is a simple mathematical reason why this statement has to be true. During 2015, for instance, about 40% of institutional money in equities was invested in index funds and ETFs and about 60% in active investing of all types. The money invested in index funds and ETFs will track the index, with a very small percentage (about 0.11%) going to cover the minimal transactions costs. Thus, active money managers have to start off with the recognition that they collectively cannot beat the index and that their costs (transactions and management fees) will have to come out of the index returns. Not surprisingly, therefore, active investors will collectively generate less than the index during every period and more than half of them will usually underperform the index.  To back up the first statement, here are the median returns for all actively managed funds, relative to passive index funds for various time periods ending in 2015:
      Source: S&P (SPIVA)
      The median active equity fund manager underperformed the index by about 1.21% a year between 2006 and 2015 and by far larger amounts over one-year (-2.92%), three year (-2.78%) and five year (-2.90%). Thus, it should come as no surprise that well over half of all active fund managers have been outperformed by the index over different time periods:
      Note that in this graph, active fund managers in equity, bond and real estate all under perform their passive counterparts, suggesting that poor performance is not restricted just to equity markets.

      If active money managers cannot beat the market, by construct, how do you explain the few studies  that claims to find that they do? There are three possibilities. The first is that they look at subsets of active investors (perhaps hedge funds or professional money managers) rather than all active investors and find that these subsets win, at the expense of other subsets of active investors. The second is that they compare the returns generated by mutual funds to the return on a stock index during the period, a comparison that will yield the not-surprising result that active money managers, who tend to hold some of their portfolios in cash, earn higher returns than the index in down markets, entirely because of their cash holdings. You can perhaps use this as evidence that mutual fund managers are good at market timing, but only if they can generate excess returns over long periods. The third is that these studies are comparing returns earned by active investors to a market index that might not reflect the investment choices made by the investors. Thus, comparing small cap active investors to the S&P 500 or global investors to the MSCI may reveal more about the limitations of the index than it does about active investing. 

      2. No sub-group of active investors seems to be able to beat the market
      The standard defense that most active investors would offer to the critique that they collectively underperform the market is that the collective includes a lot of sub-standard active investors. I have spent a lifetime talking to active investors who contend that the group (hedge funds, value investors, Buffett followers) that they belong to is not part of the collective and that it is the other, less enlightened groups that are responsible for the sorry state of active investing. In fact, they are quick to point to evidence often unearthed by academics looking at past data that stocks with specific characteristics (low PE, low Price to book, high dividend yield or price/earnings momentum) have beaten the market (by generating returns higher than what you would expect on a risk-adjusted basis). Even if you conclude that these findings are right, and they are debatable, you cannot use them to defend active investing, since you can create passive investing vehicles (index funds of just low PE stocks or PBV stocks) that will deliver those excess returns at minimal costs. The question then becomes whether active investing with any investment style beats a passive counterpart with the same style. SPIVA, S&P’s excellent data service for chronicling the successes and failures of active investing, looks at the excess returns and the percent of active investors who fail to beat the index, broken down by style sub-group. 
      Source: S&P (SPIVA)
      Note that not only is there not a single sub-group that has been able to beat the index for that group but also that the magnitude of under performance is staggering. It is true that these are the results for US equity fund managers, but just in case you are holding out hope that active money management is better at delivering results in other markets, the following table that looks at the percent of active managers who fail to beat indices in their markets should cast doubt on that claim:
      Source: S&P (SPIVA)
      There are glimmers of hope in the one-year returns in Europe and Japan and in the emerging markets, but there is not a single geography where active money managers have beaten the index over the last five years.

      3. Consistent winners are rare
      The third and final line of defense for active investors is that while they collectively underperform and that underperformance stretches across sub-groups, there is a subset of consistent winners who have found the magic ingredient for investment success. That last hope is dashed, though, when you look at the numbers. If there is consistent performance, you should see continuity in performance, with highly ranked funds staying highly ranked and poor performers staying poor. To see if that is the case, I looked at how portfolio managers ranked by quartile in one period did in the following three years:

      Note that the numbers in the table, when you look at all US equity funds, suggest very little continuity in the process. In fact, the only number that is different from 25% (albeit only marginally significant on a statistical basis) is that transition from the first to the fourth quartile, with a higher incidence of movement across these two quartiles than any other two. That should not be surprising since managers who adopt the riskiest strategies will spend their time bouncing between the top and the bottom quartiles.

      As your final defense of active investing, you may roll out a few legendary names, with Warren Buffett, Peter Lynch and the latest superstar manager in the news leading the list, but recognize that this is more an admission of the weakness of your argument than of its strength. In fact, successful though these investors have been, it becomes impossible to separate how much of their success has come from their investment philosophies, the periods of time when they operated and perhaps even luck. Again, drawing on the data, here is what Morningstar reports on the returns generated by their top mutual fund performer each year in the subsequent two years:
      While the numbers in 2000 and 2001 look good, the years since have not been kind to super performers who return to earth quickly in the subsequent years. We could try to explain the failure of active investing to deliver consistent returns over time with lots of reasons, starting with the investment world getting flatter, as more investors have access to data and models but I will leave that for another post. Suffice to say, no matter what the reasons, active investing, as structured today, is an awful business, with little to show for all the resources that are poured into it. In fact, given how much value is destroyed in this business, the surprise is not that passive investing has encroached on its territory but that active investing stays standing as a viable business. 

      The What next?
      Since it is no longer debatable that passive investing is winning the battle for investor money, and for good reasons, the question then becomes what the consequences will be. The immediate effects are predictable and painful for active money managers. 
      1. The active investing business will shrink: The fees charged for active money management will continue to decline, as they try to hold on to their remaining customers, generally older and more set in their ways. Notwithstanding these fee cuts, active money managers will continue to lose market share to ETFs and index funds as it becomes easier and easier to trade these options. The business will collectively be less profitable and hire fewer people as analysts, portfolio managers and support staff. If the last few decades are any indication, there will be periods where active money management will look like it is mounting a comeback but those will be intermittent. 
      2. More disruption is coming: In a post on disruption, I noted that the businesses that are most ripe for disruption are ones where the business is big (in terms of dollars spent), the value added is small relative to the costs of running the business and where everyone involved (businesses and customers) is unhappy with the status quo. That description fits the active money management like a glove and it should come as no surprise that the next wave of disruption is coming from fintech companies that see opportunity in almost every facet of active money management, from financial advisory services to trading to portfolio management.
      While active investing has contributed to its own downfall, there is a dark side to the growth of passive investing and many in the active money management community have been quick to point to some of these. 
      1. Corporate Governance: As ETFs and index funds increasing dominate the investment landscape, the question of who will bear the burden of corporate governance at companies has risen to the surface. After all, passive investors have no incentive to challenge incumbent management at individual companies nor the capacity to do so, given their vast number of holdings. As evidence, the critics of passive investors point to the fact that Vanguard and Blackrock vote with management more than 90% of the time. I would be more sympathetic to this argument if the big active mutual fund families had been shareholder advocates in the first place, but their track record of voting with management has historically been just as bad as that of the passive investors. 
      2. Information Efficiency: To the extent that active investors collect and process information, trying to find market mistakes, they play a role in keeping prices informative. This is the point that was being made, perhaps not artfully, by the Bernstein piece on how passive investing is worse than Marxism and will lead us to serfdom. I wish that they had fully digested the Grossman and Stiglitz paper that they quote, because the paper plays out this process to its logical limit. In summary, it concludes that if everyone believes that markets are efficient and invests accordingly (in index funds), markets would cease to be efficient because no one would be collecting information. Depressing, right? But Grossman and Stiglitz also used the key word (Impossibility) in the title, since as they noted, the process is self-correcting. If passive investing does grow to the point where prices are not informationally efficient, the payoff to active investing will rise to attract more of it. Rather than the Bataan death march to an arid information-free market monopolized by passive investing, what I see is a market where  active investing will ebb and flow over time.
      3. Product Markets: There are some who argue that the growth of passive investing is reducing product market competition, increasing prices for customers, and they give two reasons. The first is that passive investors steer their money to the largest market cap companies and as a consequence, these companies can only get bigger. The second is that when two or more large companies in a sector are owned mostly by the same passive investors (say Blackrock and Vanguard), it is suggested that they are more likely to collude to maximize the collective profits to the owners. As evidence, they point to studies of the banking and airline businesses, which seem to find a correlation between passive investing and higher prices for consumers. I am not persuaded or even convinced about either of these effects, since having a lot of passive investors does not seem to provide protection against the rapid meltdown of value that you still sometimes observe at large market cap companies and most management teams that I interact with are blissfully unaware of which institutional investors hold their shares.
      The rise of passive investing is an existential threat to active investing but it is also an opportunity for the profession to look inward and think about the practices that have brought it into crisis. I think that a long over-due shakeup is coming to the active investing business but that there will be a subset of active investors who will come out of this shakeup as winners. As to what will make them winners, I have to hold off until another post.

      Making it personal
      Should you be an active investor or are you better off putting your money in index funds? The answer will depend on not only what you bring to the investment table in the resources but also on your personal make-up. I have long argued that there is no one investment philosophy that works for all investors but there is one that is just right for you, as an investor. In keeping with this philosophy of personalized investing, I think it behooves each of us, no matter how limited our investment experience, to try to address this question. To start this process, I will make the case for why I am an active investor, though I don’t think any you will or should care. I will begin by listing all the reasons that I will not give for investing actively. Since I use public information in financial statements and databases, my information is no better than anyone else’s. While my ego would like to push me towards believing that I can value companies better than others, that is a delusion that I gave up on a long time ago and it is one reason that I have always shared my valuation models with anyone who wants to use them. There is no secret ingredient or special sauce in them and anyone with a minimal modeling capacity, basic valuation knowledge and common sense can build similar models. 

      So, why do I invest actively? First, I am lucky enough to be investing my own money, giving me a client who I understand and know. It is one of the strongest advantages that I have over a portfolio manager who manages other people’s money. Second, I have often described investing as an act of faith, faith in my capacity to value companies and faith that market prices will adjust to that value. I would like to believe that I have that faith, though it is constantly tested by adverse market movements. That said, I am not righteous, expecting to be rewarded for doing my homework or trusting in value. In fact, I have made peace with the possibility that at the end of my investing life, I could look back at the returns that I have made over my active investing lifetime and conclude that I could have done as well or better, investing in index funds. If that happens, I will not view the time that I spend analyzing and picking stocks as wasted since I have gained so much joy from the process. In short, if you don’t like markets and don’t enjoy the process of investing, my advice is that you put your money in index funds and spend your time on things that you truly enjoy doing!

      YouTube Video



      January 2017 Data Update 7: Profitability, Excess Returns and Governance

      If asked to describe a successful business, most people will tell you that it is one that makes money and that is not an unreasonable starting point, but it is not a good ending point. For a business to be a success, it is not just enough that it makes money but that it makes enough money to compensate the owners for the capital that they have invested in it, the risk that they are exposed to and the time that they have to wait to get their money back. That, in a nutshell, is how we define investment success in corporate finance and in this post, I would like to use that perspective to measure whether publicly traded companies are successful.

      Measuring Investment Returns
      The first step towards measuring investment success is measuring the return that companies make on their investments. This step, though seemingly simple, is fraught with difficulties. First, corporate measures of profits are not only historical (as opposed to future expectations) but are also skewed by accounting discretion and practice and year-to-year volatility. Second, to measure the capital that a company has invested in its existing investments, you often have begin with what is shown as capital invested in a balance sheet, implicitly assuming that book value is a good proxy for capital invested. Notwithstanding these concerns, analysts often compute a return on invested capital (ROIC) as a measure of investment return earned by a company:

      This simple computation has become corporate finance’s most widely computed and used ratio and while I compute it and use it in a variety of contexts, I do so with the recognition that it comes with flaws, some of which can be fatal. In the context of reporting this statistic at the start of last year, I reported my ROIC caveats in a picture:

      Put simply, it would be unfair of me to tar a young company like Tesla as a failure because it has a negative return on invested capital, and dangerous for me to view HP as a company that has made good investments, because it has a high ROIC, since is only due to the fact that it has written off almost $16 billion of mistakes, reducing its invested capital and inflating its ROIC. I compute the return on invested capital at the start of 2017 for each company in my public company sample of 42,668 firms, using the following judgments in my estimation:

      I do make adjustments to operating income and invested capital that reflect my view that accounting miscategorizes R&D and operating leases. I am still using a bludgeon rather than a scalpel here and  the returns on invested capital for some companies will be off, either because the last year’s operating income was abnormally high or low and/or accountants have managed to turn the invested capital at this company into a number that has little to do with what is invested in projects. That said, I have the law of large numbers as my ally.

      Measuring Excess Returns

      If the measure of investment success is that you are earning more on your capital invested than you could have made elsewhere, in an investment of equivalent risk, you can see why the cost of capital becomes the other half of the excess return equation. The cost of capital is measure of what investors can generate in the market on investments of equivalent risk. Thus, a company that can consistently generate returns on its invested capital that exceed its cost of capital is creating value, one that generates returns equal to the cost of capital is running in place and one that generates returns that are less than the cost of capital, it is destroying value. Of course, this comparison can be done entirely on an equity basis, using the cost of equity as the required rate and the return on equity as a measure of return:

      In general, especially when comparing large numbers of stocks across many sectors, the capital comparison is a more reliable one than the equity comparison. My end results for the capital comparison are summarized in the picture below, where I break my global companies into three broad groups. The first, value creators, includes companies that earn a return on invested capital that is at least 2% greater than the cost of capital, the second, value zeros, includes companies that earn within 2% (within my estimation error) of their cost of capital in either direction and the third, value destroyers, that earn a return on invested capital that is 2% lower than the cost of capital or worse. 

      The public market place globally, at least at the start of 2017, has more value destroyers than value creators, at least based upon 2016 trailing returns on capital. The good news is that there are almost 6000 companies that are super value creators, earning returns on capital that earn 10% higher than the cost of capital or more. The bad news is that the value destroying group has almost 20,000 firms (about 63% of all firms) in it and a large subset of these companies are stuck in their value destructive ways, not only continuing to stay invested in bad businesses, but investing more capital.

      If you are wary because the returns computed used the most recent 12 months of data, you are right be. To counter that, I also computed a ten-year average ROIC (for those companies with ten years of historical data or more) and that number compared to the cost of capital. As you would expect with the selection bias, the results are much more favorable, with almost 77% of firms earning more than their cost of capital, but even over this much longer time period, 23% of the firms earned less than the cost of capital. Finally, if you are doing this for an individual company, you can use much more finesse in your computation and use this spreadsheet to make your own adjustments to the number.

      Regional and Sector Differences
      If you accept my numbers, a third of all companies are destroying value, a third are running in place and a third are creating value, but are there differences across countries? I answer that question by computing the excess returns, by country, in the picture below:
      Link to live map

      Just a note on caution on reading the numbers. Some of the countries in my sample, like Mali and Kazakhstan have very few companies listed and the numbers should taken with a grain of salt. Breaking out the excess returns by broad regional groupings, here is what I get:
      Spreadsheet with country data
      Finally, I took a look at excess returns by sector, both globally and for different regions of the world, comparing returns on capital on an aggregated basis to the cost of capital. Focusing on non-financial service sectors, the sectors that delivered the most negative and most positive excess returns (ROIC - Cost of Capital) are listed below:
      Spreadsheet with sector data
      Many of the sectors that delivered the worst returns in 2016 were in the natural resource sectors, and depressed commodity prices can be fingered as the culprit. Among the best performing sectors are many with low capital intensity and service businesses, though tobacco tops the list with the highest return spread, partly because the large buybacks/dividends in the sector have shrunk the capital invested in the sector.

      For investors, looking at this listing of good and bad businesses in 2017, I would offer a warning about extrapolating to investing choices. The correlation between business quality and investment returns is tenuous, at best, and here is why. To the extent that the market is pricing in investment quality into stock prices, there is a very real possibility that the companies in the worst businesses may offer the best investment opportunities, if markets have over reacted to investment performance, and the companies in the best businesses may be the ones to avoid, if the market has pushed up prices too much. There is, however, a corporate governance lesson worth heeding. Notwithstanding claims to the contrary, there are many companies where managers left to their own devices, will find ways to spend investor money badly and need to be held to account.

      What next?

      I am not surprised, as some might be, by the numbers above. In many companies, break even is defined as making money and profitable projects are considered to be pulling their weight, even if those profits don’t measure up to alternative investments. A large number of companies, if put on the spot, will not even able to tell you how much capital they have invested in existing assets, either because the investments occurred way in the past or because of the way they are accounted for. It is not only investors who bear the cost of these poor investments but the economy overall, since more capital invested in bad businesses means less capital available for new and perhaps much better businesses, something to think about the next time you read a rant against stock buybacks or dividends.

      YouTube Video


      Spreadsheet
      1. ROIC Calculator
      Datasets
      1. Excess Returns, by Country- January 2017
      2. Excess Returns, by Industry - January 2017



      January 2017 Data Update 6: A Cost of Capital Update!

      I have described the cost of capital as the Swiss Army knife of finance, a number that shows up in so many different places in corporate financial and analysis and valuation and in so many different contexts, that it is easy to mangle and misunderstand. In this post, my objective is simple. I will start with a description of the sequence that I use to get to a cost of capital for companies in January 2017, but the bulk of the post will be describing what the cost of capital looks like at the start of 2017 for companies around the world.

      The Cost of Capital: Hurdle Rate, Opportunity Cost and Discount Rate
      As I move from corporate finance to valuation to investment philosophies, the one number that seems to show up in almost every aspect of analysis is the cost of capital. In corporate finance, it is the hurdle rate that determines whether companies should make new investments, the optimizer for financing mix and the divining rod for how much to return to stockholders in dividends and buybacks. In valuation, it is the discount rate in discounted cash flow valuations and the determinants of enterprise value multiples (of EBITDA and sales).

      It is perhaps because it is used in so many different contexts by such varied sub-groups that it remains a vastly misunderstood and misused number. If you are interested in reading more about the cost of capital, you may want to try this paper that I have on the topic (it is not technical or theoretical).

      The Cost of Capital Calculation
      The cost of capital is the weighted average of the costs of equity and debt for a business. While entire books have been written on the measurement questions, I will keep it simple.
      1. The cost of equity is the rate of return that the marginal investors, i.e., the investors who are most influential at setting your market price, are demanding to invest in equity in your business. To get to that number, you need three inputs, a risk free rate to get started, a measure of how risky your equity is, from the perspective of the marginal investors, and a price for taking that risk.
      Cost of Equity = Risk Free Risk + Relative Risk Measure * Price of Risk
      In the rarefied world of the capital asset pricing model, you assume that the marginal investor is diversified, beta measures relative risk and the equity risk premium is the price of risk, yielding a cost of equity.
      2. The cost of debt is the rate at which you can borrow money, long term and today. It is not a historic cost of borrowing, nor can it be influenced by decisions on changing debt maturity. It can be computed by adding a credit or default spread to the risk free rate but it does come, in many markets, with a tax benefit which is captured by netting it out of your cost.
      After-tax Cost of Debt = (Risk Free Rate + Default Spread) (1- Marginal Tax Rate)
      The default spread can sometimes be observed, if the company issues long term bonds, sometimes easily estimated, if the company has a bond rating and you trust that rating, and sometimes requires more work, if you have to estimate default risk yourself.
      3. The weights on debt and equity should be based upon market values, not book values, and can change over time, as your company changes.

      Since I want to compute the cost of capital for every one of the 42,668 firms that comprised this year’s sample, I had to make some simplifying (and perhaps even simplistic) assumptions, some of which were necessitated by the size of my sample and some by data limitations. I have summarized them in the picture below.

      I have computed the costs of capital for all companies in US dollar terms, not for parochial reasons, since converting to another currency is trivial (as I noted in my post on cracking the currency code) but to allow for consolidation and comparison.

      The costs of capital that I compute for individual companies have two shortcomings, driven primarily by data limitations. The first is that the beta that I use for a company comes from the business that it is categorized in, rather than a weighted average of the multiple businesses that it may operate in. The second is that I have attached the equity risk premium of the country of incorporation rather than a weighted average of the ERPs of the countries in which a company operates; I had to do this since the revenue breakdowns by country were either not available for many companies or in too difficult a form to work with. If you want to compute the cost of capital for a company using my data, I have a spreadsheet that you can use that will let you break out of these bounds, allowing you to compute a beta across multiple businesses and an equity risk premium across many countries/regions.

      Differences across Geographies
      The first comparison I make is in the costs of capital across different countries and regions. The picture below shows cost of capital by country and you can download the data in a spreadsheet at this link.
      Given that these are all US-dollar based costs of capital, the differences across countries can be attributed to four factors:
      1. Country risk: Country risk shows up in two places in the cost of capital calculation, the equity risk premium for the company (which is set equal to the equity risk premium of the country it is in) and an additional default spread in the cost of debt. 
      2. Industry concentration: Since my measure of relative risk comes from looking at the global beta for the sector in which a company operates, the cost of capital for a country will reflect the breakdown of industries in that country. Thus, the cost of capital for Peru, a country with a disproportionately large number of natural resource companies, will reflect the beta of mining and natural resource companies.
      3. Marginal tax rate: To the extent that a higher marginal tax rate lowers the after-tax cost of debt, holding all else constant, countries with higher marginal tax rates will have lower after-tax costs of debt and perhaps lower costs of capital.
      4. Debt ratio: Twinned with the marginal tax rate, in computing how much a company is being helped by the tax benefit of debt, is the amount of debt that the company uses, with higher debt ratios often translating into lower costs of capital.
      Differences across Industry Groups
      I next turn to industry groupings and differences in cost of capital across them. In the table below, I list the ten (non-financial service) industry groupings globally, with the highest costs of capital, and the ten, with the lowest, at the start of 2017.
      The reason for excluding financial service companies is simple. For banks, insurance companies and investment banks, the only hurdle rate that has relevance is a cost of equity, since debt is more raw material than a source of capital for these firms. You can download the entire industry list (with Global, European, Emerging Market and Australia/Canada worksheets) at this link, but again there are only a few reasons for the differences:
      1. Business risk: Some businesses are clearly more risky than others and I am using my sector betas to capture the differences in risk. 
      2. Leverage differences: Companies in some sectors borrow more than others, with mixed effects on the cost of capital. The resulting higher debt to equity ratios push up sector betas more, leading to higher costs of equity. That, though, is more than partially offset by the benefit of raising financing at the after-tax cost of debt, a bargain relative to equity.
      3. Country exposure: Some industry groupings have geographic concentrations and to the extent that those concentrations are in countries with very low or very high risk, relative to the rest of the world, your cost of capital will be skewed low or high.
      Distributional Perspective
      I have long argued that analysts spend far too much time on tweaking and finessing costs of capital in valuation and not enough on estimating earnings and cash flows, and I base my argument on a very simple fact. The distribution of costs of capital for publicly traded companies is a tight one, with a large proportion of companies falling in a very narrow range. Rather than talk in abstractions, consider the histogram of costs of capital for US and global companies at the start of 2017:

      The median US $ cost of capital for a US company is 7.22%, 50% of all US companies have costs of capital between 5.69% and 8.14%, and 80% have costs of capital between 4.59% and 8.87%. If you expand the distribution to include all global stocks, your distribution widens but not by as much as you might think. The median US $ cost of capital for a global company is 8.03%, half of all global companies have costs of capital between 6.88% and 9.15% and 90% of all companies globally have costs of capital between 5.63% and 10.68%. In other words, you don't have a lot of leeway to move your cost of capital for publicly traded firms. It is true that as you bring in other currencies into the mix, you can make the differences larger, but as I noted in my post on currencies, it is because of differences in inflation. You may want to pay heed to these distributions the next time that you see an analyst using a 20% US$ cost of capital to value a "risky" company or a 3% US$ cost of capital for a "safe" company, since neither number looks defensible, given the distribution.

      Cost of Capital Maxims
      I think that we not only spend too much time on estimating costs of capital in valuation but we also misunderstand what it is designed to measure. At the risk of repeating myself, here are four suggestions that I have on the cost of capital:
      1. Don't make the cost of capital the receptacle of all your hopes and fears: Many analysts take to heart the principle that riskier firms should have higher costs of capital (or discount rates) but then proceed to intuit what that discount rate should be for company, given how risky they think it is.  In the process, they often incorporate risks that don't belong in discount rates and attach prices for those risks that reflect their gut responses rather than what the market is paying.
      2. Focus on cash flows, not discount rates: When your valuations go awry, it is almost never because of the mistakes that you made on the discount rate and almost always because of errors in your estimates of cash flows (with growth, margins and reinvestment). 
      3. Spend less time on estimating discount rates: It follows then that when you have a limited amount of time that you can spend on a valuation (and who does not?), that time is better spent on assessing cash flows than in fine tuning the discount rate.
      4. An approximation works well : When I am in a hurry to value a company, I use my distributional statistics (see graph above) to get started. Thus, if I am valuing an average risk company in US dollars, I will start off using an 8% cost of capital (the global median is 8.03%) and complete my valuation with that number, and if I still have time, I will come back and tweak the cost of capital. If it is very risky firm, I will start off with a 10.68% cost of capital (the 90th percentile) and gain revisit that number, if I have the time.
      All in all, if your find yourself obsessing about the minutiae of discount rates in a valuation, it is perhaps because you want to avoid the big questions that make valuation interesting and challenging at the same time.

      YouTube Video

      1. Cost of Capital (US$), by Country - January 2017
      2. Cost of Capital (US$), by Industry - January 2017
      3. US $ Cost of Capital - Percentiles for US and Global companies



      January 2017 Data Update 5: A Taxing Year Ahead?

      There are three realities that you cannot avoid in business and investing. The first is that your returns and value are based upon the cash flows you have left over after you pay taxes. The second is that the taxes you pay are a function of both the tax code of the country or countries that you operate in and how you, as a business, work within (or outside) that code. The third is that the tax code itself can change over time, as countries institute changes in both rates and rules. The upcoming year looks like it will be more eventful than most, especially for US companies, as there is talk about major changes coming to both corporate and individual taxation.

      Why taxes matter
      While we are often casual in our treatment of taxes, the value of a business is a affected substantially by tax policy, with our measures of expected cash flows and discount rates both being affected by taxes.
      • In the numerator, you have expected cash flows after taxes, where the taxes you pay will reflect not only where in the world you generate income (since tax rates and rules vary across countries) but how the country in which you are incorporated in treats that foreign income. The US, for instance, requires US companies to pay the US tax rate even on foreign income, though the additional tax is due only when that income is remitted back to the US, leading to a predictable result. Multinational US companies leave their foreign income un-remitted, leading to the phenomenon of trapped cash (amounting to more than $2 trillion at US companies at the start of 2017).
      • The denominator, which is the discount rate, is also affected by the tax code. To the extent that tax laws in much of the world benefit debt over equity, using more debt in your financing mix can potentially lower your cost of capital. In computing this tax benefit from debt, there are two points to keep in mind. The first is that interest expenses save you taxes at the margin, i.e., your dollar in interest expense offsets your last dollar of income, saving you taxes on that last dollar, making it imperative that you use the marginal tax rate when computing your tax benefit from borrowing. The second is that companies have a choice on where to borrow money and not surprisingly choose those locations where they get the highest tax benefit (with the highest marginal tax rate). Is it any surprise that while Apple generates its income globally and finds ways to pay an effective tax rate of 21% on its taxable income in 2016, almost all of its debt is in the United States, saving taxes at an almost 40% marginal tax rate?
      Following up, then, the values of all companies in a country can change, some in positive and some in negative ways, when tax codes get rewritten. Even if the corporate tax codes don’t change, a company’s decisions on how to structure itself and where geographically to go for growth will affect its cash flows and discount rates in future years.

      Marginal Tax Rates
      If the marginal tax rate is the rate that a business pays on its last dollar of income, where in its financial statements are you most likely to find it? The answer in most companies is that you do not, and that you have to look in the tax code instead. Fortunately, KPMG does a yeoman job each year of pulling these numbers together and reporting them and the most recent update can be found here. The map below lists marginal tax rates by country and you also download a spreadsheet with the latest numbers at this link:
      Link to live map
      As you survey the world's marginal tax rates, you can see why trapped cash has become such a common phenomenon at US companies. The US has one of the highest marginal tax rates in the world at 40% (including a federal tax rate of 35%, topped off with state and local taxes) and is one of only a handful of countries that still insist on taxing companies incorporated in their domiciles on their global income, rather than adopting the more defensible practice of territorial taxation, where you require businesses to pay taxes in the countries that they generate their income in. As Congress looks at what to do about “trapped cash”, with many suggesting a one-time special deal where companies will be allowed to bring the cash back, they should also realize that unless the underlying reason for it is fixed, the problem will recur. That will mean either lowering the US marginal tax rate closer to the rest of the world (about 25%) or changing to a territorial tax model.

      The marginal tax rate is the number that you use to compute your after-tax cost of debt but that practice is built on the presumption that all interest expenses are tax deductible (and that you have enough taxable income to cover the interest deduction). That is still true in much of the world but there are parts of the world, where you either cannot deduct interest expenses (such as the Middle East) or you have taxes computed on a line item like revenues (thus nullifying the tax benefit of debt), where you will have to alter the practice of giving debt a tax benefit. For multinational companies that face different marginal tax rates in different operating countries, my recommendation is that you use the highest marginal tax rates across countries, since that is where these companies will direct their borrowing. 

      Effective Tax Rates: Country Level Differences
      If the marginal tax rate is the tax rate on your last dollar of income, what is the effective tax rate, the number that you often see reported in financial statements? In most cases, it is a computed tax rate that comes directly from the income statement and is computed as follows:
      Effective Tax Rate = (Accrual) Taxes Payable / (Accrual) Taxable Income
      Both number are accrual income numbers and thus can be different from cash taxes paid, with the differences usually visible in the statement of cash flows. Let’s start with looking at what companies pay as effective tax rates in the United States, a country with a marginal tax rate of 40%. In the most recent twelve months leading into January 2017, the distribution of effective tax rates paid by tax-paying US companies is captured below.

      The most interesting numbers in this distribution are the average effective tax rate of 26.42% across profitable US companies, well below the marginal tax rate of 40%. and the fact that 88% of US companies have effective tax rates that are lower than the marginal. The most important reason for this difference, in my view, is foreign operations with those firms that generate revenues outside the United States paying lower taxes, simply because the tax rate on income outside the United States is much lower (and that differential tax is not due until the cash is remitted). While there are some who suggest that a simple fix for this is to force US firms to pay the entire marginal tax rate when they make their income in foreign locales immediately (rather than on repatriation), this will be a powerful incentive for US companies to move their headquarters overseas. 

      In these populist times, you may be convinced that US companies are not paying their fair share of taxes but is that true? To make that judgment, I looked at effective tax rates paid by companies in different countries in the picture below and you can download the data in a spreadsheet in the link below:
      Link to live map
      At least, based upon the data on taxes paid in 2017, US companies measure up well against the rest of the world, in terms of paying taxes, with only Japanese companies paying significantly more in taxes; Indian and Australian companies pay about what US companies do and the rest of the world pays less.


      Sub GroupEffective Tax RateSub GroupEffective Tax Rate
      Africa and Middle East15.48%India27.65%
      Australia & NZ26.76%Japan31.07%
      Canada19.68%Latin America & Caribbean22.91%
      China21.72%Small Asia21.59%
      EU & Environs23.03%UK22.26%
      Eastern Europe & Russia19.88%United States26.22%
      As US companies market their products and services in other countries, it is true that some of this tax revenue is being collected by foreign governments, but that is the nature of a multinational business and is something that every country in the world with multinational corporations has as a shared problem.

      Effective Tax Rates: Industry and Company Differences
      As a final analysis, I compared the effective tax rates by US companies, categorized by industry. This table, which I have reported before, lists the ten industry groups that pay the highest effective tax rate and the ten that pay the lowest:
      The entire list can be downloaded here. Again, there are many reasons for the differences, with companies that generate more income from foreign operations paying lower taxes than domestic companies being a primary one. It is also true that the US tax code is filled with sector-specific provisions that provide special treatment for these sectors in the form of generous tax deductions. Most of these tax deductions (like higher depreciation allowances) show up as expenses in the income statement and the taxable income should already reflect them and so should the effective tax rate, but in some cases it does show up as a marginal tax rate.

      While in most years, these differences across sectors is a just a source of discussion or a reason to vent on the unfairness of taxes, I believe that investors, this year, should be paying particular attention to them. If Congress is serious about rewriting the tax code this year, there is reason to believe that the changed tax code is going to create winners and losers, and especially so, if it is designed to be revenue neutral. Those winners and losers will of course be different, depending on which version of corporate tax reform passes.
      • At one extreme in the version that is least disruptive to the current system, the marginal tax rate for corporations will be lowered, perhaps with a loss of some tax deductions/credits and adjustments on how foreign income gets taxed to reduce the problem of trapped cash. If this change occurs, the effects on value will be mixed, with cash flows increasing for those firms that will have lower effective tax rates as a consequence and the costs of debt and capital increasing as the tax benefits of debt will decrease. The biggest beneficiaries will be firms that pay high effective tax rates today (see the table above for the sectors) and have little debt. The biggest losers will be firms that pay low effective tax rates today and fund their operations with lots of debt.
      • At the other extreme, the House of Representatives is considering a more radical version of tax reform, where the current corporate income tax will be scrapped and replaced with a "Destination Based Cash-flow Tax" (DBCT), a value added tax system, with a deduction for wages, where the tax rate that you pay as a company will be a function of how much of your input material you import and where you sell your output.  The first side product of the DBCT will be that debt will lose its historical tax-favored status, relative to equity. The second side product is that, if left unadorned, it will eliminate any incentives to move profits across countries or borders, since the tax is not based on income. Companies who produce their goods with inputs from the US that then export these goods and services will benefit the most, paying the lowest taxes, whereas companies that are heavily reliant on imported inputs that sell their products in the United States would pay the most in taxes. And firms that are heavily debt funded will be adversely affected, relative to those that are not debt funded.
      There are numerous other proposals that float in the middle, most offering lower corporate tax rates in exchange for loss of tax deductions.  It is early in the game and we have no idea what the final version will look like. I will cheerfully confess that I am not expert on tax law and have absolutely no interest in providing specific directions on how the tax code should be rewritten but I will offer two simple pieces of advice having watched other attempts to rework corporate taxes:
      1. Keep it simple: When tax law gets complex, bad corporate behavior seems to follow. Unfortunately, the way legislative processes work seems to conspire against simplicity, as legislators trying to protect specific industries try to make sure that their ox does not get gored. 
      2. The tax code is not an effective behavior modifier for businesses: I understand the desire of some to use tax law as a corporate behavior modification tool but it is not a very effective one. Thus, if Congress is serious about the DBCT, it should be because they believe it is a more effective revenue generating mechanism that the current complex system and not because it wants to encourage companies to move manufacturing to the United States. If that is a byproduct, that is a plus but it should not be the end game.
      3. Make it predictable: Companies have enough uncertainty on their plates to worry about without adding uncertainty about future tax law changes to the mix. It would help if the tax code, once written, was not constantly revisited and revised.
      I am also a realist and believe that the likelihood of either of these pieces of advice being followed is close to zero.

      Closing
      In the process of computing an implied equity risk premium for the S&P 500, I collected analyst estimates of growth in earnings for the S&P 500 companies. Many of these analysts are predicting that earnings for the S&P 500 will grow strongly in 2017 and one shared reason seems to be that companies will pay less in taxes. Since legislative bodies are not known for speedy action, I am not sure that change, even if it does happen, will show up in 2017 earnings but I think that the ultimate test is not in what the tax code does to marginal tax rates (since I think it is a safe assumption that they will come down from) but the changed tax code will mean for effective tax rates. Assuming that the tax code does get rewritten, how will we know whether it is doing more good or harm?  I have two tests. First, if companies think about, talk about and factor in taxes less in their decision making, that is a good sign. Second, if fewer people are employed as tax lawyers and in transfer pricers, that is an even better one. I won't be holding my breath on either!

      YouTube Video

      Datasets



      January 2017 Data Update 4: Country Risk Update

      In my last post, I pointed to currency confusion as one of the side effects of globalization. In this one, I will argue that as companies and investors globalize,  investors and analysts have no choice but to learn how to deal with the rest of the world, both in terms of risk and pricing. One reason that I take a detailed look at country risk and pricing numbers every year is that my valuations and corporate finance rest so heavily on them. 

      Why country risk matters
      It seems to me an intuitive proposition that a company’s value and pricing can depend upon the geography of its business. Put simply, cash flows generated in riskier countries should be worth less than equivalent cash flows generated in safer ones but there are two follow up propositions worth emphasizing:
      1. Operation, not incorporation: I believe that it is where a company operates that determines its risk exposure, not just where it is incorporated. Thus, you can have US companies like Coca Cola (through its revenues) and Exxon Mobil (from its oil reserves) with substantial emerging market exposure and emerging market companies like Tata Consulting Services and Embraer with significant developed market exposure. In fact, what we face in valuation increasingly are global companies that through the accident of history happen to be incorporated in different countries.
      2. Company, Country and Global Risks: Not all country risk is created equal, especially as you are look at that risk as a diversified investor. Some country risk can be isolated to individual companies and is therefore averaged out as you diversify even across companies in that country. Still other country risk is country-specific and can be mitigated as your portfolio includes companies from across the globe. There is, however, increasingly a portion of country risk that is global, where even a global investor remains exposed to the risk and more so in some countries than others. The reason that we draw this distinction is that risks that can be diversified away will affect only the expected cash flows; that adjustment effectively takes the form of taking into account the likelihood and cash flow consequences of the risk occurring when computing the expected cash flow. The risks that are not diversifiable will affect both the expected cash flows and also the discount rates, with the mode of adjustment usually taking the form of higher risk premiums for equity and debt. That may sound like double counting but it is not, since the expected cash flows are adjusted for the likelihood of bad scenarios and their consequences and the discount rate adjustment is to demand a premium for being exposed to that risk:
        If you make the assumption that all country risk is diversifiable, you arrive at the conclusion that you don't need to adjust discount rates for country risk, a defensible argument when correlations across countries were very low (as in the 1980s) but not any more.
      Thus, dealing with country risk correctly becomes a key ingredient of both corporate finance, where multinational companies try to measure hurdle rates and returns on projects in different countries and in valuation, where investors try to attach values or prices to the same companies in financial markets. 

      Country Default Risk
      Since I have had extended posts on country risk before, I will not repeat much of what I have said before and instead focus this post on just updating the numbers. Simply put, the most easily accessible measures of country risk tend to be measures of default risk:
      1. Sovereign Ratings: Ratings agencies like S&P, Moody’s and Fitch attach sovereign ratings to countries, where they measure the default risk in government borrowing just as they do for individual companies. These ratings agencies often also provide separate ratings for local currency and foreign currency borrowings by the same government. The picture below summarizes ratings by country, in January 2017, and the linked spreadsheet contains the same data.
        Link to live version of map
      2. Government Bond Default Spreads: When a government issues bonds in a foreign currency, that are traded, the interest rate on those bonds can be compared to the risk free rate in a bond issued in the same currency to arrive at measures of default risk for the government. In much of Latin America, for instance, where countries has US-dollar denominated bonds, comparing the rates on those bonds to the US T.Bond rate (of equivalent maturity) provides a snapshot of default risk. The table below summarizes government bond default spreads as of January 1, 2017, for Latin American countries with US dollar denominated bonds:
      3. Sovereign CDS Spreads: This measure of default risk is of more recent vintage and is a market-determined number. It is, roughly speaking, a measure of how much you would have to pay, on an annual basis, to insure yourself against country default and unlike ratings can move quickly in response to political or economic developments in a country, making them both more timely and more volatile measures of country risk. In January 2017, sovereign CDS spreads were available for 64 countries and you can see them in the picture below and download them as a spreadsheet at this link.
        Link to live version of the map
      Country Equity Risk
      There are many who use country default spreads as a proxy for the additional risk that you would demand for investing in equity in that country, adding it on to a base equity risk premium (ERP) that they have estimated for a mature market (usually the US).
      ERP for Country A = ERP for US + Default Spread for Country A
      The limitation of the approach is that there are not only are equities affected by a broader set of risks than purely default risk but that even default can have a larger impact on equities in a country than its bonds, since equity investors are the residual claimants of cash flows.

      There are broader measures of country risk, taking the form of country risk scores that incorporate political, economic and legal risks, that are estimated by entities, some public (like the World Bank) and some private (like PRS and the Economist). The first is that they tend to be unstandardized, in the sense that each service that measures country risk has its own scoring mechanism, with World Bank scores going from low to high as country risk increases and PRS going from high to low. The second is that they are subjective, with variations in the factors considered and the weights attached to each. That said, there is information in looking at how the scores vary across time and across countries, with the picture below capturing PRS scores by country in January 2017. The numbers are also available in the linked spreadsheet.
      Link to live map
      I have my own idiosyncratic way of estimating the country risk premiums that builds off the country default spreads. I use a ratio of market volatility, arguing that default spreads need to be scaled to reflect the higher volatility of equities in a market, relative to government bonds in that market. 

      Since the volatility ratio can be both difficult to get at a country level and volatile, especially if the government bond is illiquid, I compute volatilities in an emerging market equity index and an emerging market government bond index and use the resulting ratio as a constant that I apply globally to arrive at equity risk premiums for individual countries. In January 2017, I started my estimates with a 5.69% equity risk premium for mature markets (set equal to the implied premium on January 1, 2017, for the S&P 500) and then used a combination of default spreads for countries and a ratio of 1.23 for relative equity market volatility (from the index volatilities) to arrive at equity risk premiums for individual countries.

      For countries that had both sovereign CDS spreads and sovereign ratings, I was able to get different measures of equity risk premium using either. For countries that had only a sovereign rating, I used the default spread based on that rating to estimate equity risk premiums (see lookup table here). For those countries that also had sovereign CDS spreads, I computed alternate measures of equity risk premiums using those spreads. Finally, for those frontier countries (mostly in the Middle East and Africa) that were neither rated nor had sovereign CDS spreads, I used their PRS scores to attach very rough measures of equity risk premiums (by looking at other rated countries with similar PRS scores). The picture below summarizes equity risk premiums by country and the link will give you the same information in a spreadsheet.
      Link to live map
      Closing
      The one prediction that we can also safely make for next year is that just as we have each year since 2008, there will be at least one and perhaps even two major shocks to the global economic system, precipitated by politics or by economics or both. Those shocks affect all markets globally, but to different degrees and it behooves us to not only be aware of the impact after they happen but be proactive and start building in the expectation that they will happen into our required returns and values.

      YouTube Video


      Datasets
      1. Sovereign Ratings by Country, S&P and Moody's on January 1, 2017
      2. Sovereign CDS spreads (ten-year) on January 1, 2017
      3. Political Risk Services (PRS) scores by country, January 1, 2017
      4. Equity Risk Premiums and Country Risk Premiums by country on January 1, 2017



      January 2017 Data Update 3: Cracking the Currency Code

      There was a time in the not so distant past, where analysts could do their analysis in their local currencies and care little or not at all about foreign currencies, how they moved and why. This was particularly true for US analysts in the last half of the last century, where the US dollar was the unchallenged global currency and the US economy bestrode the world. Those days are behind us and it is almost impossible to do valuations or corporate financial analysis without understanding how to deal with currencies correctly. Since the perils of misplaying currencies can be catastrophic, I decided to spend this post getting up to speed on the basics of how currency choices play out in valuation and where the numbers stand at the start of 2017.

      A Currency Primer in Valuation

      In intrinsic valuation, the value of an asset is the expected cash flows on that asset, discounted back at a risk adjusted discount rate.
      Note that there is no currency specification in the DCF equation and that analysts are given a choice of currencies. So, what currency should you use in valuing a company? While some analysts view this choice rigidly as being determined by the country in which the company operates in or the currency that it reports its financial statements in, there are two basic propositions that govern this choice.
      1. The first is that currency is a measurement mechanism and that you should be able to value any company in any currency, since all it will require is restating cash flows, growth rates and discount rates in that currency
      2. The second is that in a robust DCF valuation, your value should be currency invariant. Put differently, the value of Petrobras should be unchanged, whether you value the company in nominal Brazilian Reais ($R), US dollars or Euros. 
      The second proposition may strike some as impractical, since risk free rates vary across currencies and some currencies, like the $R, have higher risk free rates than others, like the US dollar. But the key to understanding currency invariance is recognizing that currency choices affect both your cash flows and your discount rate and if you are being consistent about your currency estimates, those effects should cancel out.
      Intuitively, picking a high inflation currency will lead to higher discount rates but also to higher cash flows and growth rates. In fact, if the currency effect is a pure inflation effect, you can see very quickly that you could make your valuation currency-free by doing your entire analysis in real terms, where you cash flows reflect only real growth (without the boost offered by inflation) and your discount rate is built on top of a real risk free rate. Your value should be again equivalent to the value you would have obtained by using the currency of your choice in your valuation.

      To make these estimation choices real, consider valuing a company that derives half its cash flows in the United States (in US dollars) and half in Brazil (in nominal $R). You can value the company in US dollars, and to do so, you would have to estimate its cost of capital in US $ and convert the portion of its cash flows that are in $R to US$ in future years; that would require forecasting exchange rates. Alternatively, you can value the company in $R, converting the portion of cash flows in US$ to $R and then estimating a cost of capital in $R. This may sound simple, even trivial, but a whole host of estimation challenges lie in wait. 

      Expected Exchange Rates
      If you want to make your valuations currency invariant, and inflation is what sets currencies apart, the way to estimate expected future exchange rates is to assume purchasing power parity, where exchange rates move to capture differential inflation. Specifically, you can get from the current exchange rate of local currency (LC) for the foreign currency (FC) to an expected exchange rate in a future year (t) using the expected inflation rates in the two currencies: 
      Simply put, if the inflation in the local currency is 5% higher than the inflation in the US$, you are assuming that the local currency will depreciate about 5% a year. I know that exchange rate movements deviate from purchasing power parity significantly over short and perhaps even extended periods and that expected inflation can be difficult to estimate in many currencies, but there is a simple reason why you should stick with this simplistic way of forecasting exchange rates, at least when it comes to valuation. First, it is far easier (and less expensive) that creating a full-fledged exchange rate forecasting model or paying a forecaster, especially because you have to forecast exchange rate changes over very long time periods. Second, it forces you to be explicit about your inflation expectations and by extension, at least be aware of inconsistencies, where you assume one measure of inflation for exchange rates (and cash flows) and another for discount rates. (You can use forward exchange rates for the near years, as long as you are willing to then use interest rate differentials as proxies for inflation differentials.)

      But what if you have strong views on the future direction of exchange rates that deviate from inflation expectations? I would argue that you should not bring them into your company valuations for a simple reason. If you incorporate your idiosyncratic exchange rate forecasts into cash flows and value, your final valuation of a company will be a joint consequence of your views on the company and of your views on exchange rates, with no easy way to separate the two. Thus, if you expect the Indian rupee to appreciate over the next five years, rather than depreciate (given your expectations of inflation in the rupee), you will find most Indian companies that you value to be cheap. If that conclusion is being driven by your exchange rate views, why invest in Indian companies when there are far easier and more profitable ways of playing the exchange rate game?

      Currency Costs of Capital
      Let's start with the challenge of estimating costs of capital in different currencies. There are two general approaches that you can use to get there. One is to compute the cost of capital in a  currency from the ground up, starting with a risk free rate and then estimating and adding on risk premiums to arrives at costs of equity, debt and capital. The other is to compute the cost of capital in a base currency (say the US dollars) and then converting that cost of capital to the local currency.

      Currency Risk Free Rates
      Every economics student, at some point early in his or her education, has seen the Fisher equation, where the nominal interest rate is broken down into an expected inflation component and an expected real interest rate:
      Nominal Interest Rate = Expected Inflation + Expected Real Interest Rate
      Note that this is neither a theory nor a hypothesis, but a truism, if you add no constraints on either the expected inflation and real interest rate. It is also a powerful starting point for thinking about what goes into a risk free rate and why it changes over time. It is as you add constraints on the components of interest rates that you start making assumptions which may or may not be true, and require testing. You could assume, for instance, that actual inflation in the most recent periods is a reasonable proxy for expected inflation in the future and that the real interest rate can be approximated to by the real growth rate in the economy in the most recent period (not an unreasonable assumption in mature economies). In fact, it is this proposition that I used in my last post on US markets to estimate intrinsic T.Bond rates that I compared to actual rates. I will use this framework as my back up as I look at four different ways of estimating risk free rates in different currencies.

      1. Government Bond Rate
      In this, the most common practice in valuation, analysts assume that the local currency government bond rate is the risk free rate in that currency. To justify this usage, they argue that governments will not default on local currency bonds, since they can always print off enough currency to pay off debt. In table 1, I graph local currency 10-year government bond rates as of January 1, 2017 for those currencies where I was able to obtain them.  


      This approach has the advantage of simplicity and is perhaps even intuitively defensible but there are real dangers associated with it. The first is that the government bond may not be liquid and traded and/or the government exercises control over the rate, it is not a market-set rate reflecting demand and supply. The second is that implicit in the use of the government bond rate as the risk free rate is the assumption that governments never default in the local currency. That assumption has been violated at least a half a dozen times just in the last twenty years, thus making the government bond rate a "risky", rather than a risk free, rate. The third is that using government bond rates as local currency risk free rates while using actual inflation rates as expected inflation can lead to both inconsistent and currency dependent valuations. For instance, assume that you decide to value Natura, the Brazilian cosmetics company, in $R and use the Brazilian government $R bond rate of 11.37%, on January 1, 2017, as the risk free rate while using the actual inflation rate of 6.29% (inflation rate last year, according to government statistics) as the expected inflation rate. The value that you estimate for the company will be much lower than the value that you estimate for the company if you valued it in US dollars, with a risk free rate of 2.50% and an expected inflation rate of 2%. The reason for the valuation difference is intuitive. By using the $R numbers, you are effectively using a real risk free rate of 5.08%, when you do your valuation in $R, and only 0.5%, when you do your valuation in US dollars.

      2. Government Bond Rate, net of default spread
      In this approach, you do not start with the presumption that governments are default free. Instead, you start with the local currency government bond rate and subtract out the portion of that rate that you believe is due to perceived default risk:
      Risk free rate in local currency = Local Currency Government Bond rate – Default Spread in Local Currency Government Bond rate
      The practical question then becomes how best to estimate the local currency default spread and there are a few approaches, though each comes with limitations. The first is to find a US dollar denominated bond issued by the government in question and netting out the US T.Bond rate, thus getting a default spread on the bond. The second is to use a sovereign CDS spread for the country as a proxy for default risk. In the table below,  Subtracting these default spreads from the local currency bond rates, on the assumption that default risk in both local and foreign currency borrowing is equivalent, would yield local currency risk free rates. Using the sovereign rating-based default spreads, we can estimate the risk free rates in different currencies in January 2017:


      This approach comes with its own perils that are layered on top of the assumption that the government bond rate is a market-set interest rate. First, it assumes that the local currency sovereign rating is measuring the default risk in the currency and that you can estimate the default spread based on it. Second, both the rating-based and sovereign CDS default spreads are US dollar based and netting it out against a local currency government bond rate can be viewed as inconsistent.

      3. Differential Inflation Based Rates
      The third approach is to ignore government bond rates in the local currency entirely, either because you believe that they are not liquid enough to yield reliable numbers or because they contain default risk. Instead, you start with a risk free rate in a currency where you believe that the government bond rate is a reliable measure of the risk free rate (US Treasury Bond, German Euro Bond) and then add to this number the differential inflation rate between the US dollar and the local currency.
      Local Currency Risk free Rate = US $ Risk free Rate + (Expected inflation in local currency – Expected inflation in US $)
      This is an approximation that works reasonably well when local currency inflation is low (close to the US dollar inflation rate) but the more precise version of this formulation will be based upon compounding, just as the Fisher equation was:
      The linked table lists differential inflation based risk free rates in all currencies, using expected inflation rates (the World Bank's estimates) and the US dollar (estimated at about 2%, the difference between the US 10-year T.Bond and TIPs rates).  If you are concerned about being able to forecast expected inflation in the local currency, you should rest easy. As long as you use that same expected inflation rate in your cash flow estimation, your valuation will be inflation-invariant and currency consistent, since the effects of under or over estimating inflation will cancel out.

      4. Intrinsic Risk Free Rates
      In the differential inflation approach, using the US dollar risk-free rate as the starting point, you are assuming a global real risk free rate, set equal to that rate embedded in the US treasury bond rate as the base for all local currency risk free rates. If you feel uncomfortable with this assumption, you can estimate a synthetic risk free rate from scratch, drawing on the Fisher equation:
      Risk free Rate = Expected Real Interest Rate + Expected inflation rate
      You can augment this equation with the assumption that long term real growth in an economy will converge on the long term real interest rate. 
      Expected Real Interest Rate = Expected Real Growth Rate
      Synthetic Risk free Rate = Expected Real Growth Rate + Expected inflation rate
      This approach yields the maximum flexibility but it will also create differences in valuations in different currencies. This linked table lists out synthetic risk free rates using this approach, using average real GDP growth as your expected real growth rate. The downside of this approach will be that your valuations will vary across currencies, yielding difficult-to-defend conclusions sometimes, where a company looks cheap when analyzed in US dollars but expensive when valued again in the local currency. The advantage of this approach, as with the differential inflation approach, is that you can estimate risk free rates for many more countries than with the government bond approach.

      Currency Cost of Capital
      If you start with a  risk free rate in a local currency and build up to a cost of capital using equity risk premiums and default spreads, often available only in dollar-based markets, you are effectively assuming that risk premiums are absolute numbers that don't change as the risk free rate changes. Thus, the equity risk premium of 5.69%, estimated in a dollar-based US market, applies not only to the US dollar risk free rate of 2.45% but also to the Nigerian Naira risk free rate of 10.77%. That is a stretch, since you would expect to risk premium you charge to be higher with the latter than the former. There is an easy and logical fix for it and it lies in the differential inflation approach. Rather than apply it to adjust the US$ riskfree rate to a local currency rate, you could apply it to the cost of equity or capital instead:
      Thus, if your cost of capital in US $ is 8%, the inflation rate in $R is 6% and in US$ is 2%, your cost of capital would be 12.24%. (Using the short cut of just adding the differential inflation would yield 12%). As part of my data update, I have reported costs of capital, by industry, in US dollars, for the last two decades. In this year's update, I have added a differential inflation feature allowing you to change that cost of capital to any currency of your choice in this spreadsheet. You will need to input the inflation rate in the local currency to get the costs of capital to update and you are welcome to use either the estimates that I supply in an additional worksheet or enter your own. Remember, though, that you should stay true to whatever this estimate is when estimating growth rates and cash flows in that currency.

      The Closing
      If your valuations are sensitive to your currency choice, you face a fundamental problem. You can find the same company, at the same pricing and point in time, to be both under and over valued, an indefensible conclusion. That conclusion, though, is being driven by some aspect of your valuation process that is making your company's fundamentals (risk, growth and cash flow potential) look different when you switch currencies. That, in my view, is a violation of intrinsic valuation and it requires you to make your inflation assumptions explicit and check for consistency. 

      YouTube Video


      Datasets
      1. Government Bond Rates, Default Spreads and Risk free Rates - By Currency
      2. Inflation Rates, GDP Growth and Fundamental Growth - By Country
      3. Cost of Capital, by Sector - January 2017 (with currency translator)



      My Snap Story: Valuing Snap ahead of it's IPO!

      Five years ago, when my daughter asked me whether I had Snapchat installed on my phone, my response was “Snapwhat?". In the weeks following, she managed to convince the rest of us in the family to install the app on our phones, if for no other reason than to admire her photo taking skills. At the time, what made the app stand out was the impermanence of the photos that you shared with your circle, since they disappeared a few seconds after you viewed them, a big selling point for sharers lacking impulse control. In 2013, when Facebook offered $3 billion to buy Snap, it was a clear indication that the new company was making inroads in the social media market, especially with teenagers. When Evan Spiegel and Bobby Murphy, Snap's founders, turned down the offer, I am sure that there were many who viewed them as insane, since Snap had trouble attracting advertisers to its platform and little in revenues, at the time. After all, what advertiser wants advertisements to disappear seconds after you see them? Needless to say, as the IPO nears and it looks like the company will be priced at $20 billion or more, it looks like Snap's founders will have the last laugh!

      Snap: A Camera Company?
      The Snap prospectus leads off with these words: Snap Inc. is a camera company. But is it? When I think of camera companies, I think of Eastman Kodak, Polaroid and the Japanese players (Fuji, Pentax) as the old guard, under assault as they face disruption from smartphone cameras, and companies like GoPro as the new entrants in the space, struggling to convert sales to profits. I don't think that this is the company that Snap aspires to keep and since it does not sell cameras or make money on photos, it is difficult to see it fitting in. If you define business in terms of how a company plans to make money, I would argue that Snap is an advertising business, albeit one in the online or digital space. I do know that Snap has hardware that it is selling in the form of Spectacles, but at least at the moment, the glasses seem to be designed to get users to stay in the Snap ecosystem for longer and see more ads.

      So, why does Snap present itself as a camera company? I think that the answer lies in the social media business, as it stands today, and how entrants either carve a niche for themselves or get labeled as me-too companies. Facebook, notwithstanding the additions of Instagram and WhatsApp, is fundamentally a platform for posting to friends, LinkedIn is a your place for business networking, Twitter is where you go if you want to reach lots of people quickly with short messages or news and Snap, as I see it, is trying to position itself as the social media platform built around visual images (photos and video). The question of whether this positioning will work, especially given Facebook's investments in Instagram and new entrants into the market, is central to what value you will attach to Snap.

      The Online Advertising Business
      If you classify Snap as an online advertising company, the next step in the process becomes simple: identifying the total market for online advertising, the players in that market and what place you would give Snap in this market. Let’s start with some basic data on the online advertising market.
      1. It is a big market, growing and tilting to mobile: The digital online advertising market is growing, mostly at the expense of conventional advertising (newspapers, TV, billboards) etc. You can see this in the graph below, where I plot total advertising expenditures each year and the portion that is online advertising for 2011-2016 and with forecasted values for 2017-2019. In 2016, the digital ad market generated revenues globally of close to $200 billion, up from about $100 billion in 2012, and these revenues are expected to climb to over $300 billion in 2020. As a percent of total ad spending of $660 billion in 2016, digital advertising accounted for about 30% and is expected to account for almost 40% in 2020. The mobile portion of digital advertising is also increasing, claiming from about 3.45% of digital ad spending to about half of all ad spending in 2016, with the expectation that it will account for almost two thirds of all digital advertising in 2020.
        Sources: Multiple
      2. With two giant players: There are two dominant players in the market, Google with its search engine and Facebook with its social media platforms. These two companies together control about 43% of the overall market, as you can see in this pie chart:
        If you are a small player in the US market, the even scarier statistic is that these two giants are taking an even larger percentage of new online advertising than their historical share. In 2015 and 2016, for instance, Google and Facebook accounted for about two-thirds of the growth in the digital ad market. Put simply, these two companies are big and getting bigger and relentlessly aggressive about going after smaller competitors.
      In a post in August 2015, I argued that the size of the online advertising market may be leading both entrepreneurs and investors to over estimate their chances of both growing revenues and delivering profits, leading to what I termed the big market delusion. As Snap adds its name to the mix, that concern only gets larger, since it is not clear that the market is big enough or growing fast enough to accommodate the expectations of investors in the many companies in the space. 

      Snap: Possible Story Lines
      To value a young company, especially one like Snap, you have to have a vision for what you see as success for the company, since there is little history for you to draw on and there are so many divergent paths that the company can follow, as it ages. That might sound really subjective, but without it, you are at the mercy of historical data that is both scarce and noisy or of metrics (like users and user intensity) that can lead you to misleading valuations.
      Link to my book
      That is, of course, another shameless plug for my book on narrative and numbers, and if you have heard it before or have no interest in reading it, I apologize and let's go on. To get perspective on Snap, let’s start by comparing it to three social media companies, Facebook, Twitter and LinkedIn and to Google, the old player in the mix, at the time of their initial public offerings. The table below summarizes key numbers at the time of their IPOs, with a  comparison to Snap's numbers.

      GoogleLinkedInFacebookTwitterSnap
      IPO date19-Aug-0419-May-1118-May-127-Nov-13NA
      Revenues$1,466 $161 $3,711 $449 $405
      Operating Income$326 $13 $1,756 $(93)$(521)
      Net Income$143 $2 $668 $(99)$(515)
      Number of UsersNA80.6845218161
      User minutes per day (January 2017)50 (Includes YouTube)NA50225
      Market Capitalization on offering date$23,000 $9,000 $81,000 $18,000 ?
      Link to Prospectus (from IPO date)Link Link Link Link Link

      At the time of its IPO, Snap has less revenues than any of its peer group, other than LinkedIn, and is losing more money than any of them. Before you view this is a death knell for Snap, one reason for Snap’s big losses is that unlike its competitors, Snap pays for server space as it acquires new users, thus pushing up its operating expenses (and pushing down capital investment in servers). There is one other dimension where Snap measures up more favorably against at least two of the other companies: its users are spending more time on its platform that they were either on Twitter and LinkedIn and it ranks second only to Facebook on this dimension.

      The more important question that you face with Snap, then, is which of these companies it will emulate in its post IPO year. The table below provides the contrast rather by looking at the years since the IPO for each company.
      Google and Facebook stand out as success stories, Google because it has maintained high revenue growth for almost a decade with very good profit margins and Facebook doing even better on both dimensions (higher growth in the earlier years and even higher margins). The least successful company in this mix is Twitter which has seen revenue growth that has trailed expectations and has been unable to unlock the secret to monetizing its user base, as it continues to post losses. Linkedin falls in the middle, with solid revenue growth for its first four years and some profits, but its margins are not only small but showed no signs of improvement from year to year. Now that it has been acquired by Microsoft, it will be interesting to see if the combination translates into better growth and margins.

      My Snap Story & Valuation
      To value Snap, I built my story by looking at what its founders have said about the company, how its structured and the strengths and weaknesses of its platform, at least as I see them. As a consequence, here is what I see the company evolving.
      1. Snap will remain focused on online advertising: I believe that Snap's revenues will continue to come entirely or predominantly from advertising. Thus, the payoff to Spectacles or any other hardware offered by the company will be in more advertising for the company. 
      2. Marketing to younger, tech-savvy users: Snap's platform, with its emphasis on the visual and the temporary, will remain more attractive to younger users. Rather than dilute the platform to go after the bigger market, Snap will create offerings to increase its hold on the youth segment of the market.
        Source: The Economist
      3. With an emphasis on user intensity over users: Snap's prospectus and public utterances by its founders emphasize user intensity more than the number of users, in contrast to earlier social media companies. This emphasis is backed up by the company's actions: the new features that it has added, like stories and geofilters, seem designed more to increase how much time users spend in the app than on getting new users. Some of that shift in emphasis reflects changes in how investors perceive social media companies, perhaps sobered by Twitter's failure to convert large user numbers into profits, and some of it is in Snap's business model, where adding users is not costless (since it has to pay for server space). 
      These assumptions, in turn, drive my forecasts of revenues, margins and reinvestment. In my story, I don't see Snap reaching revenues of the magnitude delivered by Google and Facebook, the two big market players in the game, settling instead for smaller revenues. If Snap is able to hold on to its target market (young, tech savvy and visually inclined) and keep its users engaged, I think Snap has a chance of delivering high operating profit margins, perhaps not of the magnitude of Facebook today (45% margin) but close to that of Google (25% margin). Finally, its reinvestment will take the form of acquisition of technology and server space to sustain its user base, but by not trying to be the next Facebook, it will not have to over reach. Is there substantial risk that the story may not work out the way I expect it to? Of course! While I will give Snap a cost of capital of close to 10% (and in the 85th percentile of US companies), reflective of its online advertising business,  I will also assume that there remains a non-trivial chance (10%) that the company will not make it. The picture below captures my story and the valuation inputs that emerge from it:

      To complete the valuation, there are two other details that relate to the IPO.
      1. Share count: For an IPO, share count can be tricky, and especially so for a young tech company with multiple claims on equity in the form of options and restricted stock issues. Looking through the prospectus and adding up the shares outstanding on all three classes of shares, including shares set aside for restricted stock issues and assorted purposes, I get a total of 1,243.10 million shares outstanding in the company. In addition, I estimate that there are 44.90 million options outstanding in the company, with an average exercise price of $2.33 and an assumed maturity of 3 years.
      2. IPO Proceeds: This is a factor specific to IPOs and reflect the fact that cash is raised by the company on the offering date. If that cash is retained by the company, it adds to the value of the company (a version of post-money valuation). In the case of Snap, it is estimated that roughly $3 billion in cash from the offering that will be held by the company,  to cover costs like the $2 billion that Snap has contracted to pay Google for cloud space for the next five years.
      These valuation inputs become the basis for my valuation and yield a value of $14.4 billion for the equity (and you can download the spreadsheet at this link).
      Download spreadsheet
      Allowing for the uncertainty inherent in my estimates, I also computed probability distribution for three key inputs, revenue growth, operating margin and cost of capital, and my value for Snap's equity is in the distribution below:
      Snap Simulation Details
      Assuming that my share count is right, my value per share is about $11 per share. As you can see though, as is the case with almost any young company where the narrative can take you in other directions, there is a wide range around my expectations, with the lowest value being less than zero and the highest value pushing above $66 billion ($50/share). The median value is $13.3 billion and the average is $14.9 billion; one attractive feature to investors is that there is potential for breakout values (optionality) that exceed $30 billion.
      • The numbers at the high end of the spectrum reflect a pathway for Snap that I call the Facebook Light story, where it emerges as a serious contender to Facebook in terms of time that users spend on its platform, but with a smaller user base. That leads to revenues of close to $25 billion by 2027, an operating margin of 40% for the company and a value for the equity of $48 billion.
      • The numbers at the other end of the spectrum capture a darker version of the story, that I label Twitter Redux, where user growth slows, user intensity comes under stress and advertising lags expectations. In this variant, Snap will have trouble getting pushing revenue growth past 35%, settling for about $4 billion in revenues in 2027, is able to improve its margin to only 10% in steady state, yielding a value of  equity of about $4 billion.
      As I learned the painful way with my Twitter experiences, the quality of the management at a young company can play a significant role in how the story evolves. I am impressed with both the poise that Snap's founders are showing in their public appearances and the story that they are telling about the company, though I am disappointed that they have followed the Google/Facebook path and consolidated control in the company by creating shares with different voting rights. I know that is in keeping with the tech sector's founder worship and paranoia about "short term" investors , but my advice, unsolicited and perhaps unwelcome, is that Snap's founders should trust markets more. After all, if you welcome me to invest me in your company and I do, you should want my input as well, right?

      The Pricing Contrast
      As I finish this post, I notice this news story from this morning that suggests that bankers have arrived at an offering price, yielding a pricing for the company of $18.5 billion to $21.5 billion for the company, about $4 billion above my estimate. So, how do I explain the difference between my valuation and this pricing? First, I have never felt the urge to explain what other people pay for a stock, since it is a free market and investors make their own judgments. Second, and this is keeping with a theme that I have promoted repeatedly in my posts, bankers don't value companies; they price them! If you are missing the contrast between value and price, you are welcome to read this piece that I have on the topic, but simply put, your job in pricing is not to assess the fair value of a company but to decide what investors will pay for the company today. The former is determined by cash flows, growth and risk, i.e., the inputs that I have grappled with in my story and valuation, and the latter is set by what investors are paying for other companies in the space. After all, if investors are willing to attach a pricing of $12 billion to Twitter, a social media company seeming incapable of translating potential to profits, and Microsoft is paying $26 billion for LinkedIn, another social media company whose grasp exceeded its reach, why should they not pay $20 billion for Snap, a company with vastly greater user engagement than either LinkedIn or Twitter? With pricing, everything is relative and Snap may be a bargain at $20 billion to a trader.

      YouTube Video


      Link to book
      1. Narrative and Numbers: The Value of Stories in Business
      Attachments
      1. Snap: Prospectus for IPO
      2. Snap: My IPO Valuation
      3. Snap: As Facebook Lite
      4. Snap: As Twitter Redux
      5. Snap: Simulation Inputs & Output



      Apple: The Greatest Cash Machine in History?

      As as sports fan, watching Brady and Belichick win the Super Bowl, Roger Federer triumph at the Australian Open and LeBron James carry the Cleveland Cavaliers to victory over the Warriors, it struck me how we take uncommon brilliance for granted. It is so easy, in the moment, to find fault, as many have, with these superstars and miss how special they are. That was the same reaction that I had as I watched another earnings report from Apple and the usual mix of reactions to it, some ho hum that the company made only $45 billion last year, some relieved that the company was able to post a 3% growth rate in revenues and the usual breast beating from those who found fault with it for not delivering another earth-shaking disruption. Since this is a company that I have valued after every quarterly earnings report since 2010, I thought this would be a good time to both take stock of what the company has managed to do over the last decade and to value it, given where it stands today.

      The Cash Machine Revs up
      In my last post on dividend payout and cash return globally, I noted that large cash balances don't happen by accident but are a direct result of companies paying out less than they have available as potential dividends or free cash flows to equity, year after year. Since Apple's cash balance almost reached $250 billion in its most recent quarterly report, by far the largest cash balance ever accumulated by a publicly traded company, I decided that the place to start was by looking at how it got to its current level. I started by collecting the operating, debt financing and reinvestment cash flows each year from 2007 to 2016 and computing a free cash flow to equity (or potential dividend) each year.
      Starting in 2013, when Apple started to tap into its debt capacity, the company has been able to add to its potential dividends each year. In 2015 alone, Apple generated $93.6 billion in FCFE or potential dividends, an astounding amount, larger that the GDP of half the countries in the world in 2015. Each year, I also looked at how much Apple has returned to stockholders in the form of dividends and stock buybacks.
      Note that while Apple took a while to start returning cash, and it needed prompting from David Einhorn and Carl Icahn, it not only initiated dividends in 2012 but has supplemented those dividends with stock buybacks of increasing magnitude each year. In fact, Apple returned $183 billion in cash to stockholders in the last five years, making it, by far, the largest cash-returner in the world over that period.

      There are two amazing (at least to me) aspects to this story. The first is that in spite of the immense amounts of cash that Apple has returned each year, its cash balance has increased each year, partly because its operating cash flows are so high and partly because they are being supplemented by debt payments. You can see the cash build up between 2007 and 2016 in the chart below:

      Note that while Apple was returning $183 billion in cash between 2013-2016, its cash balance continued to increase, as its cash inflows increased even more.  If having a cash spigot that never turns off is a problem, Apple has it, but I am sure that it will not get about as much sympathy from the rest of the world as a supermodel who complains that she cannot put on weight, no matter how much she eats. The other equally surprising feature of this story is that Apple's managers have not felt the urge (yet) to use their huge cash reserves to buy a company, a whole set of companies or even an entire country, a fact that those who like Apple will attribute to the discipline of its management and Apple haters will argue is due to a lack of imagination.

      My Apple Valuation History
      As many of you who have been reading this blog are aware, I have valued Apple many times before but rather than rehash old history, let me summarize. For Apple, the story that I have been telling about the company for the last five years has been remarkably unchanged. In my July 2012 valuation, where I looked at Apple just after it had become the largest market cap company in the world and had come off perhaps the greatest decade of disruption of any company in history (iTunes, iPod, iPhone and iPad), I concluded that while Apple was one of the great cash machines of all time, its days of disruption were behind it, partly because Steve Jobs was no longer at the helm but mostly because of its size; it is so much more difficult for a $600 billion company to create a significant enough disruption to change the trend lines on earnings, cash flows and value. 

      So, in my story, I saw Apple continuing to produce cash flows, with low revenue growth and gradually decreasing margins, as the smartphone business became more competitive. I won't make you read all of the posts that I have on Apple, but let me start with a post that I had in August 2015, when I updated the Apple story (and looked at Facebook and Twitter at the same time). The value I estimated for Apple in that post was $130, higher than the stock price of $110 at the time, prompting me to buy the stock. I revisited the story after an earnings report from Apple in February 2016 and compared it to Alphabet. At the time, I valued Apple at about $126 per share, well above the $94/share that it was trading at the time. In May 2016, Carl Icahn, a long time bull on Apple sold his shares, and Warren Buffett, a long time avoider of tech companies, bought shares in the company. In a post at the time, I argued that while these big names entering and exiting the stock may have pricing consequences, I saw no reason to change my story and thus my value, leaving my Apple holdings intact. 

      Apple's Earnings Report & My Narrative
      Last week, Apple released its latest 10Q and in conjunction with its latest 10K (Apple's fiscal year end is in September). It contained a modicum of good news, insofar as there was growth in revenues as opposed to the decline posted in the prior quarter and still-solid profit margins, but the revenue growth was only 3% and the margins are still lower than they used to be.  Using the numbers in the most recent report, I took at look at my Apple story and guess what? It looks just like it did last year, a great cash machine, with very slow-growing revenues and declining margins. Using the process that I describe, perhaps in too much detail in my book on narrative and numbers, I converted my story in inputs to my valuation:

      Some of you may find my story too cramped , seeing a greater possibility than I do of Apple breaking through into a new, big market (with Apple Pay or the Apple iCar). If you are in that group, please take my structure and make it yours, with a higher growth rate coming from your disruptive story, accompanied by lower margins and higher reinvestment. Others may find this story too optimistic, perhaps seeing a more precipitous fall of profit margins in the smart phone business and a greater tax liability from trapped cash. You too can alter the inputs to your liking and make your own judgment on Apple!

      An Updated Valuation of Apple
      Once you have a story for a company and convert that story into valuation inputs, the rest of the process becomes just mechanics. In the picture below, I have my February 2017 valuation of Apple. 
      Download spreadsheet with valuation
      Just as my valuation looked too optimistic a year, when the earnings report contained darker news, it may seem too pessimistic this year, after a much sunnier report. That said, it is worth emphasizing how much Apple is on the iPhone roller coaster ride, reporting better earnings in the quarters immediately after a new iPhone is released and much worse earnings in the quarters thereafter. While the market seems to want to go on a ride with Apple on its ups and downs, my fundamental story for Apple has barely shifted in the last few years and my valuations reflect that story stability.

      Apple's Price/Value Dynamics
      I have taken my share of punishment on investments that have not gone well, with Valeant being a source of continuing pain (which I will return to after its next earnings report). Apple, though, has served me well in the last decade, but even with Apple, I have had extended periods where my faith has been tested. The picture below graphs Apple's stock price from 2010 and 2017 with my valuations shown across time:

      I held Apple from 2010 to 2012, as it traded under my estimated value. I sold in April 2012, just before a brief interlude where the price popped above value in June 2012, it reverted back to being under valued until June 2014. After spending a few months as an overvalued stock, the price plummeted in the late summer of 2015, making me a buyer, but it continued to drop until almost April 2016. It's been a good ride since, and much as I want to attribute this to my valuation insights and brilliant timing, I have a sneaking suspicion that luck had just as much or perhaps more to do with it. Now that the stock is fully valued, decision time is fast approaching and I am ready with my sell trigger at $140/share, the outer end of the range that I have for Apple's value today.

      Conclusion
      Apple is the greatest corporate cash machine in history and it is fully deserving of its market value. Its history as a disruptive force has led some investors to expect Apple to continue what it did a decade ago and come up with new products for new markets. Those expectations, though, don't factor in the reality that as a much larger player with huge profit margins, Apple is more likely to be disrupted than be disruptor. Until investors learn to live with the company, as it exists now and not the company that they wish would exist in its place, there will continue to be mood swings in the market translating into the ebbs and flows of its stock price, and I hope to take advantage of them.

      YouTube


      My book
      1. Narrative and Numbers (Columbia University Press)

      Prior Blog Posts on Apple
      1. Narrative Resets: Revisiting a Tech Trio (August 2015)
      2. Race to the top: The Duel between Apple and Alphabet (February 2016)
      3. Icahn exits, Buffett enters: Whither Apple? (June 2016)
      Spreadsheets
      1. Apple: FCFE, Dividends and Cash Build up - 1988-2016
      2. Apple: Valuation in February 2017



      January 2017 Data Update 9: Dividends and Buybacks

      If you are from my generation, I am sure that you remember Rodney Dangerfield, whose comedy routine was built around the fact that "he got no respect". This post is about dividends and cash return, the Rodney Dangerfield of Corporate finance, a decision that gets no respect and very little serious attention from either academics or practitioners. In many companies, the decision of how much to pay on dividends is made either on auto pilot or on a me-too basis, which is surprising, since just as a farmer’s payoff from planting crops comes from the harvest, an investor’s payoff from investing should come from cash flows being returned. The investment decisions get the glory, the financing decisions get in the news but the dividend decisions are what complete the cycle.

      The Dividend Decision
      The decision of whether to return cash to the owners of a business and if yes, in what form, is the dividend decision. Since these cash flows are to equity investors, who are the residual claim holders in a business, logically, the dividend decision should be determined by and come after the investment and financing decisions made by a business. The picture below captures how dividends would be set, if they were truly residual cash flows:

      The process, which mirrors what you see in a statement of cash flows, starts with the cash flow to equity from operations, computed by adding back non-cash charges (depreciation and amortization) to net income. From that cash flow, the firm decides how much to reinvest in short term assets (working capital) and long term assets (capital expenditures), supplementing these cash flows with debt issuances and depleting them with debt repayments. If there is any cash flow left over after these actions, and there is not guarantee that there will be, that cash flow is my estimate of potential dividend or if you prefer a buzzier word, the free cash flow to equity. With this free cash flow to equity, the firm can do one of three things: hold the cash (increasing its cash balance), pay a dividend or buy back stock.  To the right of the picture, I use a structure that I find useful in corporate finance, which is the corporate life cycle, to illustrate how these numbers change as a company ages.
      • Early in a company’s life, the operating cash flows are often negative (as the company lose money) and the hole gets deeper as the company has to reinvest to generate future growth and is unable to borrow money. Since the potential dividends (FCFE) are big negative numbers, the company will be raising new equity rather than returning cash
      • As the company starts to grow, the earnings first turn positive but the large reinvestment needs to sustain future growth will continue to keep potential dividends negative, thus justifying a no-cash return policy still
      • As the company matures, there will be two developments: the operating cash flows to equity will start exceeding reinvestment needs and the company’s capacity to borrow money will open up. While the initial response of the company to these developments will be denial (about no longer being growth companies), you cannot hide from the truth. The cash balance will mount and the company’s capacity to borrow money will be increasingly obvious and pressure will build on it to return some of its cash and borrow money
      • Even the most resistant firms will eventually capitulate and they will enter the period of plentiful cash returns, with large dividends supplemented by stock buybacks, at least partially funded by debt. 
      • Finally, you arrive at that most depressing phase of the corporate life cycle, decline, when reinvestment is replaced with divestitures (shrinking the firm and increasing free cash flows to equity) and the cash return swells. The company, in a sense, is partially liquidating itself over time.
      The truth is that there are companies where the decision on how much to pay in dividends in not the final one but the one made first.  Put differently, rather than making investment and financing decisions first, based upon what works best for the firm, and paying the residual cash flow as dividends, firms make their dividend decisions (and I include buybacks in dividends)  first and then modify their financing and investing decisions, given the dividends.


      The companies that follow this backward sequence, and there are a lot of them, can easily end up with severely dysfunctional dividend policies that can destroy them, unless good sense prevails. It is an attitude that was best captured by Andrew Mackenzie, CEO of BHP Billiton, who when analysts asked him in 2015 whether he planned to cut dividends, as commodity prices plummeted and earnings dropped, responded by saying "over my dead body". 

      Dividends, Cash Return and Potential Dividends: The US History
      Let’s start with some history on dividends, using the US market. In the graph below, I start by providing the basis for my inertia theory of dividends by looking at the proportion of US firms each year that increase dividends, decrease dividends and leave dividends unchanged:

      In every year, since 1988, far more firms left dividends untouched than increased or decreased them, and when dividends did get changed, they were far more likely to be increased than decreased.

      Let’s follow with another fact about US companies. Increasingly, they are replacing dividends, the time-tested way of returning cash to stockholders, with stock buybacks, as you can see in the figure below, where I graph dividends and stock buybacks from the S&P 500 companies from 1988 to 2016.

      The shift is remarkable. In 1988, almost 70% of all cash returned to stockholders took the form of dividends and by 2016, close to 60% of all cash returned took the form of buybacks. I have written about why this shift has occurred in this post and also why much of the breast beating you hear about how buybacks represent the end of the economy is misdirected. That said, the amount of cash that US companies are returning to stockholders is unsustainable, given the earnings and expectations of growth. In the figure below, I look at for the S&P 500, the cash returned to investors as a proportion of earnings each year from 2001 to 2016:

      In 2015 and 2016, the companies in the S&P 500 returned more than 100% of earnings to investors. It is the reason that I highlighted the possibility of a pull back on cash flows as on the stock market’s biggest vulnerabilities this year in my post on US equities. 

      Cash Return: A Global Comparison
      Having looked at US companies, let’s turn the focus to the rest of the world. The stickiness of dividends that we see in the United States is a global phenomenon, though it takes different forms in some parts of the world; in Latin America, for instance, it is payout ratios, not absolute dividends, that companies try to maintain. To provide a measure of cash returned, I report on three statistics:

      Cash Return StatisticDefinitionWhat it measures
      Dividend YieldDividends/Market CapPortion of equity return that comes from dividends.
      Dividend PayoutDividends/Net Income (if net income is positive, NA if negative)Proportion of earnings held back by the company for reinvestment or as cash balance.
      Cash Return/FCFE(Dividends + Buybacks)/FCFE (if FCFE is positive, NA if negative)Percentage of potential dividends returned to stockholders. Remaining goes into cash balance.
      The picture below looks at these dividend yields and payout ratios across the globe:
      Link to live map
      Unlike investment and debt policy, it is difficult to determine what number here would be the “best” number to see. Clearly, over time, you would like companies to return residual cash to stockholders but prudent companies, facing difficult business times, should try to hold back some cash as a buffer. Returning too little cash (low payout ratios) for long periods, though, is indicative of an absence of stockholder power and a sign that managers/insiders are building cash empires. Returning too much cash can mean less cash available for good projects and/or increasing debt ratios. In the table below, you can see the statistics broken down by region:
      Link to full country spreadsheet
      Let's take a look at the numbers in this table. The shift towards buybacks which has been so drastic in the United States seems to be wending its way globally. While there are markets like India, where buybacks are still uncommon (comprising only 6.36% of total cash returned), almost 30% of cash returned in Europe and 33% of cash returned in Japan took the form of buybacks. In Canada and Australia, companies returned over 150% of potential dividends to investors, perhaps because natural resource companies are hotbeds of dysfunctional dividend policy, with top managers maintaining dividends even in the face of sustained declines in commodity prices (and corporate earnings). The Mackenzie "over my dead body" dividend policy is live and well at many of other natural resource companies. With buybacks counted in, you see cash return rising above 100% for the US as well, backing up the point made earlier about unsustainable dividends.

      Cash Return: A Company and Sector Comparison
      Dividend policy varies across firms, the result of not only financial factors (where the company is in its life cycle, what type of business it is in and how investors get taxed) but also emotional ones (how risk averse managers are and how much they value control). As a result dividend yields and payout ratios vary widely across companies, and the picture below captures the distribution of both statistics across US and global companies:
      There are wide variations in cash return across sectors, some reflecting where they stand in the life cycle and some just a function of history. In the table below, I highlight the sectors that returned the most cash, as a percent of net income, in the table below:

      It is difficult to see a common theme here. You can see the residue of sticky dividends and inertia in the high cash return at oil and gas companies, perhaps still struggling to adapt to lower oil prices. There are surprises, with application software and biotech firms making the list. Looking at the sectors that returned the least cash, here is the list of the top ten:

      If the cash that companies can return increases as they age, you should see the cash return policies change over time for sectors. Many of the technology firms that were high growth in the 1980s are now ageing and they are returning large amounts of cash to their stockholders; Apple, IBM and Microsoft are at the top of the list of companies that have bought back the most stock in the last decade.

      Cash Balances
      While this post has been about how much cash companies return to stockholders, the inverse of whatever is said about cash return can be said about cash retained in companies, which shows up as cash balances. In fact, if you use potential dividend (FCFE) as your measure of cash that can be returned and dividends plus buybacks as your measure of cash that is actually returned, your cash balance at any point in time for a publicly traded firm can be written as:
      When companies accumulate large cash balances, it is never by accident but a direct consequence of having held back cash for long periods. So, how much cash do publicly traded companies hold? To answer that question for US companies, I look at a distribution of cash as a percent of firm value (market value of equity + total debt) in the figure below:

      Thus, the median company in the United States at the start of 2017 held 2.45% of its value in cash; remember that with the US tax code’s strictures on foreign income being taxed on repatriation, a significant portion of this cash may be beyond the reach of stockholders, at least for the moment. The median company globally holds 5.50% of value in cash, with small differences across regions with one exception. Japan is the outlier, with the median company holding 22.24% of its value in cash. Expanding the comparison globally, I look at cash as a percent of firm value by country in the picture below:
      Link to live map
      Note that, as with dividend payout, it is difficult to decide what to make of a large (or a small) cash holding. Thus, large cash balances may provide a buffer against bad times, but they may also indicative of poor corporate governance, where stockholders are powerless while manager accumulate cash. 

      Conclusion

      Since equity is a residual claim, it has never made sense to me that companies commit to paying a fixed dividend every year. I know that this is how dividend policy has been set since the beginning of equity markets, but that reflects the fact that stocks, when first traded, were viewed as bonds with price appreciation, with dividends standing in for coupons. As companies increasingly face global competition and much more uncertainty about future earnings, their reluctance to increase dividend commitments is understandable. If you buy into my characterization of dividends as analogous to getting married and buybacks as the equivalent of hooking up, companies and investors are both choosing to hook up, and who can blame them?

      YouTube Video


      Datasets
      1. Dividend and Cash Return, by Country
      2. Dividend and Cash Return, by Industry
      Data 2017 Posts



      A Valeant Update: Damaged Goods or Deeply Discounted Drug Company?


      Rats get a bad rap for fleeing sinking ships. After all, given that survival is the strongest evolutionary impulse and that rats are not high up in the food chain, why would they not? That idiom, unfortunately, is what came to mind as I took another look at Valeant, the vessel in my investment portfolio that most closely resembles a sinking ship. This is a stock that I had little interest in, during its glory days as the ultimate value investing play, but that I took first a look at, after its precipitous fall from grace in November 2015. While I stayed away from it then, I bought it in May 2016 after it had dropped another 60% and I found it cheap enough to add to my portfolio. I then compounded my losses when I doubled my holding in October 2016, arguing that while it was, at best, an indifferently managed company in a poor business, it was under priced at $14 . With the stock trading at less than $12 (and down to $10.50, as I write this post) and its biggest investor/promoter abandoning it, there is no way that I can avert my eyes any longer from this train wreck. So, here I go!

      Valeant: A Short (and Personal) History
      I won't bore you by repeating (for a third time) the story of Valeant's fall from investment grace, which happened with stunning speed in 2015, as it went from value investing favorite to untouchable, in the matter of months. My first post, from November 2015, examined the company in the aftermath of the fall, as it was touted as a contrarian bet, trading at close to $90, down more than 50% in a few months. My belief then was that the company's business model, built on acquisitions, debt and drug repricing was broken and that the company, if it became a more conventional drug business company, with low growth driven by R&D, was worth $73 per share. I revisited Valeant in April 2016, after the company had gone through a series of additional setbacks, with many of its wounds self inflicted and reflecting either accounting or management misplays. At the time, with the updated information I had and staying with my story of Valeant transitioning to a boring drug company, with less attractive margins, I estimated a value per share of $44, above the stock price of $33 at the time. I bought my first batch of shares. In the months that followed, Valeant's woes continued, both in terms of operations and stock price. After it announced a revenue drop and a decline in income in an earnings report in November 2016, the stock hit $14 and I had no choice but to revisit it, with a fresh valuation. Adjusting the valuation for the new numbers (and a more pessimistic take on how long it would take for the company to make its way back to being a conventional, R&D-driven pharmaceutical company, I valued the shares at $32.50. That may have been hopeful thinking but I added to my holdings at around $14/share.

      Valeant: Updating the Numbers
      Since that valuation, not much has gone well for the company and its most recent earnings report suggests that its transition back to health is still hitting roadblocks. While talk of imminent default seems to have subsided, there seems to be overwhelming pessimism on the company's operating  prospects, at least in the near term. In its most recent earnings report, Valeant reported further deterioration in key numbers:
      2016 10K2015 10K% Change
      Revenues$9,674.00 $10,442.00 -7.35%
      Operating income or EBIT$3,105.46 $4,550.38 -31.75%
      Interest expense$1,836.00 $1,563.00 17.47%
      Book value of equity$3,258.00 $6,029.00 -45.96%
      Book value of debt$29,852.00 $31,104.00 -4.03%
      Much as I would like to believe that this decline is short term and that the stock will come back, there is now a real chance that my story for Valeant, not an optimistic and uplifting story to begin with, is now broken. The company's growth strategy of acquiring other companies, using huge amounts of debt, raising prices on "under priced" drugs and paying as little in taxes as possible were perhaps legally defensible but they were ethically questionable and may have damaged its reputation and credibility so thoroughly that it is now unable to get back to normalcy. This can explain why the company has had so much trouble not only in getting its operations back on track but also why it has been unable to pivot to being a more traditional drug company. If researchers are leery about working in your R&D department, if every price increase you try to make faces scrutiny and push back and your credibility with markets is rock bottom, making the transition will be tough to do. It can also indirectly explain why Valeant may be having trouble selling some of its most lucrative assets, as potential buyers seem wary of the corporate taint and perhaps have lingering doubts about whether they can trust Valeant's numbers.

      In fact, the one silver lining that may emerge from this experience is that I now have the perfect example to illustrate why being a business entity that violates the norms of good corporate behavior (even if their actions legal) can destroy value. At least in sectors like health care, where the government is a leading customer and predatory pricing can lead to more than just public shaming, the Valeant story should be a cautionary note for others in the sector who may be embarking on similar paths.

      The Ackman Effect
      You may find it strange that I would spend this much time talking about Valeant without mentioning what may seem to be the big story about the stock, which is that Bill Ackman, long the company's biggest investor and cheerleader and for much of the last two years, a powerful board member, has admitted defeat, selling the shares that Pershing Square (his investment vehicle) has held in Valeant for about $11 per share, representing a staggering loss of almost 90% on his investment. The reasons for my lack of response are similar to the ones that I voiced in this post, when I remained an Apple stockholders as Carl Icahn sold Apple and Warren Buffett bought the stock in April 2016. As an investor, I have to make my own judgments on whether a stock fits in my portfolio and following others (no matter how much regard I have for them) is me-too-ism, destined for failure.  

      Don't get me wrong! I think Bill Ackman, notwithstanding his Valeant setbacks, is an accomplished investor whose wins outnumber his losses and when he takes a position (long or short) in a stock, I will check it out. That said, I did not buy Valeant because Ackman owned the stock and I am not selling, just because he sold. In fact, and this may seem like a stretch, it is possible that Ackman's presence in the company and the potential veto power that he might have been exercising over big decisions may have become more of an impediment than a help as the company tries to untangle itself from its past. I am not sure how well-sourced these stories are, but there are some that suggest that it was Ackman who was the obstacle to a Salix sale last year.

      Valeant: Three Outcomes
      As I see it, there are three paths that Valeant can take, going forward.
      1. Going Concern: To value Valeant as a going concern, I revisited my valuation from November 2016 and made its pathway to stable drug company more rocky by assuming that revenues would continue to drop 2% a year and margins will stay depressed at 2016 levels for the next 5 years and that revenue growth will stay anemic (3% a year) after that, with a moderate improvement in margins. With those changes put in and leaving the likelihood that the company will not make it at 10% (since the company has made some headway in reducing debt), the value per share that I get is $13.68. 
      To illustrate the uncertainty associated with this value estimate, I ran a simulation with my estimated distributions for revenue growth, margins and cost of capital and arrived at the following distribution of values.

      The simulation confirms the base case intrinsic valuation, insofar as the median value of $13.31 is close to the price at the time of the valuation ($12) but it provides more information that may or may not tilt the investment decision. There is a clear chance that the equity could go to zero (about 12%), if the value dips below the outstanding debt ($29 billion). At the same time, there is significant upside, if the company can find a way to alter its trajectory and become a boring, low growth drug company.
      2. Acquisition Target: It is a sign of desperation when as an investor, your best hope is that someone else will acquire your company and pay a premium for it. I am afraid that the Valeant taint so strong and its structure so opaque and complex that very few acquirers will want to buy the entire company. I see little chance of this bailing me out.
      3. Sum of its parts, liquidated: It is true that Valeant has some valuable pieces in it, with Bausch & Lomb and Salix being the biggest prices. While neither business has attracted as much attention as Valeant had hoped, there are two reasons why. The first is that Ackman, with significant losses on the stock and a seat on the board, may have exercised some veto power over any potential sales. The second is that potential buyers may be scared away by Valeant's history. One solution, now that Ackman is no longer at the company, is for Valeant to open its books to potential acquirers and sell its assets individually to the best possible buyers. Note that this liquidation value will have to exceed $29 billion, the outstanding debt, for equity investors to generate any remaining cash.

      There is one other macro concern that may make Valeant's future more thorny. As a company that pays a low effective tax rate and borrows lots of money, the proposed changes to the tax law (where the marginal tax rate is likely to be reduced and the tax savings from interest expenses curbed), Valeant will probably have to pay a much higher effective tax rate going forward, one reason why I have shifted to a 30% tax rate for the future.

      The Bottom Line
      Let's start with the easy judgment. This was not an investment that I should have made and much as I would like to blame macro forces, the company's management and Bill Ackman for my losses, this was my mistake. I was right in my initial post in concluding that the company's old business model (of acquiring growth with borrowed money and repricing drugs) was broken but I clearly underestimated how much damage that model has done to the company's reputation and how much work it will take for it to become a boring, drug company. In fact, it is possible that the damage is so severe, the company will not be able to make the adjustments necessary to survive as a going concern. 

      So, now what? I cannot reverse the consequences of my original sin (of buying Valeant at $32) in April 2017 and the secondary sin (of doubling down, when Valeant was trading at $14) by selling now. The question then becomes a simple one. Would I buy Valeant at today's price? If the answer is yes, I should hold and if the answer is no, I should fold. My intrinsic value per share has dropped to just above where the stock is trading at now, and at this stage, my judgment is that, valued as a going concern, it would be trading slightly under value. In a strange way, Bill Ackman's exit is what tipped the scales for me, since it will give Valeant's management, if they are so inclined, the capacity to make the decisions that they may have been constrained from making before. In particular, if they recognize that this may be a clear case where the company is worth more as the sum of its liquidated parts than as a going concern, there is still a chance that I could reduce my losses on this investment. Note, though, that based on my numbers, I don't expect to make my original investment (which averages out to $21/share) back. I am not happy about that but sunk costs are sunk!

      As I continue to hold Valeant, I am also aware that I might be committing one of investing's biggest sins, which is an aversion to admitting mistakes by selling losers. My discounted cash flow valuations may be an after-the-fact rationalizing of something that I don't want to do, i.e., sell a big loser. To counter this, I briefly considering selling the shares and rebuying them back immediately; that makes me admit my mistake and take my losses while restarting the investment process with a new buy, but the "wash sales" rule is an impediment to this cleansing exercise. The bottom line is that if I am holding on to Valeant, not for intrinsic value reasons (as I am trying to convince myself) but because I have an investing blind spot, I will be last one to know!

      YouTube Video


      Previous Posts on Valeant
      1. Checkmate or Stalemate: Valeant's Fall from Investing Grace (November 2015)
      2. Valeant: Information Vacuums, Management Credibility and Investment Value (April 2016)
      3. Faith, Feedback and Fear: The Valeant Test (November 2016)
      Spreadsheets
      1. Valeant Valuation: March 2017





      January 2017 Data Update 10: The Pricing Game!

      It's taken me a while to get here, but in this, the last of my ten posts looking at publicly traded companies globally, I look at pricing differences across regions and sectors. I laid out my rationale for looking at pricing in my most recent post on the topic, where I drew a distinction between good companies, good management and good investments, arguing that investing is about finding mismatches between reality (as driven by cash flows, growth and risk) and perception (as determined by the market). 

      Multiple = Standardized Price
      When looking at how stocks are priced and especially when comparing pricing across stocks, we almost invariably look at pricing multiples (PE, EV to EBITDA) rather than absolute prices. That is because prices per share are a function of the number of shares and are, in a sense, almost arbitrary. Before you respond with indignation, what I mean to say is that I can make the price per share decrease from $100/share to $10/share, by instituting a ten for one stock split, without changing anything about the company. As a consequence, a stock cannot be classified as cheap or expensive based on price per share and you can find Berkshire Hathaway to be under valued at $263,500 per share, while viewing a stock trading at 5 cents per share as hopelessly overvalued. 

      The process of standardizing prices is straight forward. In the numerator, you need a market measure of value of  equity, the entire firm (debt + equity) or the operating assets of the firm (debt + equity -cash = enterprise value). If you confused about the distinction, you may want to review this post of mine from the archives. In the denominator, you can scale the market value to revenues, earnings, accounting estimates of value (book value) or cash flows.

      As you can see, there is a very large number of standardized versions of value that you can calculate for firms, especially if you bring in variants on each individual variable in the denominator. With net income, for instance, you can look at income in the last fiscal year (current), the last twelve months (trailing) or the next year (forward). The one simple proposition that you should always follow is to be consistent in your definition of multiple.

      The "Consistent Multiple" Rule:   If your numerator is the market value of equity (market capitalization or price per share), your denominator has to be an equity measure as well (net income or earnings per share, book value of equity. For example, a price earnings ratio is consistent, since both the numerator and denominator are equity values, and so is an EV to EBITDA multiple. A Price to EBITDA or a Price to Sales ratio is inconsistent, since the numerator is an equity value and the denominator is to the entire business, and will lead to conclusions that are not merited by the fundamentals.

      Pricing – A Global Picture
      To see how stocks are priced around the world at the start of 2017, I focus on four multiples, the price earnings ratio, the price to book (equity) ratio, the EV/Sales multiple and EV/EBITDA. With each multiple, I will start with a histogram describing how stocks are priced globally (with sub-sector specifics) and then provide country specific numbers in heat maps. 

      PE ratio 
      The PE ratio has many variants, some related to what period the earnings per share is measured (current, trailing or forward), some relating to whether the earnings per share are primary or diluted and some a function of whether and how you adjust for extraordinary items. If you superimpose on top of these differences the fact that earnings per share reported by companies reflect very different accounting standards around the world, you can already start to see the caveats roll out. That said, it is still useful to start with a histogram of PE ratios of all publicly traded companies around the world: 
      Note that of the 42,668 firms in my global sample, there were only 25,493 firms that made it through into this graph; the rest of the sample (about 40%) had negative earnings per share and the PE ratios was not meaningful.  While the histogram provides the distributions by regional sub-groups, the heat map below provides the median PE ratio by country: 
      If you go to the live heat map, you will also be able to see the 25th and 75th quartiles within each country, or you can download the spreadsheet that contains the data.  I mistrust PE ratios for many reasons. First, the more accountants can work on a number, the less trustworthy it becomes, and there is no more massaged, manipulated and mangled variable than earnings per share. Second, the sampling bias introduced by eliminating a large subset of your sample, by eliminating money losing companies, is immense. Third, it is the most volatile of all of the multiples as it is based upon earnings per share.

      Price to Book 
      In many ways, the price to book ratio confronts investors on a fundamental question of whether they trust markets or accountants more, by scaling the market’s estimate of what a company is worth (the market capitalization) to what the accountants consider the company’s value (book value of equity). The rules of thumb that have been build around book value go back in history to the origins of  value investing and all make implicit assumptions about what book value measures in the first place. Again, I will start with the histogram for all global stocks, with the table at the regional level imposed on it: 
      The price to book ratio has better sampling properties than price earnings ratios for the simple reason that there are far fewer firms with negative book equities (only about 10% of all firms globally) than with negative earnings. If you believe, as some do, that stocks that trade at less than book value are cheap, there is good news: you have lots and lots of buying opportunities (including the entire Japanese market). Following up, let’s take a look in the heat map below of median price to book ratios, by country. 
      Again, you can see the 25th and 75th quartiles in either the live map or by downloading the spreadsheet with the data. Pausing to look at the numbers, note the countries shaded in green, which are the cheapest in the world, at least on a price to book basis, are concentrated in Africa and Eastern Europe, arguably among the riskiest parts of the world. The most expensive countries are China, a couple of outliers in Africa (Ivory Coast and Senegal, with very small sample sizes) and Argentina, a bit of a surprise.

      EV to EBITDA 
      The EV to EBITDA multiple has quickly grown in favor among analysts, for some good reasons and some bad. Among the good reasons, it is less affected by different financial leverage policies than PE ratios (but it is not immune) and depreciation methods than other earnings multiples. Among the bad ones is that it is a cash flow measure based on a dangerously loose definition of cash flow that works only if you live in a world where there are no taxes, debt payments and capital expenditures laying claim on those cash flows. The global histogram of EV to EBITDA multiples share the positive skew of the other multiples, with the peak to the left and the tail to the right: 
      Again, there will be firms that had negative EBITDA that did not make the cut, but they are fewer in number than those with negative EPS.  Looking at the median EV to EBITDA multiple by country in the heat map below, you can see the cheap spots and the expensive ones. 
      As with the other data, you can get the lower and higher quartile data in the spreadsheet. As with price to book, the cheapest countries in the world lie in some of the riskiest parts of the world, in Africa and Eastern Europe. China remains among the most expensive countries in the world but Argentina which also made the list, on a  price to book basis, drops back to the pack.

      EV to Sales 
      If you share my fear of accounting game playing, you probably also feel more comfortable working with revenues, the number on which accountants have the fewest degrees of freedom. Let’s start with the histogram for global stocks: 
      Of all the multiples, this should be the one where you lose the least companies (though many financial service companies don’t report conventional revenues) and the one that you can use even on young companies that are working their way through the early stages of the life cycle.  The median EV/Sales ratio for each country are in the heat map below: 
      You can download more extensive numbers in the spreadsheet. By now, the familiar pattern reasserts itself, with East European and African companies looking cheap and China looking expensive. With revenue multiples, Canada and Australia also enter the overvalued list, perhaps because of the preponderance of natural resource companies in these countries.

      Pricing – Sector Differences 
      All of the multiples that I talked about in the last section can also be computed at the industry level and it is worth doing so, partly to gain perspective on what comprises cheap and expensive in each grouping and partly to look for under and over priced groupings. The following table, lists the ten lowest-priced and highest priced industry groups at the start of 2017, based upon trailing PE: 
      Multiples by Sector
      In many of the cheapest sectors, the reasons for the low  pricing are fundamental: low growth, high risk and an inability to generate high returns on equity or margins. Similarly, the highest PE sectors also tend to be in higher growth, high return on equity businesses. I will leave the judgment to you whether any fit the definition of a cheap company. The entire list of multiples, by sector, can be obtained by clicking on this spreadsheet.

      One comparison that you may consider making is to pick and multiple and trace how it has changed over time for an industry group. Isolating pharmaceutical and biotechnology companies in the United States, for instance, here is what I find when it comes to EV to EBITR&D for the two groups over time:

      You can read this graph in one of two ways. If you are a firm believer in mean reversion, you would load up on biotech stocks and hope that they revert back to their pre-2006 premiums, but I think you would be on dangerous ground. The declining premium is just as much a function of a changing health care business (with less pricing power for drug companies), increasing scale at biotech companies and more competition. 

      Rules for the Road
      1. Absolute rules of thumb are dangerous (and lazy): The investing world is full of rules of thumb for finding bargains. Companies that trade at less than book value are cheap, as are companies that trade at less than six times EBITDA or have PEG ratios less than one. Many of these rules have their roots in a different age, when data was difficult to access and there were no ready tools for analyzing them, other than abacuses and ledger sheets. In Ben Graham's day, the very fact that you had collected the data to run his "cheap stock" screens was your competitive advantage. In today's market, where you can download the entire market with the click of a button and tailor your Excel spreadsheet to compute and screen, it strikes me as odd that screens still remain based on absolute values. If you want to find cheap companies based upon EV to EBITDA, why not just compute the number for every company (as I have in my histogram) and then use the first quartile  (25th percentile) as your cut off for cheap. By my calculations, a company with an EV/EBITDA of 7.70 would be cheap in the United States but you would need an EV to EBITDA less than 4.67 to be cheap in Japan, at least in January 2017.
      2. Most stocks that look cheap deserve to be cheap: If your investment strategy is buying stocks that trade at low multiples of earnings and book value and waiting for them to recover, you are playing a game of mean reversion. It may work for you, but there is little that you are bringing to the investing table, and there is little that I would expect you to take away. If you want to price a stock, you have to bring in not just how cheap it is but also look at measures of value that may explain why the stock is cheap. 
      3. If you are paying a price, you are "estimating" the future: When I do an intrinsic valuation (as I did a couple of weeks ago with Snap), I am often taken to task by some readers for playing God, i.e., forecasting revenue growth, margins and risk for a company with a very uncertain future. I accept that critique but I don't see an alternative. If your view is that using a multiple lets you evade this responsibility, it is because you have chosen not to look under the hood, If you pay 50 times revenues for a company, which is what you might be with Snap, you are making assumptions about revenue growth and margins, whether you like it or not. The only difference between us seems to be that I am being explicit about my assumptions, whereas your assumptions are implicit. In fact, they may be so implicit that you don't even know what they are, a decidedly dangerous place to be in investing.





      Explaining a Paradox: Why Good (Bad) Companies can be Bad (Good) Investments!

      In nine posts, stretched out over almost two months, I have tried to describe how companies around the world make investments, finance them and decide how much cash to return to shareholders. Along the way, I have argued that a preponderance of publicly traded companies, across all regions, have trouble generating returns on the capital invested in them that exceeds the cost of capital. I have also presented evidence that there are entire sectors and regions that are characterized by financing and dividend policies that can be best described as dysfunctional, reflecting management inertia or ineptitude. The bottom line is that there are a lot more bad companies with bad managers than good companies with good ones in the public market place. In this, the last of my posts, I want to draw a distinction between good companies and good investments, arguing that a good company can often be a bad investment and a bad company can just as easily be a good investment. I am also going argue that not all good companies are well managed and that many bad companies have competent management.

      Good Businesses, Managers and investments
      Investment advice often blurs the line between good companies, good management and good investments, using the argument that for a company to be a "good" company, it has to have good management, and if a company has good management, it should be a good investment. That is not true, but to see why, we have to be explicit about what makes for a good company, how we determine that it has good management and finally, the ingredients for a good investment.

      Good and Bad Companies
      There are various criteria that get used to determine whether a company is a good one, but every one of them comes with a catch. You could start with profitability, arguing that a company that generates more in profits is better than generates less, but that statement may not be true if the company is capital intensive (and the profits generated are small relative to the capital invested) and/or a risky business, where you need to make a higher return to just break even. You could look at growth, but growth, as I noted in this post, can be good, bad or neutral for value and a company can have high growth, while destroying value. The best measure of corporate quality, for me, is a high excess return, i.e., a return on capital that is vastly higher than its cost of capital, though I have noted my caveats about how return on capital is measured. Reproducing my cross sectional distribution of excess returns across all global companies in January 2017, here is what I get:

      Blog Post on Excess Returns
      To the extent that you want the capital that you have invested in companies to generate excess returns, you could argue that the good companies in this graph as the value creators and the bad ones are the value destroyers. At least in 2017, there were a lot more value destroyers (19,960) than value creators (10,947) listed globally!

      Good and Bad Management
      If a company generates returns greater (less) than its opportunity cost (cost of capital), can we safely conclude that it is a well (badly) managed company?  Not really! The “goodness” or “badness” of a company might just reflect the ageing of the company, its endowed barriers to entry or macro factors (exchange rate movements, country risk or commodity price volatility). The essence of good management is being realistic about where a company is in the life cycle and adapting decision making to reflect reality. If the value of a business is determined by its investment decisions (where it invests scarce resources), financing decisions (the amount and type of debt utilized) and dividend decisions (how much cash to return and in what form to the owners of the business), good management will try to optimize these decisions at their company. For a young growth company, this will translate into  making investments that deliver growth and not over using debt or paying much in dividends. As the company matures, good management will shift to playing defense, protecting brand name and franchise value from competitive assault, using more debt and returning more cash to stockholders. At a declining company, the essence of “good” management is to not just avoid taking  more investments in a bad business, but to extricate the company from its existing investments and to return cash to the business owners. My way of capturing the quality of a management is to value a company twice, once with the management in place (status quo) and once with new (and "optimal" management).

      I term the difference between the optimal value and the status quo value the “value of control” but I would argue it is also just as much a measure of management quality, with the value of control shrinking towards zero for “good” managers and increasing for bad ones.

      Good and Bad Investments
      Now that we have working definitions of good companies and good managers, let’s think about good investments. For a company to be a good investment, you have to bring price into consideration. After all, the greatest company in the world with superb managers can be a bad investment, if it is priced too high. Conversely, the worst company in the world with inept management may be a good investment is the price is low enough. In investing therefore, the comparison is between the value that you attach to a company, given its fundamentals and the price at which it trades.

      As you can see at the bottom, investing becomes a search for mismatches, where the market's assessment of a company (and it's management) quality is out of sync with reality. 

      Screening for Mismatches
      If you take the last section to heart, you can see why picking stocks to invest in by looking at only one side of the price/value divide can lead you astray. Thus, if your investment strategy is to buy low PE stocks, you may end up with stocks that look cheap but are not good investments, if these are companies that deserve to be cheap (because they have made awful investments,  borrowed too much money or adopted cash return policies that destroy value). Conversely, if your investment strategy is focused on finding good companies (strong moats, low risk), you can easily end up with bad investments, if the price already more than reflects these good qualities. In effect, to be a successful investor, you have to find market mismatches, a very good company in terms of business and management that is being priced as a bad company will be your “buy”. With that mission in hand, let’s consider how you can use multiples in screening, using the PE ratio to illustrate the process. To start, here is what we will do. Starting with a very basic dividend discount model, you can back out the fundamentals drivers of the PE ratio:

      Now what? This equation links PE to three variables, growth, risk (through the cost of equity) and the quality of growth (in the payout ratio or return on equity). Plugging in values for these variables into this equation, you will quickly find that companies that have low growth, high risk and abysmally low returns on equity should trade at low PE ratios and those with higher growth, lower risk and sold returns on equity, should trade at high PE ratios. If you are looking to screen for good investments, you therefore need to find stocks with low PE, high growth, a low cost of equity and a high return on equity. Using this approach, I list multiples and the screening mismatches that characterize cheap and expensive companies.


      MultipleCheap CompanyExpensive Company
      PELow PE, High growth, Low Equity Risk, High PayoutHigh PE, Low growth, High Equity Risk, Low Payout
      PEGLow PEG, Low Growth, Low Equity Risk, High PayoutHigh PEG, High Growth, High Equity Risk, Low Payout
      PBVLow PBV, High Growth, Low Equity Risk, High ROEHigh PBV, Low Growth, High Equity Risk, Low ROE
      EV/Invested CapitalLow EV/IC, High Growth, Low Operating Risk, High ROICHigh EV/IC, Low Growth, High Operating Risk, Low ROIC
      EV/SalesLow EV/Sales, High Growth, Low Operating Risk, High Operating MarginHigh EV/Sales, Low Growth, High Operating Risk, High Operating Margin
      EV/EBITDALow EV/EBITDA, High Growth, Low Operating Risk, Low Tax RateHigh EV/EBITDA, Low Growth, High Operating Risk, High Tax Rate

      If you are wondering about the contrast between equity risk and operating risk, the answer is simple. Operating risk reflects the risk of the businesses that you operate in, whereas equity risk reflects operating risk magnified by financial leverage; the former is measured with the cost of capital whereas the latter is captured in the cost of equity. With payout, my definition is broader than the conventional dividend-based one; I would include stock buybacks in my computation of cash returned, thus bringing a company like Apple to a high payout ratio.

      The Bottom Line 
      If the length of this post has led you to completely forget what the point of it was, I don’t blame you. So, let me summarize. Separating good companies from bad ones is easy, determining whether companies are well or badly managed is slightly more complicated but defining which companies are good investments is the biggest challenge. Good companies bring strong competitive advantages to a growing market and their results (high margins, high returns on capital) reflect these advantages. In well managed companies, the investing, financing and dividend decisions reflect what will maximize value for the company, thus allowing for the possibility that you can have good companies that are sub-optimally managed and bad companies that are well managed. Good investments require that you be able to buy at a price that is less than the value of the company, given its business and management.

      Thus, you can have good companies become bad investments, if they trade at too high a price, and bad companies become good investments, at a low enough price.    Given a choice, I would like to buy great companies with great managers at a great price, but greatness on all fronts is hard to find. So. I’ll settle for a more pragmatic end game. At the right price, I will buy a company in a bad business, run by indifferent managers. At the wrong price, I will avoid even superstar companies. At the risk of over simplifying, here is my buy/sell template:

      Company's BusinessCompany's ManagersCompany PricingInvestment Decision
      Good (Strong competitive advantages, Growing market)Good (Optimize investment, financing, dividend decisions)Good (Price < Value)Emphatic Buy
      Good (Strong competitive advantages, Growing market)Bad (Sub-optimal investment, financing, dividend decisions)Good (Price < Value)Buy & hope for management change
      Bad (No competitive advantages, Stagnant or shrinking market)Good (Optimize investment, financing, dividend decisions)Good (Price < Value)Buy & hope that management does not change
      Bad (No competitive advantages, Stagnant or shrinking market)Bad (Sub-optimal investment, financing, dividend decisions)Good (Price < Value)Buy, hope for management change & pray company survives
      Good (Strong competitive advantages, Growing market)Good (Optimize investment, financing, dividend decisions)Bad (Price > Value)Admire, but don't buy
      Good (Strong competitive advantages, Growing market)Bad (Sub-optimal investment, financing, dividend decisions)Bad (Price > Value)Wait for management change
      Bad (No competitive advantages, Stagnant or shrinking market)Good (Optimize investment, financing, dividend decisions)Bad (Price > Value)Sell
      Bad (No competitive advantages, Stagnant or shrinking market)Bad (Sub-optimal investment, financing, dividend decisions)Bad (Price > Value)Emphatic Sell

      YouTube Video





      User/Subscriber Economics: An Alternative View of Uber's Value

      In the week since I posted my Uber valuation, I have received many suggestions on what I should have done differently in the valuation, with many of you arguing that I was being a over optimistic in my forecasts of total market, market share and margin improvements and some of you positing that I was too pessimistic. I don't claim to have any certitude about these numbers but the spreadsheet that I used to value Uber is an open one, and you are welcome to convert your suggestions into valuation inputs and make the valuation your own. In just the last few days, though, I have been watching an argument unfold among people that I respect. about whether the reason for my low valuation for Uber is that I am using a DCF model, with the critics making the case that valuing a company based upon its expected cash flows is an old economy framework that will not yield a reasonable estimate of value for new economy companies, driven less by infrastructure investments and returns on those investments, and more by user and subscriber economics.  I have long argued that DCF models are much more flexible than most people give them credit for, and that they can be modified to reflect other frameworks. So, rather than deflect the criticism, I will try to build a user based model to value Uber and contrast with my conventional valuation.

      Aggregated versus Disaggregated Valuation
      If you are doing an intrinsic valuation, the principle that the value of a business is the present value of the expected cash flows from that business, with the discount rate adjusted for risk, cannot be contested. That is true for any business, manufacturing or service, small or large, old economy or new economy. Since that is what a discounted cash flow valuation is designed to do, I have to believe that what critics find objectionable in my Uber DCF model is not with the model itself but in how I estimated the cash flows for Uber, and adjusted for risk. I followed the aggregated model for discounted cash flow valuation where I estimated the cash flows to Uber as a company, starting with its revenues and working through the consolidated expenses and total reinvestment each year and discounted these cash flows at a cost of capital that I estimated for the entire company. Along the way, I had to make assumptions about a total market that Uber would go after, the market share that I expect the company to get in that market and the operating margins in steady state. 

      Disaggregated Valuation
      Value is additive and you can value any company on a disaggregated basis, breaking it down into different divisions/businesses, geographical areas or by units:
      • Business Units: In a sum of the parts valuation (SOTP), you can break a multi-business company into its individual business units and value each unit separately.  I have a paper where I describe the process of doing a SOTP valuation, using United Technologies, a conglomerate, as my example. If that SOTP valuation is much higher than the value that the market attaches to the company, you may very well find an activist investor targeting the company for a break up. 
      • Geographical Groupings: When valuing a multinational, you can break the company's operations down geographically and value each geographical grouping (Asia, Latin America, North America, Europe) separately, not only using different assumptions about growth and risk in region but even different currencies for each region. 
      • Unit-based Valuation: More generally, when valuing any company, you can try to value it on a unit-basis, building up to its value by valuing each unit separately and then aggregating across units. Thus, a pharmaceutical company can be valued by taking each of the drugs that are in its portfolio, including those in the pipeline, and valuing that drug based upon its cash flows and risk and then adding up the values across the entire portfolio. A retail business can be valued by valuing individual stores and adding up the store values and a subscription-based company can be valuing by valuing a subscription and multiplying by the number of subscriptions, current and forecasted.
      I may be misreading the critics of my Uber valuation but it seems to me that some of them, at least are making the argument it is better to value Uber, by valuing an individual Uber user first, and then scaling the value up to reflect not just the number of users that Uber has today (existing users) but also new users it expects to add in the future. 

      Aggregated versus Disaggregated Valuations: Weighing the Trade offs
      Valuation on a disaggregated basis allows you to be much more flexible in your assumptions, allowing them to vary across each grouping but there are four reasons why you seldom see them practiced (or at least practiced well) in company valuation.
      1. Law of large numbers: As companies get larger and more diverse, there is an argument to be made that you are better off estimating on an aggregated basis rather than a disaggregated one. The reason is statistical. To the extent that your estimation errors on a unit basis are uncorrelated or lightly correlated, your estimates on an aggregated level will be more precise than the unit-based estimates. For example, you will have a much better chance of estimating the aggregate revenues for Pfizer correctly than you do of estimating the revenues of each of its dozens of drugs.
      2. Information Vacuums: Information on a disaggregated basis is difficult to get for individual businesses, geographies, products or users, if you are an investor looking at a company from the outside. If you are doing your valuation from inside the company (as an owner or venture capitalist), you may be able to get this information, but as you will see with my Uber user valuation, even insiders will face limits.
      3. Missing Value Pieces: When valuing a company on a disaggregated business, it is easy to overlook some items that are consequential for value. In sum of the parts valuation, for instance, analysts are so caught up in estimating the values of individual businesses that they sometimes forget to value "corporate costs", which can be a multi-billion drag on value.  
      4. Corporate Structure: There are some items that are easier to deal with at the aggregate level, because that is where they affect the business. Thus, you can model when taxes come due and the effect of losses easier when you are valuing an aggregated business than when you are valuing it on a disaggregated level. Similarly, if you are concerned about legal penalties or corporate governance, these are better addressed at the aggregated level.
      It is true that aggregation comes with costs, starting with the blurring of differences across disaggregated units (business, geographies, products, users) as well as the missing of competitive advantages that apply only to some units of the business and not to others. It is also true that using an aggregated valuation can result in a process that is disconnected from how the owners and managers at user-based companies think about their companies and thus cannot help them in managing these companies or valuing them better.

      User Based Valuation
      Now that we have laid out the pluses and minuses of aggregated versus disaggregated valuation, let us think about how you would construct a disaggregated valuation of a company that derives its value from users or subscribers. In general, the value of such a company can be written as the sum of three components:
      Value of user-based company = Value of existing users + Value added by new users - Value drag from corporate expenses

      1. Valuing Existing Users
      The key step in a user-based valuation is estimating the value of a user and that value is a function of many variables: the cash flows that you are currently generating from a typical user, the length of time you expect that user to use your product or service, your expectations of how much growth you can expect in cash flows from a user over time and the uncertainty that you feel about all of these judgments:

      Consider the implications that emerge from this simple framework:
      1. The value of a user increases with user stickiness and loyalty (captured in the expected lifetime of a user and the annual renewal rate).
      2. The value of a user is directly proportional to the profitability of that user (captured as the difference between the revenues from that user and the cost of servicing that user). 
      3. The value of a user is directly proportional to the growth that you can generate in profits over time, by either getting the user to use more of your product or service or coming up with other products or services that you can sell that user. 
      4. The value of a user decreases as you become more uncertain about future cash flows from that user, with that uncertainty being a function of the revenue model that you use and the discretionary nature of the product or service. A subscription-based model, where users agree to pay a fixed amount every period, will generally be less risky and more valuable than a transaction-based model or an advertising-based model, that delivers the same cash flows. A product or service that delivers a necessity (transportation) is less risky than one that meets a more discretionary need (travel). 
      If you can value a user, you can then estimate the value of an existing user base, by multiplying the value/user by the number of existing users. If you have multiple types of users, with perhaps different revenue models for each, as is the case with LinkedIn's premium and regular members, you can value each user group separately. 

      Value Added by New Users
      The second segment of value is the value added by new users that you expect to see added in the future. To estimate this value, you can start with the value per user from the last section but you have to net out the cost of acquiring a new user, which can take the form of advertising, introductory discounts and/or infrastructure investments to enter new markets. That net value added by a new user  (value per user minus cost of acquiring a user) then has to be multiplied by the number of new users that you expect to add each period and brought back to the present, adjusting for both the risk in the cash flows and the time value of money.

      Again, I will agree that this is simplistic but consider the common sense implications:
      1. The value added by a new user increases with the value of a user, estimated in the last section. A strategy of going for fewer and more intense users may create more value than one with more and less engaged users, a warning that pursuing user growth at any cost can be dangerous for value.
      2. The value added by a new user decreases as the cost of adding users increases. That cost will be a function of the competitiveness of the business (increasing as competition increases) but also of networking effects. If you have strong networking effects, the cost of adding new users will decrease as you accumulate new users, thus creating a value accelerator for your business.
      3. The value added by a new user decreases as you become more uncertain about user growth. That uncertainty will be a function of competition and whether the technology that you have built your product or service on is sustainable.
      Corporate Expenses and Value
      To get from user value to the value of the business, you have to bring in the rest of the company into your analysis. To the extent that you have expenses that are unrelated to servicing existing users or adding new ones, i.e., corporate expenses, for lack of a better term, you have to compute the value of these expenses over time and reduce your value as a company by this amount:

      While at first sight, this item may look like wasteful that should be eliminated, it represents both a danger and an opportunity for young companies. It is a danger to the extent that bloated corporate expenses can drag a company's value down, but it can be an opportunity insofar as it is at the basis of economies of scale. If corporate expenses represent necessary expenses to keep a business going, and they grow at a rate much lower than the growth rate in users and revenues, you will see margins improve quickly as a company scales up.

      Valuing Uber: A User based Model
      Can Uber be valued using a user-based model? Yes, but it will require assumptions about users that are, at best, tentative and at worst, based upon little information. While I will attempt with the limited information that I have on Uber to do a user-based valuation, I will leave it to someone who has access to more information than I do (a VC invested in Uber or an Uber manager) to tweak the numbers to get better estimates of value.

      Deconstructing the Financials
      The numbers that we have on Uber's operations are minimalist, reflecting both its standing as a private company and its general secretiveness. In 2016, according to the financials that Uber provided to a Bloomberg reported, Uber reported $20 billion in gross billings, $6.5 billion in net revenues (counting all revenues from UberPool) and a loss of $2.8 billion (not counting the $1 billion loss on the China operations). According to other reports, Uber had about 40 million users at the end of 2016, up from 24 million users at the end of 2015. Finally, other (dated) reports suggest Uber's contribution margins (revenues minus variable costs) in its most profitable cities ranges from 3-11% of gross billings and its contribution margin in San Francisco, its longest standing and most mature market, is 10.1%. Bringing in these noisy and diverse estimates together, here are my estimates of user statistics:

      These numbers are stitched together from diverse sources and vary in reliability, but based upon my judgments, I break down Uber's operating expenses in 2016 into three categories: to service existing users (48.17%), to get new users (41.08%) and corporate expenses (10.75%); the last estimate is a shot in the dark, since there is no information available on the value. The annual profit from an existing user, based on 2016 numbers, is about $50.50 (Net Revenues - Expense/user) and the  cost of adding a new user is about $238/75, and both will be key inputs in my valuation.

      Valuing Existing Users
      To value Uber's existing users, I use the framework developed in the last section, in conjunction with the estimates that I obtained from the limited financial information provided by Uber. I valued existing users, assuming four additional parameters: a lifetime of 15 years for users, an annual renewal likelihood of 95%, a compounded growth rate of 12% in annual revenues from users expanding their user of Uber services and a growth rate of 9.9% a year in annual user servicing expenses (on the assumption that 80% of the servicing cost is variable). Assuming a cost of capital of 10% (in the 75th percentile of US firms), the resulting value per user and the overall value of existing users is shown below:
      Download spreadsheet
      The value per existing user is about $410 and the overall value of Uber's 40 million existing users is $16,412 million. Not surprisingly, this value is sensitive to user stickiness (as measured by user lifetime) and user growth potential (as measured by the growth rate in annual revenues):

      In a market where investors swoon at user numbers, this table makes an obvious point. Not all users are created equal, with more intense, sticky users being worth a great deal more than transient, switching users.

      Value Added by New Users
      To estimate the value added by new users, I start with the value per user (estimated in the last section to be $410), which I grow at the inflation rate to get expected value per user over time, and use the cost of acquiring a new user from 2016 (about $240/user). Assuming a growth rate of 25% a year for the next five years, 10% between years six and ten and overall economic growth after year ten, I estimate the value added by new users over time. (With those growth rates, I more than quadruple the number of users over the next ten years to 164 million.) In coming up with value, I assume that new user growth is more uncertain than the value created by existing users, and use a 12% cost of capital (at the 90th percentile of US firms) to get today's value.
      Download spreadsheet
      The value added by new users, based upon my estimates, is $20,191 million. That value is sensitive to the net value created by each new user (value of a new user minus the cost of adding a new user) and the growth rate in the number of users:
      This table illustrates the point made earlier about how some companies will be better off trading off higher value added per user for lower user growth, since there are clearly lower growth/ higher value added scenarios that dominate higher growth/lower value added scenarios in terms of value creation.  

      Corporate Expenses and overall Value
      The final loose end is the corporate expense component, a number that I estimated (arbitrarily) to be $1 billion in 2016. Allowing for the tax savings that these expenses will generate and assuming a 4% compounded growth rate, well below the 15.16% compounded growth rate in total users, I estimate a value for these corporate expenses (using the 10% cost of capital that I used for existing users):
      Download spreadsheet
      The value drag created by corporate expenses is about $10,369 million. Bringing together all three components, we get a value for Uber's operations of $26.2 billion
      Value of Uber's Operating Assets:
      = Value of Existing Users+  Value added by New Users - Value drag from corporate expenses
      = $16.4 billion + $20.2 billion + $10.4 billion = $26.2 billion
      Adding the cash balance ($5 billion) and the holding in Didi Chuxing (estimate value of $6 billion) results in an overall value of equity of $37.2 billion for the company (and its equity, since it has no debt):
      Value of Uber Equity = Value of Operating Assets + Cash - Debt = $26.2 + $5.0 + $6.0 = $37.2 billion
      This is close to the value that I obtained for Uber on an aggregated basis, but that is a reflection of my understanding of the company's economics.

      Pricing versus Valuing Users
      As you can see, valuing users requires assumptions about users that can be difficult to make. So, how do venture capitalists and other early stage investors come up with per user or per subscriber numbers? The answer is that they do not. Drawing on an earlier post that I had on how venture capitalists play the pricing game, venture capitalists price users, rather than value them. What does that involve? Very simply put, the price per user at Uber, given its most recent pricing of $69 billion and the estimated 40 million users is $1,725/user ($69,000/40).  To make a judgment on whether that number is a high or a low number, you would compare that price to what you the market is pricing a user at Lyft or Didi Chuxing and if naive, argue that the lower the price per user, the cheaper the company. Using the most recent estimates of pricing and users for the five big ride sharing companies, here is what we get:

      CompanyMost Recent Pricing (in $ millions)# Users (in millions)Price/User
      Uber$69,00040.00$1,725.00
      Lyft$7,5005.00$1,500.00
      Didi Chuxing$50,000250.00$200.00
      Ola$3,00010.00$300.00
      GrabTaxi$4,2003.80$1,105.26
      If you follow the user valuation in the last section, you can see why this pricing comparison can be dangerous. The aggregate pricing that you get for individual companies reflects not only existing users but also new users, and dividing by the existing users will give you much higher numbers for companies that expect to grow their user base more. Even if every company is correctly priced, you should expect to see users at companies with less cash flows per user, lower user growth, less intense and loyal users and more uncertainty about future cash flows to be priced much lower than at companies with intense and sticky users, with more growth potential.

      The Bottom Line
      If your argument against using discounted cash flow valuation (at least in the aggregated form that it is usually done) is that you have to make a lot of assumptions, I hope that this process of valuing users brings home the reality that you cannot escape having to make those assumptions. In fact,  the assumptions that you need to make to value a company on a disaggregated basis (based on users or subscribers) are often more involved and complex than the ones that you have to make in an aggregated valuation. That said, I do agree that looking at value on a disaggregated basis can not only give you insights about value drivers but also about questions that you would want to ask (and get answered) if you are thinking about investing in or building a young company whose value is coming from its user or subscriber base. 

      YouTube Video

      Attachments
      1. Uber User-based Valuation
      2. Uber aggregated DCF
      Previous Posts on Uber



      Uber's bad week: Doomsday Scenario or Business Reset?

      Uber just cannot seem to help itself, finding a way to get in the news, and often in ways that leave its image in tatters. You could see this pattern in full display last week, where Travis Kalanick, its founder and CEO took a leave of absence to reinvent himself as Travis 2.0, and David Bonderman, founding partner at TPG and Uber director, had to step down after making a sexist remark at a meeting with Uber employees about countering sexism. Today, Travis made his departure permanent, throwing the company into chaos as the board searches for a replacement. As someone who has been collecting stories almost obsessively about the company since June 2014, this is just the latest in a long string of news events, where Uber has been portrayed as a bad corporate citizen. As with prior episodes, there are many who are writing the company’s epitaph but I would not be in too much of a hurry. This is a company that built itself by breaking rules, and while I believe that the latest controversies will damage Uber, they will not disable it.

      Uber: Retracing history
      If you are just starting to pay attention to Uber, after the last week, let me start by bringing you up to date with the company. Founded in 2009, by Travis Kalanick and Garrett Camp, in San Francisco as UberCab, and going into operation in 2010, the company has redefined the car service business, making the taxi cab a relic, at least for some segments of the population. Uber’s initial business model, which became the template for the ride sharing business, was a simple one. The company entered the car service business, and did so without buying any cars or hiring any drivers, essentially letting independent contractors use their own cars and operating as match-maker (with customers). That low capital intensity model has allowed the company to grow at an astronomical rate, with almost no large infrastructure or capital investments through much of its life.

      My first brush with Uber was in June 2014, when I tried to value the company. While many have since reminded me how wrong I was in my judgment, I have no qualms about repeating the story that I said about Uber at the time and the resulting valuation. Framing Uber as an urban, car-service company with local networking benefits and a low capital intensity model, I valued the company at about $6 billion. In fact, Bill Gurley, a partner at Benchmark Capital and an early investor in Uber, took me to task for the narrowness of my story, arguing that I was missing how much Uber would change the logistics market with his offerings.

      Bill was right, I was wrong, and I did underestimate Uber’s growth potential, both in terms of geography and in attracting new users into the car service business. In October 2015, I revisited my Uber valuation and told a more expansive story of the company, incorporating its global reach and the influx of new users, while also noting that the pathway to profitability now faced far more roadblocks (as Didi Chuxing, Ola and GrabTaxi all found investors with open pockets and ramped up the competition). That resulted in a much higher revenue forecast, combined with more subdued operating margins, to yield a value of about $23 billion for the company.

      In August 2016, I took another look at Uber, after it exited the Chinese market (the largest potential ridesharing market in the world) ceding the market to Didi Chuxing in return for Uber getting a 20% stake in Didi. I argued that this was a good development, since China had become a money pit for the company, sucking up more than a billion dollars in cash in the prior year. While there was some positive movement on some of my assumptions (slightly smaller losses and continued revenue growth), they were offset by some negative movement in other assumptions, leaving my value at about $28 billion, with almost all of the change in value from the prior year coming from the Didi stake that Uber got in exchange for leaving the China market. These are, of course, my stories about Uber and valuations and they matter little in how Uber is perceived by the market. In fact, there is clear evidence that notwithstanding all of the negativity around the company, investors have consistently pushed up its pricing from $ 60 million in 2011 to $3.5 billion in 2013 to $17 billion in June 2014 to almost $70 billion in the most recent capital round.

      Uber: An Operations Update
      The problem with Uber is that as a private business, albeit one with a high profile, its financial statements are not public. For much of its life, the only numbers that have been made public about the company have been leaked and my valuations have been based on this leaked information. Early this year, Uber finally departed from the script, partly with the intent of drawing attention away from negative stories about the company, and revealed selected financials for 2016. In particular, it reported that it generated more than $20 billion in gross billings in 2016, doubling its 2015 numbers, and that its share of these billings was $6.5 billion (which represents its net revenues). The latter number is puzzling since the company's stated share of the billings is only 20% (which would have meant only $4 billion in revenues) but part of the difference can be explained by the fact that Uber reported its gross billings from UberPool, its car pooling service, as revenues. The revenue growth has been dazzling but the losses continued to mount as well. Uber reported a loss of $2.8 billion for 2016, but that number would have been worse (closer to $3.8 billion) if losses in its defunct China operations had been counted. Overall, though, like all of its financial disclosures, leaked or otherwise, the number paint a mixed picture of Uber. On the plus side, they show a company growing explosively, adding cities, drivers and gross billings as it goes along. On the minus side, you are not seeing the rapid improvements in margins that you would expect to see as a company scales up, if it has economies of scale. 

      One reason why losses at Uber have continued to mount, even as revenues rise, is that the competition has not cooperated in Uber's quest for world domination. Rather than be intimidated by the Uber presence and capital advantage, some competitors (like Lyft) have adapted and narrowed their focus to markets, where they can compete. In fact, it is ironic that Lyft, which has long been viewed as the weaker competitor, reported an increase in market share in the US ride sharing market in 2016 and may be first to turn a profit in this business. Others, like Didi Chuxing, have attacked Uber's strength with strength, showing the capacity to raise capital and burn through it just as fast and recklessly as Uber has. Still others, like Ola, have played to local advantages to establish a beachhead against Uber. If Uber's original intent was to use shock and awe to wipe out its competition and emerge as the only player standing, it will have to rethink its plans.

      The final leaked reports from the first quarter of 2017 seem to offer some glimmers of hope for Uber, as net revenues continued to increase (rising 18% from the prior quarter's numbers to 3.4 billion) and losses shrunk to $708 million from the $991 million in the prior quarter. Uber optimists found reasons to celebrate in these numbers, arguing that the much awaited margin improvement is now observable, but I would hold off until we not only get fuller financials but also are able to see how much the company paid out in stock based compensation. Using the same indefensible practice that other technology companies have adopted, Uber reports its profits (or in its case, its losses) before stock based compensation.

      Uber: The Extracurricular Activity
      With Uber, it has never just been about the numbers, because the company finds a myriad of ways to get in the news. Early on its life, some of this was by design, especially when the news stories were about the company evading rules and regulations to offer service in a city, since it burnished the company's reputation for getting things done first and worrying about the rules afterwards. In the last few months, it looks like the news cycle has spun out of Uber's control and that the stories have the potential, at least, to do real damage.
      1. The Google/Waymo Legal Tangle: Uber has not been shy about its desires to one day have self driving cars be its vehicles of choice, increasing investment needs in the business and potentially profit margins. The problem with this strategy it that it has brought Uber head to head against Google, a player with not only a head start in this business but also pockets so deep that it make's Uber's access to capital look paltry. That is perhaps why Uber announced with fanfare that it had hired Anthony Levandowski, a key player on the Google Waymo team, to lead its self driving car project. Any positive payoff from this announcement has been more than erased by subsequent developments, starting with Google accusing Mr. Levandowski of stealing proprietary information and suing Uber for being complicit in the deception,  and with Uber folding, by firing Mr. Levandowski. I am not sure how far this has set Uber back in the driverless car business, but it certainly could not have helped.
      2. Travis YouTube Meltdown: You would think that someone with Travis Kalanick's tech savvy would know better, but his public confrontation with an Uber driver about whether Uber was squeezing drivers was recorded and went public. While this was a small misstep, relative to Uber's much bigger public relations fiascos, the incident reinforced the view among some that Kalanick was too impetuous and immature to be the CEO of a high profile company.
      3. Sexism and Boorishness: The stories about boorish behavior at Uber have been around a long time, and for a while, the company seemed to not just ignore these stories but feed off them. In the last few months, the stories acquired a darker edge with Susan Fowler, an ex-Uber engineer, writing about sexual harassment during her tenure at the company and the unwillingness of the company to do anything about it.  Susan Fowler's chronicling of sexism at Uber had consequences, since the company hired Eric Holder and Tammy Albaran  to look at corporate behavior and culture. Their report not only contained a listing of Uber's cultural problems but also included forty seven recommendations on how Uber could create an inclusive workplace, leading off with the one that Uber's board of directors "should evaluate the extent to which some of the responsibilities that Mr.Kalanick has historically possessed should be shared or given outright to other members of senior management".
      The Covington report could not be ignored and the last week was consequential. Travis Kalanick announced that he was taking a break from his role as CEO "to work on Travis 2.0 to become the leader that this company needs and that you deserve". It was in a follow-up meeting with Uber employees that Arianna Huffington chaired, with the intent of making Uber a more welcoming environment for women, that David Bonderman quipped about how having more women as directors would make it "much more likely there’ll be more talking" at meetings. Talk about being stone deaf!

      What now?
      In a post from long ago, I talked about how news events can alter valuations by affecting the stories that you tell about companies and classified these story alterations into three groups:
      • In a story break, you learn something about a company that renders your story moot and makes your valuation irrelevant (perhaps making it zero). This is the take that some have taken with Uber, when they have argued that the most recent news stories have doomed the company by breaking its story.
      • In a story change, the news that you acquire can lead to you significantly expanding or contracting the story that you were telling about the company, with the former increasing value and the latter reducing it. My story for Uber dramatically expanded from the urban, car service company, with a value of $6 billion in June 2014, to a global logistics company facing challenges in turning revenues to profits, with a value of $23 billion, in September 2015.
      • In a story shift, your basic story stays unchanged but with shifted contours. With Uber, that is what transpired, at least for me, between September 2015 and September 2016, where notwithstanding all of the news about the company, the story remained mostly unchanged, with perhaps higher revenue growth and lower profitability offsetting each other to leave value unchanged at about $25 billion.
      So, are the events of the last few months at Uber a story break (which would be catastrophic for its business and value), a story change (where Uber will continue to operate but with much more restraint in going for growth) or just a story shift (where after a few bumps and bruises, the company will continue on its current path)? To answer this question, you have to look how the different constituent groups, that are key to the company's pathway to profits, will react to these latest news stories. On the operations side, there are the regulators, who set the entry and operating rules in the cities that Uber operates in, the drivers who provide the life blood for the ride sharing operations and the customers, who choose to uber rather than use their own cars, mass transit or cabs. On the business side, there are the managers, from the top levels down to middle management, who will chart the future growth map for the company, and the engineers and technical staff, who make it a functional company. On the financing side, there are the venture capitalists who provided the initial capital for the company to go from start up to operations and the public equity investors (mutual funds and sovereign funds). Each of these groups has the potential to alter the Uber story and thus its value:
      The doomsday scenario is embedded in this picture. For this crisis to take Uber down, millions of Uber customers will have to delete their apps, droves of Uber drivers will quit, regulators will rescind permissions already granted to operate in cities, Uber managers will be paralyzed, engineers will refuse to work for the company and investors (both venture capital and public equity) will not only cut off access to fresh capital and mark down their existing investments. Could these events unfold? It is possible, but unlikely, because each of these groups, I think, has too much to lose, if Uber implodes:
      • Customers use Uber because it is cheap, convenient and quick and I seriously doubt that the corporate culture makes it even to the top ten list of considerations for most customers. Remember that the much publicized #DeleteUber movement a few months ago resulted in about 200,000 people deleting the app, about 0.5% of Uber's 40 million users. When moral arguments conflict with basic economics, economics almost always wins, and I seriously doubt that Uber will face much of a customer backlash.
      • Without its drivers, there would be no Uber but of all of the constituent groups, drivers are likely to have the fewest delusions about the company, since they have been at the receiving end of its ruthless competitiveness. Given their need to make an income, it is both unfair and unrealistic to expect a significant number of drivers to stop driving for Uber just because of recent news stories, especially since most of these stories reaffirm what the drivers have always believed about the company.
      • It is true that Uber has handed regulators another cudgel to beat them with and perhaps use as an excuse for crimping their operations, but given how ineffective regulators have been in slowing the company down, especially in the fact of backlash from Uber customers, I don't see the recent news changing the dynamics by enough to make a difference.
      • On the managerial front, several news stories over the last week suggest that while Travis Kalanick was away on his reinvention mission, the company would be run by a committee of thirteen lieutenants (the people reporting to Kalanick), not a good development, especially when you have to make decisions quickly, but since these are people who were all hand picked by Kalanick, and are therefore more likely to think alike than disagree, it may work. This morning's news story that Kalanick had quit as CEO does create some uncertainty about future direction, which will not be resolved until a new CEO is hired.
      • Susan Fowler, the author of the blog post that led Uber to their current woes, was an engineer at Uber and she indicates that Uber's actions resulted in female engineers fleeing the company, dropping from 25% to less than 3% of the engineering workforce.  There is the danger that Uber's environment is viewed as so toxic that engineers will refuse to work for the company and that could be devastating for the company. While I think that this will weigh, at least in the near term, on Uber's capacity to attract investors, there will be enough engineers who will still be swayed by the company's resources and the excitement of working on the next big thing in sharing economy.
      • The investors (venture capitalists and public investors) who seeded this company clearly have the most to lose (in potential profits) from the company imploding and the desire to preserve capital will lead them to do whatever needs to be done to save the company. Consequently, it is extremely unlikely that they will abandon their investments, just because of public outrage, or stop providing more capital to the firm, if the failure to do so is a complete loss in value. In fact, I believe that Kalanick's resignation today was prompted by investor pressure to move on; they have too much money at stake for them for them to let personal friendship or loyalty get in the way. That said, these investors play the pricing game and much of how investors will react will depend on what the pricing is for the next round of financing. If that happens at a price greater than the most recent round, all will be forgiven and investors will view this episode as a bump in the road to one of the most lucrative IPOs of all time. If not, and this is the biggest risk that Uber faces, you can see a shrinking story (and value) for the company.

      The bottom line is that I don't see the events as story breaks. There is the possibility that it is a story change, but that new story cannot be told until we find out who will head the company. For the moment, my story for Uber is mostly unchanged from September 2016 with two shifts: there is now a change, albeit a small one (5%), that the company could fail and I believe that these events have increased the likelihood that Uber will have to follow a more conventional business path of treating drivers as employees (lowering target operating margins). The resulting valuation is below:
      Download spreadsheet
      The value that I attach to the operating assets stays at the $25 billion that I estimated in September 2015 and 2016, with the additional value of close to $11 billion coming from cash on hand and the Didi Chuxing stake.  Could the new CEO affect this value? Yes, and here is why. Uber's value requires that the company continue to be audacious in its reach for new markets, aggressive in challenging competition and willing to be dependent on new capital for growth. If, as some news stories suggest, Uber's directors are thinking of playing it safe and hiring a corporatist and a rule follower, you may need to reassess the story to a safer, smaller one, delivering less value. This is still a company that needs a visionary CEO, but one with a little more self-restraint than Travis Kalanick.  Good luck with that!

      In Closing
      My conclusion is that the Uber's value, notwithstanding the sturm und drang of the last week, is intact but at a number that is far lower than investors have priced it at recently. The effect of the last week may be to bring the pricers back to earth, by reminding investors that there is a long way to go for Uber to convert potential to profits. Prior to these news stories, Uber was a rule breaking company with a business model that delivered revenue growth but offered a very narrow path to profitability. After these news stories, the story remains the same but Uber has just made its narrow path even narrower and much rests on who will head the company on this path.

      YouTube video

      Blog Posts on Uber
      1. A Disruptive Cab Ride to Riches (June 2014)
      2. Possible, Plausible and Probable: Big Markets and Networking Effects (July 2014)
      3. Up, Up and Away: A Crowd Valuation of Uber (December 2014)
      4. On the Uber Rollercoaster: Narrative Tweaks, Twists and Turns (October 2015)
      5. The Ride Sharing Business: Is a Bar Mitzvah moment coming? (August 2016)
      Uber valuation spreadsheets
      1. Uber valuation (June 2014)
      2. Uber valuation (September 2015)
      3. Uber valuation (August 2016)
      4. Uber valuation (June 2017)





      A Tale of Two Markets: Politics and Investing!


      "It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way.” That Charles Dickens opening to The Tale of Two Cities is an apt description of financial markets today. While disagreement among market participants has always been a feature of markets, seldom has there been such a divide between those who believe that we are on the verge of a massive correction and those who equally vehemently feel that this is the cusp of a new bull market, and between those who see unprecedented economic and policy uncertainty and market indicators that suggest the exact opposite. Is one side right and the other wrong? Is it possible that both sides are right? Or that both sides are wrong?

      The Divergence
      The investor divide is visible, and sometimes dramatically so, in almost every aspect of markets, from risk indicators to fund flows to consumer behavior.

      1. Risk on? Risk off?
      Do we live in risky or safe times? It depends on who you ask and what indicator to look at. Over the last two decades, the VIX (Volatility Index) has become a proxy for how much risk investors see in  equity markets and the graph below captures the movement of the index (and a similarly constructed index for European stocks) over much of that period:
      VIX: S&P 500, Euro VIX: Euro Stoxx 50
      Last year, the volatility measures in both the US and Europe not only took Brexit and the Trump election in stride but they have, in the months since the US presidential elections, continued their downward move, ending May 2017 at close to historic lows.
      Lest you believe that this drop in volatility is restricted to stocks, you see similar patterns in other measures of risk including treasury yield volatility (shown in the graph) and in corporate bond volatility. This volatility swoon is also not restricted to the US, since measures of global volatility have also leveled off or decreased over the last few months. In fact, the volatility in currency movements has also dropped close to all-time lows. 

      In sum, the market seems to be signaling a period of unusual stability. That is at odds with what we are reading about economic policies, where there is talk of major changes to the US tax code and trade policies, signaling a period of high volatility for global economies. The economic policy uncertainty index, is an index constructed by looking at news stories, CBO lists of temporary tax code provisions and disagreement among economic forecasters, has been sending a very different signal to the market than the market volatility indices:

      In the months since the election, the indices have spiked multiple times, breaking through records set during the 2008 crisis. In short, we are either on the cusp of unprecedented stability (at least as measured with the market volatility indices) or explosive change (according to the economic policy indices).

      2. Funds in? Funds out?
      The ultimate measure of how comfortable investors feel about risk is whether they are putting money into stocks or taking them out and fund flows have historically been a good measure of that comfort. Put simply, if investors are wary and risk averse about an asset class or market, you should expect to see money flow out of that market and if they are sanguine, you should see money flow in. In the graph below, we look at fund flows into equity, bond and commodity funds, by month, from the start of 2016 to the April 2017:
      Source: Investment Company Institute
      More money has flowed into both equity and bond funds, on a monthly basis, since November 2016 than in the first ten months of 2016.  While the fund flow picture is consistent with the drop in volatility that you see across the market-based risk measures, there are discordant notes here as well. First, and perhaps least surprisingly, the perennial market bears have become even more bearish, with concerns about macroeconomic risk augmenting their long-standing concerns about stocks trading at high PE ratios. Second, there are big name investors who are cautioning that a market correction is around the corner, with Jeff Gundlach being the latest to argue that it is time to sell the S&P 500 and buy emerging market stocks. Finally, there is some evidence that money is leaving US stocks, with the Wall Street Journal reporting that money going into US stocks is at a 9-year low, while inflows into European stocks hit a five-year high.

      3. Corporate and Business Behavior
      Ultimately, risk does not come from market perceptions or newsletters but is reflected in consumer spending and business investment. On these dimensions as well, there is enough ammunition for both sides to see what they want to see. With consumer confidence, the trend lines are clear cut, with consumers becoming increasingly confident about both their current and future prospects:

      That confidence, though, is not carrying through into consumer spending, where the numbers indicate more uncertainty about the future:

      While consumer spending has increased since November, the rate of change has not accelerated from growth in prior years. You can see similar divergences between confidence and spending numbers at the business level, with business confidence up strongly since November 2016 but business investment not showing any significant acceleration.  In short, both consumers and businesses seem to be feeling better about future prospects but they don't seem willing to back up that confidence with spending.

      The Diagnostics
      So, how do we go about explaining these stark differences between different indicators? Has risk gone up or has it gone down in the last few months? Is money coming into stocks or is it leaving stocks? Why, if consumers and businesses are feeling better about the future, are they not spending and investing more? There are four possible explanations and they are not mutually exclusive. In fact, I believe that all four contribute to the dichotomy.
      1. Markets have become inured to crises: The last decade has been one filled with crises, in different regions and with different origins, with each one described as the one that is going to tip markets into collapse. Each time, after the debris has cleared, markets have emerged resilient and sometimes stronger than they went in. It is possible that investors have learned to take these market shocks in stride. Like the boy who cried wolf, it is possible that market pundits are viewed by investors as prone to hysteria, and are being ignored.
      2. Disagreement about economic policy changes/effects: It is also possible that economic pundits and investors are parting ways on both the likelihood of economic policy shocks and/or the consequences. On economic policy changes, the skepticism on the part of investors can be explained by the fact that governments across the globe seem to be more interested in talking about making big changes than they are in making those changes. On the effects of changes, the logic that policy uncertainty leads to economic uncertainty which, in turn, causes market uncertainty is being put to the test as governments and central banks are discovering that policy changes, on everything from interest rates to tax rates, are having a much smaller impact on both economic growth and investor behavior than they used to, perhaps because of globalization. 
      3. Macro to Micro Risk: One of the residual effects of the 2008 crisis was an increase in correlation across stocks, with the proportion of risk attributable to market risk in individual stocks rising, relative to firm-specific risk, with that effect persisting into 2016.  Since November 2016, the correlation across stocks has dropped, as investors try to assess how new policies on taxes and infrastructure will help or hurt individual stocks.and this may explain the drop in the VIX, even as individual stocks are perhaps getting riskier.
      4. Politics first, analysis later: It is no secret that we live in partisan times, where almost every news story is viewed through political lens. Why should financial markets be immune from political partisanship? I have seen no research to back this up, but my very limited sampling of investor views (on politics and markets) indicates a convergence of the two in recent months. Put simply, Trump supporters are more likely to be bullish on stocks and confident about the future of the economy, and Trump opponents are more likely to be bearish about both stocks and the economy. Both sides see what they want to see in news stories and data releases and ignore that which does not advance their theses.
      So, who is right here? I think that both sides have reasonable cases to make and both have their blind spots. On crisis weariness, it is true that market watchers have been guilty of hyping every crisis over the last decade, but it is also true that not all crises are benign and that one of them may very well be the next "big one". On economic policy changes and effects, I am inclined to side with those who feel that the powers of governments and central banks to guide economies is overstated but I also know that both entities can cause serious damage, if they pursue ill-thought through policies. On the political front, I won't tip my hand on my political affiliations but I believe that viewing economics and markets through political lens can be deadly for my portfolio. 

      My Sanity Check:  Equity Risk Premiums
      As you can see, it is easy to talk yourself on to the cliff or off the cliff but after all the talking is done, it remains just that, talk. So, I will fall back on a calculation that lets the numbers do the talking (rather than my biases) and that is my computation of the implied equity risk premium for US stocks. On June 1, 2017, as I have at the start of every month since September 2008 and every year going back to 1990, I backed out the rate of return that investors can expect to make on the S&P 500, given where it was trading at on that day (2411.8) and expected cash flows from dividends and buybacks on the index in the future (estimated from the cash flows in the most recent twelve months and consensus estimates of earnings growth over the next five years in earnings). Given the index level and cash flows on June 1, 2017, the expected annual return on stocks (the IRR of the cash flows) is 7.50%. Netting out the 10-year treasury bond rate (2.21%) on June 1 yields an implied equity risk premium of 5.29%.
      Download spreadsheet
      To put this in perspective, I have graphed out the implied equity risk premiums for the S&P 500, by year, going back to 1960.
      Download historical data
      To the extent that the equity risk premium is higher than median values over values over the 1960-2017 time period, you should feel comforted, but the market's weakest links are visible in this graphs as well. Much of the expansion in equity risk premiums in the last decade has been sustained by two forces.
      1. Low interest rates: If the US treasury bond rate was at its 2007 level of 4.5%, the implied equity risk premium on June 1, 2017, would have been 3%, dangerously close to all time lows. 
      2. High cash return: US companies have been returning immense amounts of cash in the form of buybacks over the last decade and it is the surge in the collective cash flow that pushes premiums up. As earnings at S&P 500 companies flattened and dropped in 2015 and 2016, you can argue that the current rate of cash return is not just unsustainable but also incompatible with the infrastructure-investment driven growth stories told by some market bulls.
      The first half of 2017 delivered some good news and some bad news on this front. The good news is that notwithstanding rumors of Fed tightening, treasury bond rates dropped from 2.45% on January 1, 2017 to 2.21% on June 1, 2017, and S&P 500 companies reported much stronger earnings for the first quarter, up almost 17% from the first quarter of 2016. The bad news is that it seems a near certainty that Fed will hike the Fed Funds rate soon (though its impact on longer term rates is debatable) and that there is preliminary evidence that companies have slowed the pace of stock buybacks.  The bottom line, and this may disappoint those of you who were expecting a decisive market timing forecast, is that stocks are richly priced, relative to history, but not relative to alternative investments today. Paraphrasing Dickens, we could be on the verge of a sharp surge in stock prices or a sharp correction, entering an extended bull market or on the brink of a bear market, at the cusp of an economic boom or on the precipice of a bust. I will leave it to others who are much better than me at market timing to make these calls and continue to muddle along with my stock picking.

      YouTube Video


      Attachments

      1. Implied Equity Risk Premium for S&P 500 - June 2017
      2. Historical ERP for S&P 500: 1961-2017



      Online Teaching: Promise, Pitfalls and Potential!

      I am a teacher. That is how I describe myself to anyone who chooses to ask me what I do for a living. I am not a professor (sounds pedantic and pompous), definitely not an academic (how boring is that..) and don't consider myself anything more than a dilettante on almost every topic that I hold forth on. It is in pursuit of my teaching mission that I have put my regular classes online for most of the last two decades, though technology has made that sharing easier. For those of you who have read my postings before, I usually announce a few weeks ahead of every semester, the classes that I will be teaching at Stern, what each class is about and how you can access it, as I did in January with my Spring 2017 valuation and corporate finance classes. As September 2018 approaches, I was going to skip that ritual, since I will be on sabbatical next year (and if you have no idea what a sabbatical is, more on that later..) but I will be teaching, nevertheless, during the year.

      Online Education
      I still remember the first semester that I shared a class with an online audience was in the 1990s, when the internet was still in its infancy, we were still using dial-up modems and phones were connected to landlines. I recorded my regular classes using a VHS camcorder onto tapes, and then converted the tapes into videos of woeful quality, but with passable audio. I posted these online, but with only minimal additional material, since sharing was both time consuming and difficult to do. Needless to say, the internet has grown up and made sharing much easier, with class recordings now being made with built-in cameras in classrooms and converted to high quality videos quickly, to be watched on tablets on smart phones. Here, for instance, is my entire Spring 2017 valuation class, with links to the videos as well as almost every scrap of material that I provide for the class and even the emails I sent to the class.

      I have long believed that the traditional university model not only is ripe for, but is deserving of , disruption, saddled with legacy costs and a muddled mission. That said, the attempts by online education to upend the university model have, for the most part, had only marginal success and it is in trying to answer why that I started thinking about how we teach, and learn online. In particular, online classes have proved a imperfect substitutes for regular classes due to three shortcomings:
      1. No personal touch: This may be a reflection of my age, but there is a difference between being in a live  and watching a video of the same class, no matter how well it is recorded and presented. 
      2. No interaction: We forget how much of the learning in a classroom comes, not from lectures, but from interaction, not just between the teacher and students but between students, often in informal and serendipitous exchanges. With online education, the interaction, if it exists, is highly formalized and there is less learning.
      3. Tough to stay disciplined: When you were in college, and enrolled for an 8.30 am class, did you feel like not going to class? I certainly did, but what kept me going was the fact that my absence would be noticed, not just by the professor, but by other students in the class. In fact, it is that group pressure and class structure that keeps us focused on project deadlines and exam dates, with regular classes. With online classes, that discipline has to come from within, and it should be therefore no surprised that most people who start online classes never finish them
      It is perhaps easiest to see the challenges and limits of online teaching by looking at what it is that makes for a good class, in person or online. In my view, the measure of good teaching is that students don't get just content (tools, techniques, models) but that they learn how to create their own content, i.e., the capacity to devise their own tools to meet their needs. In the context of a regular class, you use readings, problem sets, quizzes and exams to deliver the former (content) but the latter (learning) requires a more complex mix of classroom and informal interaction, real life projects and intellectual curiosity (and I believe that it is partly a teacher's responsibility to evoke that). The time schedule of a regular class also puts limits on how much students can procrastinate, and peer pressure, from others taking the class or working with you on assignments, serves to keep most on task. 

      With this framework, the challenges of teaching online become clear. You have to find ways to keep students engaged, disciplined and interactive, and you have to do it online. While there are technical solutions to each one of these challenges (great videos for engagement, a time schedule and online exams for discipline, and discussion boards for interaction), and we have come a long way in the last few years, there is still a great deal of work to be done.  

      Online Classes: My learning curve
      My search for a better way of delivering what I teach online started about five years ago, with a simple first step. I decided to try to take each of my regular lectures, which go for 80 minutes, and see if I could compress it into a 10-12 minute slot and the results were both revealing and humbling. It was not that difficult to compress my classes, a testimonial to how much buffer I build into my regular classes to ramble and pontificate. (If you have been in one of my regular classes or watched one, you probably know that there is nothing I enjoy more than going off on a riff on a topic or news story and I think you need a few of these in a 80-minute class to keep your class engaged.) I also started developing short post-session quizzes with solutions that someone watching the class could take, to check on whether they were "getting" the session material. I organized and sequenced the sessions and you can click to see the online versions of my corporate finance, valuation and investment philosophy classes. 

      I was under no illusions that I had unlocked the key to online learning with these classes, and these classes had significant limitations. First, packing material densely into 10-12 minute chunks can make watching even these short sessions taxing. Second, the videos that I made (with the help of a friend who was a camera man) were lacking in bells and whistles, basic talking-head videos with slides in the background. Third, there is no personal touch or interaction, since the videos are recorded. Finally, given the number of people in each of these classes, there was no way for me to give and grade exams, look over valuations or corporate financial analysis (a key ingredients of my regular classes) or provide certification that someone had taken the class.

      Valuation Certificate Class
      Just over a year ago, the Stern School of Business, which is where I teach, asked me whether I would be willing to teach an online certificate class. My initial response was to say no for two reasons. First, universities always seem to operate at deficits, no matter how much revenue they collect from tuition, and I knew that Stern would extract its pound of flesh from those who took the certificate. Second, I was concerned that if I did do a certificate class, and it became a money generator, that I would be asked to remove my free online classes. Stern must have wanted to do this certificate really badly since they offered to leave my online material untouched, if I agreed to work on the certificate course. It was this assurance, in conjunction with the opportunity to have videos shot in a studio, a platform that would allow me to offer exams and quizzes and discussion boards that finally led me to yes. 

      So, what makes the valuation certificate class different from the free online version? It is certainly not the content, since everything I teach in the certificate class is available on my website in multiple forms, but here are a few of the primary differences:
      1. Studio-shot videos: A studio, with professionals manning cameras, sound and lights, does allow for much better videos. With the help of a talented group that knows a lot more about editing and animation than I ever will, the final versions of the online classes are better than my online videos. There are, in all, 28 video sessions, with two sessions each week, over a 14 week time period. 
      2. Supporting material: In addition to the post class tests and the supporting slides, I have links to papers, spreadsheets, data, YouTube videos and blog posts that go with each session. While I am a realist and know that much of this additional material will go untouched, having it accessible will make it easier for you to use it, if you feel the urge.
      3. Live Webex sessions: Every two weeks, through the semester, we will have a live webex session, where you (if you are enrolled in the class) can ask questions, not just about material covered in the previous week's sessions but news stories and happenings. I know it is not much, but it is a step in the right direction.
      4. Announcements and outreach: I contact the students in my regular classes about once a day, but I will spare you that level of harassment. You will hear from me a couple of times every week, checking in on how you are doing and keeping you updated on the course. 
      5. Exams/Quizzes: There will be three quizzes and a final exam for the class. While they will  be scheduled on specific dates, you can take them any time during a 24-hour time period and if you miss a quiz, the points will be moved to the remaining quizzes. So, if life gets in the way and you are unable to take a quiz, it is not the end of the world.
      6. Valuation Project: Each person in the class can pick any company he or she want to value and value it, over the course of the class. Midway through the semester, I will offer feedback, if you want,  to allow you to tweak your valuation, and at the end of the semester, it will become a significant part of your overall grade.
      7. Certificate: After the final exam and valuation are graded, you will receive a certificate for the class, if you complete the requirements. If you do exceptionally well (and you will have to leave that judgment to me), your certificate will come "with honors".
      There were 66 people who signed up for the pilot version of the class, which started in January 2017 and 39 completed the class in May 2017. I learned as much from my students as I hope they learned from me, and here are a few lessons. First, I discovered that the discussion boards were effective at creative interactive discussions, among the students, if I did my job and organized the boards by topic. Second, in perhaps the most rewarding part of the class, a few students, who found the material both interesting and easy to grasp, took on the role of teachers helping others deal with mechanical and conceptual questions. Since the most effective way to learn something is to explain it to someone who does not quite "get" it, I restrained myself from jumping into the discussion boards, unless absolutely necessary. Third, I was impressed with both the work that was put into and the quality of the valuations that were turned in by those who finished the class. Of the 39 who were certified at the end of the class, about a third did well enough to get "with honors" attached to the certificate. I would have been proud with any of these students in my regular classes.

      This fall, Stern will be offering the valuation certificate class to a bigger audience, with a class of several hundred. The good news is that the class will be tweaked to reflect the lessons learnt from the pilot class. I will continue to do what I did for the pilot, with my webex sessions, and provide feedback and grades not only for your exams but on the companies that you choose to value. The bad news is that Stern will charge "university level" prices for the class and I will not try to tell you that it is "worth it", since that depends on your circumstances. It is entirely possible that you will decide that the price charged is too much for a certificate, that you cannot afford it, or that you are more interested in the learning than in the certification, and if so, I hope that you give the free online version of the class a shot. If you are interested in enrolling in the class, the webpage where you can start the process is here. Incidentally, a pilot version of my corporate finance class, also offered as a certificate class, will be run in Spring 2018, and if you are interested, here is that link.

      My Sabbatical
      I mentioned, at the start of this post, that I would be on sabbatical, and at the risk of evoking envy, I will tell you what that involves. I am taking the 2017-18 academic year (September 2017- September 2018) off from my regular teaching, as I am allowed to do every seventh year. It is an entitlement that people in most other professions don't have and I recognize how incredibly lucky I am to be able to take a paid break from work. I do have a few odds and ends to take care off during the year, including teaching the certificate classes that I just listed and writing the third edition of The Dark Side of Valuation, but I plan to spend much of the year idling my time away, thinking about nothing in particular. That may sound wasteful, but I have discovered that my mind is most productive, when I am not trying too hard to be insightful. At least, that's my hope and if it does happen, that would be great. I  But then again, if I don't have a single creative thought all year, that too was meant to be! 

      YouTube Video


      My Free Online Classes
      1. Corporate Finance (YouTube Playlist version)
      2. Valuation (YouTube Playlist version)
      3. Investment Philosophies (YouTube Playlist version) (New version will be out at the start of 2018)
      Stern Certificate Classes



      The Dark Side of Globalization: An Update on Country Risk!

      The inexorable push towards globalization has stalled in the last few years, but the change it has created is irreversible. The largest companies in the world are multinationals, deriving large portions of  their revenues from outside domestic markets, and even the most inward looking investors are dependent upon global economies for their returns. As a consequence, measuring and incorporating country risk into decision making is a requirement in both corporate finance and valuation. It is in pursuit of that objective that I revisit the country risk issue twice every year, once at the start of the year and once mid-year, at which time I also update a paper that I have on the topic, that you are welcome to read or browse or ignore.

      The Globalization of Companies
      There are some investors, especially in the United States, who feel that they can avoid dealing with risk in other countries, by investing in just US stocks. That is a delusion, though, because a company that is incorporated and traded in the United States can derive a significant portion of its revenues and earnings from outside the country. In 2015, the companies in the S&P 500, the largest market cap stocks in the US, derived approximately 44% of its revenues from foreign markets, down from 48% in the prior year.
      Source: S&P
      The composition of foreign sales is also changing, though gradually, over time, shifting away from the UK and Europe to emerging markets, as evidenced in the graph below:
      Source: S&P
      Lest you feel that this graph is skewed by the biggest companies in the index, 239 of the 500 companies in the index reported that foreign sales represented between 15% and 85% of their total sales and 13 companies reported that more than 85% of their sales came from outside the US. In 2014, two companies, Accenture and Seagate Technology, reported that all their sales were foreign, making them US companies only in name. (Many of you have pointed out that Accenture has significant US sales and that is true. I am just excerpting from the S&P report, which should lead you to question how S&P classifies foreign sales.)  This phenomenon is not restricted to US companies, as the largest companies in most markets exhibit similar characteristics. While we can debate whether these trend lines are good or bad for consumers and investors, the consequences are real:
      1. Fraying link to domestic economies: For decades, the conventional wisdom has been that the stock market in a country is closely tied to how well the economy of that country is doing. That relationship has been weakened by globalization and equity market performance around the world is disconnecting from domestic economic growth. Taking the US as an example, consider that equity markets in the US have been on a bull run, with indices up 170% to 200%, cumulatively since 2009, even as the US economy has been posting anemic growth.
      2. Central Banking power is diluted: In the decades since the great depression, we have to come to accept that central banks can use the policy levers that they have at their disposal to move long term interest rates and to strongly influence overall economic growth, but that power too has been reduced by globalization and its unpredictable flows. It should come as no surprise then that the frantic efforts of central banks\ in the US, Europe and Japan, in the last decade, to use the interest rate lever to pump up economic growth or to alter the trajectory of long term interest rates have failed.
      3. Taxing questions: When writing tax code, governments have generally assumed that companies incorporated in their domiciles have little choice but to accede to tax laws eventually and pay their share of taxes. While companies have historically played the tax game by delaying and deferring taxes due, their global reach now seems to have shifted the balance of power in their direction. In the United States, in particular, where the government has tried to tax companies on their global income, this push back has taken the form of trapped cash, as companies hold trillions of dollars of cash on foreign shores, and inversions, where some US companies have chosen to move their home base to more favorable tax locales.
      4. Declining cross-market correlations: As companies globalize, it should come as no surprise that the correlations across global equity markets have climbed, with two immediate consequences. The first is that global crises are now an almost annual occurrence rather than uncommon surprises, as pain in one market quickly spreads across the world. The second is that the salve of geographic diversification, long touted as protection against domestic market shocks, provides far less protection than it used to.
      The bottom line is that there is no place to hide from country risk, and as with any other type of risk, it is best to face up to it and deal with it explicitly.

      Country Risk - Default Risk Measures
      The simplest and most easily measured country risk is the risk of sovereign default. When countries default on their obligations, it is not just the government that feels the pain but companies, consumers and investors do, as well.

      Sovereign Default: Frequency and Consequences
      Governments borrow money, both from their own citizens and from foreign entities, and they sometimes borrow too much. Some of these government default, not only on their foreign currency debt but also on their local currency debt, with the latter having become more common over time:
      Source: Fitch Ratings
      You may be puzzled by local currency debt defaults, since governments do have the capacity to print more of their own currency, but faced with a choice between defaulting or debasing their currencies, many governments choose the latter. When default occurs, the immediate pain is felt by the government and lenders, the former because it loses the capacity to borrow more, and the latter because they don't get paid., but there is collateral damage:
      1. Capital Market Turmoil: Liquidity dries up, as investors withdraw from equity and bond markets, making it more difficult for private enterprises in the defaulting country to raise funds for projects and resulting in sharp price drops in both bond and stock markets.
      2. Real growth: Sovereign defaults are generally followed by economic recessions, as consumers hold back on spending and firms are reluctant to commit resources to long-term investments.
      3. Political Instability: Default can also strike a blow to the national psyche, which in turn can put the leadership class at risk. The wave of defaults that swept through Europe in the 1930s, with Germany, Austria, Hungary and Italy all falling victims, allowed for the rise of the Nazis and set the stage for the Second World War. In Latin America, defaults and coups have gone hand in hand for much of the last two centuries.
      Sovereign Ratings
      The most accessible measures of sovereign default risk are sovereign ratings, with S&P, Moody's and Fitch all providing both local currency and foreign currency ratings for most countries around the world. While there are many who mistrust these ratings, they are widely used as proxies of country risk and changes in ratings, especially down grades, are news worthy and affect markets. The process and metrics used to arrive at the ratings are described more fully here and here but the picture below summarizes the sovereign ratings assigned to countries in July 2017 and the data can be downloaded at this link:
      Link for live map
      The last decade has turned the spotlight on both the pluses and minuses of ratings. On the plus side, as the ratings agencies are quick to point out, ratings and default spreads are highly correlated. On the minus side, ratings agencies seem to have regional biases (under rating emerging markets and over rating developed markets) and are slow to change ratings. 

      Sovereign CDS Spreads
      In the last decade, we have seen the growth of a market-based measure of default risk in the Credit Default Swap (CDS) market, where you can buy insurance against sovereign default by buying a sovereign CDS. Since the insurance is priced on annual basis, the price of a sovereign CDS becomes a market measure of the default spread for that country. In July 2017, there were 68 countries with sovereign CDS and the picture below captures the pricing (with the data available for download at this link). One of the limitations of the CDS market is that there is still credit risk in the market and to allow for the upward bias this creates in the spreads, I compute a netted version of the spread, where I net out the US sovereign CDS spread of 0.34% from each country's CDS spread. 
      Link for live map
      To provide a comparison between the CDS and sovereign rating measures of default risk, let me offer two example. The sovereign CDS for Brazil on July 1, 2017, was 3.46%. On the same day, Moody rated Brazil at Ba2, with an estimated default spread of 3.17%, close to the CDS value. For India, the sovereign CDS spread on July 1, 2017, was 2.42%, very close to the default spread of 2.32% that would have been assigned to it based upon its Baa3 rating.

      Country Risk - Institutional Risk
      When investing in a company, the sovereign default risk is just one of many risks that you have to factor into your decision making. In fact, default risk may pale in comparison to risks you face because of the institutional structure, or lack of it, in a country. At the risk of picking at scabs, here is my shot at assessing some of these risks.
      1. Corruption
      Much as we like to inveigh against its consequences, corruption is not just part and parcel of operating in some parts of the world, but it takes on the role of an implicit tax, one that is paid to free agents, acting in their own interests, rather than to governments. Transparency International, an entity that measures corruption risk around the world, estimates corruption scores for individual countries and heir findings for 2016 are summarized in the picture below. To see where a country falls on the corruption continuum, you can either click on the live link below the picture or download the data by country by clicking here.

      Link to live map
      While it is easy to fall back on cultural stereotypes to explain differences across countries, there is a high correlation between economic well being and corruption. Thus, while much of Latin America scores low on the corruption, Chile and Uruguay rank much higher, as do South Korea and Japan in Asia.

      2. Legal Protections
      Even the very best investments are only as good as the legal protections that you have as an investor, against expropriation or theft, which is why the property right protections rank high on investor wish lists. To measure the strength of property rights, I turned to the International Property Rights Index (IPRI), and report the scores they assigned in their most recent update in 2016, to countries in the picture below. You can click on the live link below the picture or download the data here.

      Link to live map
      Europe, North America, Japan and Australia all score high on property rights, but the hopeful sign is that index itself has seen increasing respect for property rights across time and Venezuela and Myanmar are now more the exception, than the rule.

      3. Risk of violence
      It is difficult to do business, when you have bullets whizzing by and bombs going off around you. Holding all else constant, you would prefer to operate in parts of the world that are safer rather than riskier. To measure exposure to violence, I again turn to an external entity, Vision of Humanity, and reproduce their Global Peace Index in the picture below (with link to live map and to data):
      Link to live map
      In keeping with the adage that when it rains, it pours, the countries that are most susceptible to corruption and have weak property rights also seem to be most exposed to physical violence.

      Country Risk - Equity Risk
      As you can see, there are multiple dimensions on which you can measure country risk, leading to different scores and rankings. As an investor in the country, you are exposed to all of these risks, albeit to varying degrees, and you have to consider all these risks in making decisions. Consequently, you would like (a) a composite measure of risk that (b) you can convert into a metric that easily fits into your investment framework.

      1. Country Risk Scores
      There are several services that provide composite measures of country risk, including the Economist, Euromoney and Political Risk Services (PRS). These country risk measures take the form of numerical scores, and in the heat map below, I report the change in the PRS country risk score between July 2016 and July 2017 and categorize countries based on the direction and magnitude of the change. Here, as in the prior pictures, you can see the PRS scores and the change, by country, by either clicking on the live map link below the picture or download the data by clicking here). 
      Link for live map
      Based on the PRS scores, the vast majority of emerging markets became safer during the time period between July 2016 and July 2017, with the biggest improvements in Latin America and Asia. The North American countries saw risk go up, as did pockets of Africa and South East Asia. The problem with country risk scores, no matter how well they are measured, is that they do not fit a standardized framework. Just to provide an illustration, PRS scores are low for risky countries and high for safe countries,  whereas the Economist risk scores are high for risky countries and low for safe countries.

      3. Equity Risk Premiums
      To incorporate and adjust for country risk into investing and valuation, I try to estimate the equity risk premiums for country, with riskier countries having higher equity risk premiums. I start with the implied equity risk premium for the US, which I estimate to be 5.13% at the start of July 2017 as my mature market premium and add to it a scaled up version of the default spread (based upon the rating); the scaling factor of 1.15 is based upon the relative volatility of emerging market equities versus bonds. You can see a more detailed description of the process in the paper that is linked at the end of this post. You can look up the equity risk premium for an individual country by clicking on the live map link or download the data by clicking here.
      Link for live map
      These equity risk premiums are central to how I deal with country risk in valuation, as I will explain in the last section of this post.

      Closing the Loop
      When valuing companies that have substantial exposure to country risk, it is easy to get overwhelmed by the variety of risks. To keep the process under your control, you should start by breaking country risk into three buckets: risk that is specific just to that country, risk that is macro/global and discrete risks that are potentially catastrophic (such as nationalization or terrorism). Each has a place in valuation, with country specific risks incorporated into expected cash flows, macro economic risks in the discount rate and discrete risks in a post-valuation adjustment. 

      1. Adjusting discount rates
      The key to a clean country risk adjustment, when estimating discount rates, is to make sure that you do not double or even triple count it. With the cost of equity for a company, for instance, where there are only three inputs that drive the cost, it is only the equity risk premium that should be conduit for country risk (hence explaining my earlier focus on equity risk premiums, by country). The risk free rate is a function of the currency that you choose to do your valuation in and the relative risk measure (or beta, if that is how you choose to measure it) should be determined by the business or businesses that the company operates in. 

      If you are discounting the composite cash flows of a multinational company, the equity risk premium should be a weighted average of the equity risk premiums of the countries that the company operates in, with the weights based on revenues or operating assets. If you are valuing just the operations in one country, you would use the equity risk premium just for that country.

      2. Expected cash flows
      With risks that are specific to a country, it is better to incorporate the risks into the expected cash flows. Thus, if a country is rife with corruption, you could treat the resulting costs as part of operating expenses, reducing profits and cash flows. When legal and regulatory delays are a feature of business in a country, you can build in the delay as lags between investing and operations. When violence (from terrorism or war) is part and parcel of operations, you may want to include a cost of insuring against the risk in your cash flows. 

      None of these adjustments are easy to make, but it is worth remembering that incorporating the risk into your cash flows is not risk adjusting the cash flow, since the latter requires replacing the expected cash flow with a certainty equivalent one.  Where does currency risk play out? When converting cash flows from one currency (foreign) to another (domestic), you should bring in expected devaluation or revaluation into expected exchange rates. If you want to hedge exchange rate risk, you can incorporate the cost of heeding into your cash flows but it is not clear that you should be adjusting discount rates for that risk, since investors can diversify it away.

      3. Post-Valuation Adjustment
      There are some risks that are rare, but if they occur, can be devastating, at least for investors in a business. Included in this grouping would be the risk of nationalization and terrorism. These risks cannot be incorporated easily into discount rates and adjusting expected cash flows in a going concern valuation (DCF) for risk that a company will be nationalized or will not survive is messy. 


      Thus, to estimate the effect that nationalization risk will have on the value of a business, you will have to assess the probability that the business will be nationalized and the value that you will receive as owners of the business, in the event of nationalization.

      Danger and Opportunity
      One of my favorite definitions of risk is the Chinese symbol for crisis, a combination of the symbols for danger and opportunity.
      危機
      With risky emerging markets, this comes into , I am reminded that to have one (opportunity), I have to be willing to live the other (danger). Blindly ignoring these markets, as some conservative developed market companies are inclined to do, because there is danger will lead to stagnation, but blindly jumping into them, drawn by opportunity, will cause implosions. The essence of risk management is to measure the danger in markets and then gauge whether the opportunities are sufficient to compensate you for the dangers. That is what I hope that I have laid the foundations for, in this post.

      YouTube Video


      Attachment
      1. Country Risk: Determinants, Measures and Implications - The 2017 Edition
      Data Links




      User/Subscriber Economics: Value Dynamics

      In my last post, I tried valuing Uber by estimating how much an existing user was worth to the company and then using that number to extrapolate to the value of all existing users and the value added by new users. As always, I got many useful comments on what I was missing, what I could do better and what could be simplified, and I thank you (really). While I could spend this entire post rehashing assumptions, I don't intend to! To me, the most useful part of valuation is not the destination, i.e., the value that you get at the end, but the journey, i.e., the process of doing valuation, since it is the process that allows us to isolate the key drivers of value, which, in turn, focuses discussions on those variables, rather than on distractions. Consequently, I decided to revisit my Uber user-based valuation to see what I could eke out as implications for user or subscriber-based businesses.

      Estimation versus Economic Risk
      I will start by conceding the obvious. I made a lot of assumptions to arrive at the value of a user at Uber, but I will go further. There was not a single fact in that valuation, since every number was an estimate. That said, you could say that about the valuation of any company, with the divergence really being one of the degree of uncertainty you face, not in whether it exists. At the risk of restating points that I have made in my other writing, here are three general points that I would make about uncertainty in valuation.

      1. Estimation uncertainty versus Economic uncertainty
      To deal with uncertainty in a sensible way, you first have to categorize it. One of the categorizations that I find useful is to break the uncertainty you face when you are trying to value a business or an asset into estimation and economic uncertainty. Estimation uncertainty comes from incomplete, missing or misleading information provided by the company that you are valuing, whereas economic uncertainty is driven by forthcoming changes in the business that the company operates in, as well as macro economic factors. Estimation uncertainty can be reduced by obtaining better and more complete information but estimation uncertainty will remain resistant, no matter how much time you put in and what data analysis that you do. Using my Uber user valuation, it is true that some of the noise in the valuation comes from Uber being a private, secretive company and but most of the uncertainty comes from the ride sharing business being in a state of flux, as regulators and competitors work out how best to deal with shifting consumer tastes and changing technologies. This has two implications. The first is that even if you had access to more information, either because Uber decides to go public or you are an insider in the company, much of the uncertainty in estimated value per user will remain. The second is that your estimated value will change considerably over time, as the facts on the ground change, and that volatility in value cannot be viewed as a shortcoming of the model.

      2. Uncertainty is an integral part of valuation
      One critique that leaves me unmoved is that valuing a business or an asset, in the face of significant uncertainty, is pointless because you will be wrong. So what? Uncertainty is part and parcel of doing business and you cannot wish it, pray it or analyze it away. As I see it, you have two choices when it comes to uncertainty. You can deal with it frontally by making explicit assumptions or you can go into "denial" model and make implicit assumptions. When I tried to value a user at Uber, I made explicit assumptions about user life, renewal rates and a host of other variables, and I will cheerfully admit that I will be wrong on every one of them, but what is the alternative? When pricing a user by looking at what others are paying for users in similar companies, you are making assumptions about all of the variables as well, but those assumptions are implicit. In fact, they are hidden so well that you may not be aware of your own assumptions, a dangerous place to be when investing.

      3. Uncertainty can (and should) be visualized 
      Here is my response to uncertainty. Where data exists but I do not have access to that data, I will try to make my best estimates based upon the existing information, noisy, dated or second hand though it might be. Where I have access to data, I will check it against other data, common sense and economic first principles. Where there is no data, I will make my best estimates and to the extent that these estimates come with probability distributions, my value itself is a distribution, not a number. Illustrating this process, with the Uber user valuation:
      Excel Add On: Crystal Ball (Oracle), Simulation Output
      I have made distributional assumptions on four of my inputs: the portion of Uber's expenses that go to servicing existing users, the life time of a user, the proportion of expenses that are variable and the cost of capital (discount rate) to compute today's value.  Since these distributions are all centered on my base case assumptions, it should come as no surprise that the median value of a user ($414) is very close to my base case value ($410). However, there is a wide spread around that value, with the numbers ranging a low of $74, when the user life is short, the expenses of servicing a user are high, most of the costs are variable and the cost of capital is low, to a high of more than $1000 per user, when the opposite conditions hold. Note that at the current pricing of $69 billion, you are valuing each user close to $900, at the upper end of the distribution. 

      User Economics: Cost Propositions
      It is true that the end game for every business is to make money for its investors. That said, there is a tendency to over react, when a young company reports a loss, as was the case when Uber reported an operating loss of $2.8 billion for 2016, a few months ago. The pessimists on Uber viewed this as further evidence that the company was on a pathway to nowhere and that investors in the company must be delusional to attach any value to it. The optimists argued that it is natural for young companies to lose money and that Uber should be judged on other dimensions such as user growth and market potential instead. At the risk of angering both groups, I will use my Uber user valuation to argue that while I agree with the second group that losing money is typical at young companies, I will also take sides with the first group that you still need a pathway to profitability amidst the losses, for value to exist.

      1. Servicing existing users versus acquiring new users
      In my Uber user valuation, I started with the operating losses reported by the company ($2.8 billion), backed into the total operating expenses for the company ($9.3 billion) and then allocated that expense across three categories: servicing existing user (48.17%), acquiring new users (41.08%) and corporate expenses (10.75%). While I based this breakdown on the information (on increase in users and contribution margins in ride sharing) that I had on Uber in 2016, that information is dated, noisy and second hand. It is entirely possible that the actual break down of expenses is different from my estimate. If you are wondering why it matters, since the end result (that Uber lost $2.8 billion) is not changing, there are consequences that you can see in the table below:
      Uber User Value: Existing User versus New User Costs

      % of Operating Expenses spent on acquiring new usersValue of Existing UsersValue of New UsersUber User Value% of Value from Existing users
      0%
      $6,167
      $18,147
      $24,314
      25.36%
      20%
      $10,619
      $19,035
      $29,654
      35.81%
      40%
      $15,071
      $19,923
      $34,994
      43.07%
      60%
      $19,523
      $20,811
      $40,334
      48.40%
      80%
      $23,974
      $21,699
      $45,673
      52.49%
      100%
      $28,426
      $22,587
      $51,013
      55.72%

      As you increase the proportion of the operating expenses that are spent on acquiring new users, the value of an existing user goes up because you are spending less money on providing service to that user, but the value of a new user also increases, as the net value added (the difference between the user value and the cost of acquiring a user) goes up. Ironically, as you spend more on acquiring new users and less on servicing existing users, the proportion of your value that comes from existing users increases.
      User Value Proposition 1: A money-losing company that is losing money providing service to existing users/customers is worth less than a company with equivalent losses, where the primary expenses are coming from customer acquisitions.
      This is, of course, neither profound nor surprising, and it explains why, left to their own devices and without any monitoring, young companies will claim that most or all of their expenses are for acquiring new customers. If you are investing in a young company, you will have to do your own assessment of whether managers are misrepresenting, by looking at expense growth over time versus new customers. If the number of total customers remains fixed and expenses keep rising, you should be skeptical about managerial claims (that most of the costs are for acquiring new customers).

      2. Cost Structure
      One reason that investors are willing to accept losses at young companies is because they believe that as the company grows its operations, there will be economies of scale. In income statement terms, this will result in expenses growing less quickly than revenues and improving operating margins. That said, you cannot take it on faith that this will always happen or that it will happen at the same rate for every company. To see the impact on user value of this dimension, I adjusted the portion of Uber's expenses that are variable (and will grow with revenues) and those that are fixed (and grow at a lower rate) and captured the value effect in this table:
      Uber User Value and Cost Structure

      % of current expenses that are fixedValue of Existing UsersValue of New UsersUber User Value% of Value from Existing users
      0%
      $14,733
      $15,250
      $29,983
      49.14%
      20%
      $16,412
      $20,191
      $36,603
      44.84%
      40%
      $17,834
      $24,373
      $42,207
      42.25%
      60%
      $19,040
      $27,924
      $46,964
      40.54%
      80%
      $20,068
      $30,949
      $51,017
      39.34%
      100%
      $20,947
      $33,536
      $54,483
      38.45%
      As the proportion of expenses that are fixed rises, the value of both existing and new users goes up but the latter goes up at a faster rate. Put simply, the economies of scale increase as you increase the rate at which you are adding scale.
      User Value Proposition 2: A company whose expenses are primarily fixed (will not grow with revenues) will be worth more than an otherwise identical company whose expenses are variable (track revenues).
      If unchallenged, young growth companies will always claim that they have massive economies of scale but that claim has to be backed up by the numbers. Specifically, investors should pay attention to the rate of change in revenues and expenses, since with large economies of scale, the former should change more than the latter. The caveat, though, is that having more fixed costs can increase risk, because it will increase the risk of failure at young companies and earnings volatility for more mature firms. As user growth levels off, having more fixed costs will reduce value rather than increasing it.

      User Economics: Growth Propositions
      For young companies, we generally view growth as good and while that is generally true, not all growth is created equal. In fact, even with young companies, there are some strategies that deliver growth in users or revenues, while destroying value. In a user or subscriber based model, there are two ways you can grow your revenues. One is to get existing users to buy more of your products or services and the other is by trying to acquire new users. While both can increase value, the former will be create more value, for two reasons. First, since it comes from existing customers, you don’t have to pay to acquire these users and it is thus less costly to the firm. Second, by increasing the value of a user, it increases the value of any new users as well, creating a secondary impact on value. Using my Uber user valuation, you can see the impact of changing the annual growth rate in revenues for an existing user in the chart below:
      As revenue growth rate increases, the value of both existing and new users increases, with the value of Uber hitting $90 billion at high annual growth rates. If there is no growth in revenues, the value of Uber collapses as new users actually destroy value (because the cost of adding a new user exceeds the value of that user). Now consider how Uber's value is affected, if we hold existing user assumptions fixed and change the compounded annual growth rate (for the next 10 years) in the number of users:
      While value increases with user growth rates, it increases at a lower rate than it did when we varied revenue growth from existing users.
      User Value Proposition 3: A company that is growing revenues by increasing revenues/user is worth more than an otherwise similar growth company that is deriving growth from increasing the number of users/customers. 
      Young companies face the question of whether to allocate resources to get new users or try to sell more to existing users is one of those. At least in the case of Uber, the numbers seem to indicate that the payoff is greater in getting existing users to use the service more than in looking for new users.

      User Economics: Business Propositions
      At the risk of stretching the user value model too far, it can be used to discuss business models in the space, from the networking benefits that so many companies in this space claim to possess to how the revenue model you choose (subscription, transaction or advertising) plays out in user values.

      1. Competitive Dynamics and Networking Benefits
      Is it better to operate in a business where the cost of acquiring a new user is low or high? Holding all else constant, the answer is obvious. A firm will maximize its value if can generate both high value per user and have a low cost of acquiring new users. That said, if everyone in the business shares these characteristics, one or another of these variables has to change. If the cost of acquiring new users is low for everyone, competition will drive down the value per new user, and if the value per user remains high, competition will drive up the cost of acquiring new users. The trade off is captured in the picture below:

      User Value Proposition 4:  The exceptional firm will be the one that is able to find a pathway to high value per user and a low cost to adding a new user in a market, where its competitors struggle with either low value per user or high costs of acquiring users.
      So how do the exceptional companies pull off this seeming impossible combination of high value per user and low cost per new user? I may be stretching, but it is at the heart of two terms that we see increasingly used in business, network benefits and big data.
      • Network Benefits: If network benefits exist, the cost of acquiring new users will decrease as a company's presence in a market increases, reaching a tipping point where the biggest player will face much lower costs in acquiring new users than the competition, allowing it to capture the market and perhaps use its market dominance to increase the value of each user. In the case of Uber and ride sharing business, the argument for networking benefits is strong on a localized basis, since there are clearly advantages for both drivers and customers to shift to the dominant ride sharing company in any locality, the former because they will generate more income and the latter because they will get better service. The argument is much weaker on a global basis, though ride sharing companies are trying to create networking benefits by allying with airlines and credit care companies, and how this attempt plays out may well determine Uber's ultimate value.
      • Big Data: While I remain a skeptic on the "big data" claims that every company seems to be making today, it is inarguable that there are companies that use big data to augment value. These companies collect data on their existing users/subscribers/customers and use that information to (a) customize existing products/services to meet user preferences, (b) create new products or services that meet perceived user needs and/or (c) for differential pricing. All of these increase user value by altering one or more of the inputs into the equation, with customization increasing user life and new products & differential the growth in revenues/user. In my view, the best users of big data (Netflix, Amazon, Google and Facebook) have used the data to increase their existing user value. Uber is still in the nascent stages, but its attempts at using data have expanded from surge pricing to differential pricing.
      2. Revenue Models
      In my version of user valuation, I look at revenues per user, drawing no distinction on how those revenues are derived. Broadly speaking, there are three revenue models that a user/subscriber based company can use, a subscription-based model where users or subscribers pay a subscription fee to continue to use the service or product, a transaction-based model where users or subscribers pay only when they use the service of product and an advertising-based model where users or subscribers get to use the product or service for free, but are targeted in advertising. Netflix operates on a subscription-based model, Uber is a transaction-based firm and Facebook generates its revenues from advertising. Some companies like LinkedIn have hybrid models, generating revenues from subscriptions (from premium members), transactions (from recruitments) and advertising.  There are other inputs into the valuation that will be affected by a company's revenue model and I have tried to capture them in the table below:

      SubscriptionTransactionAdvertising
      User Stickiness (User life & Renewal Probability)High (High life & renewal probability)Intermediate (Intermediate life & renewal probability)Low (Low life & renewal probability)
      Revenue per User Predictability (Discount rate)High (Low Discount Rate)Low Predictability (High Discount Rate)Intermediate (Average Discount Rate)
      Revenue per User Growth (Annual Growth Rate)Low (Low growth rate in revenues/user)Low (High growth rate in revenues/user)Intermediate (Intermediate growth rate in revenues/user)
      Growth rate in users (CAGR in # Users)Low (Low CAGR in # users)Intermediate (Intermediate CAGR in # users)High (High CAGR in # users)
      Cost of adding new users (Cost/New User)High (High Cost/New User)Intermediate (Middling Cost/New User)Low (Low Cost/New User)
      There is no one dominant revenue model, since each has its pluses and minuses. An advertising-based model will allow for much more rapid growth in a firm's early years, a subscription-based model will generate more sustainable growth and a transaction-based model has the greatest potential for revenue growth from existing users.
      User Value Proposition 5:  The "optimal" revenue model may vary for a firm depending upon where it is in the life cycle and across firms depending on their product or service offerings and across investors, depending on whether they are focused on user growth, revenue growth or revenue sustainability.

      3. Real Options
      When valuing a company based upon its expected cash flows, there is a chance that you will under value the company, if it has control of a resource that could be used for other purposes in the future, even if that usage makes no economic sense today. That is why a technology or natural resource reserve that is not viable today can still have value, and this is the basis for the real option premium. In the context of a user-based business, optionality can become a component of value, to the extent that companies may be able to exploit their user bases to sell other products and services in the future. While the intuition of real options is simple, valuing real options is notoriously difficult and after much hand waving, most of us (including me) give up, but the user-based valuation model provides a framework to at least eke out some general propositions about optionality and value.

      There should be no surprises in this picture, with the value of a real option in a user base tied to the inputs into an option pricing model.
      User Value Proposition 6: The value of optionality from a user base will be greatest at firms with lots of sticky, intense users in businesses where the future is unpredictable because of changes in product/service technology and customer tastes. 

      The Bottom Line
      The most direct applications of a user or subscriber based model is in the valuation of companies like Uber, Facebook and Netflix. That said, more and more companies are seeing benefits in shifting from their traditional business models to user-based ones. Apple is a cash machine built around a smartphone but it is also accumulating information on more than a billion users of these phones, to whom it may be able to offer other products and services. Amazon started life as an online retail company but there is no denying the power of its seventy million Prime members in generating revenues for the company. I have used Microsoft and Adobe products for as long as they have been around, but with both companies, but my relationship with both companies has changed. I am now a subscriber (Office 365 and  Creative Cloud member) who pays annual fees, rather than a customer who buys and upgrades software on a discretionary basis. Understanding user economics and value is central to not only investors in these companies, when valuing and pricing them, but to managers of these companies, in their day-to-day business decisions. I will admit, without shame, that my knowledge of user-based companies is rudimentary and that my user-based model may be amateurish, in what it misses or mangles. That said, if you are an expert on user-based businesses, I hope that you can build on the model to make it more realistic and useful.

      YouTube Video


      Links
      1. Crystal Ball (Simulation Add On for Excel)
      2. My paper on dealing with uncertainty in valuation
      Attachments



      A Tesla 2017 Update: A Disruptive Force and a Debt Puzzle!

      These are certainly exciting times for Tesla. The first production version of the Tesla 3 was unveiled on July 28, with few surprises on the details, but plenty of good reviews. Elon Musk was his usual self, alternating between celebrating success and warning investors in the stock that the company was approaching "manufacturing hell", as it ramps up its production schedule to meet its target of producing 10,000 cars a week. It is perhaps to cover the cash burn in manufacturing hell that Tesla also announced that it planned to raise $1.5 billion in a junk bond offering. Investors continued to be unfazed by the negative and lapped up the positive, as the stock price soared to $365 at close of trading on August 9, 2017. With all of this happening, it is time for me to revisit my Tesla valuation, last updated in July 2016, and incorporate, as best as I can, what I have learned about the company since then.

      Tesla: The Story Stock
      I have been following Tesla for a few years and rather than revisit the entire history, let me go back to just my most recent post on the company in July 2016, where I called Tesla the ultimate story stock. I argued that wide differences between investors on what Tesla is worth can be traced to divergent story lines on the stock. I used the picture below to illustrate the story choices when it comes to Tesla, and how those choices affected the inputs into the valuation.


      In that post, I also traced out the effect of story choices on value, by estimating how the numbers vary, depending upon the business, focus and competitive edge that you saw Tesla having in the future:

      With my base case story of Tesla being an auto/tech company with revenues pushing towards mass market levels and margins resembling those of tech companies, I estimated a value of about $151 a share for the company and my best case estimate of value was $316.46.

      Tesla: Operating Update
      If you are invested in or have been following Tesla for the last year, you are certainly aware that the market has blown through my best case scenario, with the stock trading on August 9, at $365 a share, completing a triumphant year in markets:

      As Tesla's stock price rose, it broke through milestones that guaranteed it publicity along the way. It's market capitalization exceeded that of Ford and General Motors in April 2016, and in June 2016, Tesla leapfrogged BMW to become the fourth largest market cap automaker in the world, though it has dropped back a little since. It now ranks fifth, in market capitalization, among global automobile companies:
      Largest Auto Companies (Market Capitalization) on August 9, 2017
      While Tesla's market cap has caught up with larger and more established auto makers, its production and revenues are a fraction of theirs, leading some to use metrics like enterprise value per car sold to conclude that Tesla is massively over valued. I don't have much faith in these pricing metrics to begin with, but even less so when comparing a company with massive potential to companies that are in decline, as I think many of the conventional auto companies in this table are currently.

      As I noted at the start of the post, it has been an eventful year for Tesla, with the completion of the Solar City acquisition, and the Tesla 3 dominating news, and its financial results reflect its changes as a company. In the twelve months ended June 30, 2017, Tesla's revenues hit $10.07 billion, up from $7 billion in its most recent fiscal year, which ended on December 31, 3016; on an annualized basis, that translates into a revenue growth rate of 107%. That positive news, though, has to be offset at least partially with the bad news, which is that the company continues to lose money, reporting an operating loss of $638 million in the most recent 12 months, with R&D expensed, and a loss of $103 million, with capitalized R&D. The growth in the company can be seen by looking at how quickly its operations have scaled up, over the last few years:

      Tesla's growth has not just been in the operating numbers but in its influence on the automobile sector. While it was initially dismissed by the other automobile companies as a newcomer that would learn the facts of life in the sector, as it aged, the reverse has occurred. It is the conventional automobile companies that are, slowly but surely, coming to the recognition that Tesla has changed their long-standing business. Volvo, a Swedish automaker not known for its flair, announced recently that all of its cars would be either electric or hybrid by 2019, and Ford's CEO was displaced for not being more future oriented. A little more than a decade after it burst on to the scene, it is a testimonial to Elon Musk that he has started the disruption of one of the most tradition-bound sectors in business.

      Tesla: Valuation Update
      The production hiccups notwithstanding, the company continues to move towards production of the Tesla 3, with the delivery of the handful to start the process. There is much that needs to be done, but I consider it a good sign that the company sees a manufacturing crunch approaching, since I would be concerned if they were to claim that they could ramp up production from 94,000 to 500,000 cars effortlessly.  My updated story for Tesla is close to the story that I was telling in July 2016, with two minor changes. The first is that the production models of the Tesla 3 confirm that the company is capable of delivering a car that can appeal to a much broader market than prior models, putting it on a  pathway to higher revenues. My expected revenues for Tesla in ten years are close to $93 billion, a nine-fold increase from last year's revenues and a higher target than the $81 billion that I projected in my July 2016 valuation. Second, the operating margins, while still negative, have become less so in the most recent period, reducing reinvestment needs for funding growth. The free cash flows are still negative for the next seven years, a cash burn that will require about $15.5 billion in new capital infusions over that period. With those changes, the value per share that I estimate is about $192/share, about 20% higher than my $151 estimate a year ago, but well below the current price per share of $365.
      Download spreadsheet
      As with every Tesla valuation that I have done, I am sure (and I hope) that you will disagree with me, with some finding me way too pessimistic about Tesla's future, and others, much too optimistic. As always, rather than tell me what you think I am getting wrong, I would encourage you to download the spreadsheet and replace my assumption with yours. I think I am being clear eyed about the challenges that Tesla will face along the way and here are the top three: 
      1. Can Tesla sell millions of cars? One of Tesla's accomplishments has been exposing the potential of the hybrid/electric car market, even in an era of restrained fuel prices. That is good news for Tesla, but it has also woken up the established automobile companies, as is evidenced by not only the news from Volvo and Ford, but also in increased activity on this front at the other automobile companies. In my valuation, the revenues that I project in 2027 will require Tesla to sell close to 2 million cars, in the face of increased competition.
      2. Can it make millions of cars? Tesla's current production capacity is constrained and there are two production tests that Tesla has to meet. The first is timing, since the Tesla 3 deliveries have been promised for the middle of 2018, and the assembly lines have to be humming by then. The second is cost, since a subtext of the Tesla story, reinforced by hints from Elon Musk, is that the company has found new and innovative ways of scaling up production quickly and at much lower costs than conventional automobile companies. 
      3. Can it generate double digit margins? In my valuation, I assume an operating margin of 12% for Tesla, almost double the average of 6.33% for global auto companies. For Tesla to generate this higher margin, it has to be able to keep production costs low at its existing and new assembly plants and to be able to charge a premium price for its automobiles, perhaps because of its brand name. 
      Tesla has shown a capacity to attract and keep customers and I think it is more than capable of meeting the first challenge, i.e., sell millions of cars, especially since its competition is saddled with legacy costs and image problems. It is the production challenge that is the more daunting one, simply because this has always been Tesla's weakest link. Over the last few years, Tesla has consistently had trouble meeting logistical and delivery targets it has set for itself, and those targets will only get more daunting in the years to come. Furthermore, if its production costs run above expectations, it will be unable to deliver on higher margins. To succeed, Tesla will require vision, focus and operating discipline. With Elon Musk at its helm, the company will never lack vision, but as I argued in my July 2016 post, Mr. Musk may need a chief operating officer at his side to take care of delivery deadlines and supply chains. 

      Financing Cash Burn: Tesla's Odd Choice
      There is much to admire in the Tesla story but there is one aspect of the story that I find puzzling, and if I were an equity investor, troubling. It is the way in which Tesla has chosen to, and continues to, finance itself. Over the last decade, as Tesla has grown, it has needed substantial capital to finance its growth. That is neither surprising nor unexpected, since cash burn is part of the pathway to glory for companies like Tesla. However, Tesla has chosen to fund its growth with large debt issues, as can be seen in the graph below:

      That debt load, already high, given Tesla’s operating cash flows is likely to get even bigger if Tesla succeeds in its newest debt issue of $1.5 billion, which it is hoping to place with an interest rate of 5.25%, trying to woo bond buyers with the same pitch of growth and hope that has been so attractive to equity markets. That suggests that those making the pitch either do not understand how bonds work (that bondholders don't get to share much in upside but share fully in the downside) or are convinced that there are enough naive bond buyers out there, who think that interest payments can be made with potential and promise.

      But setting aside concerns about bondholders, the debt issuance makes even less sense from Tesla's perspective. Unlike some, I don’t have a kneejerk opposition to the use of debt. In fact, given that the tax code is tilted to benefit debt, it does make sense for many companies to use debt instead of equity. The trade off, though, is a simple one:

      If you look at the trade off, you can see quickly that Tesla is singularly unsuited to using debt. It is a company that is not only still losing money but has carried forward losses of close to $4.3 billion, effectively nullifying any tax benefits from debt for the near future (by my estimates, at least seven years). With Elon Musk, the largest stockholder at the company, at the helm, there is no basis for the argument that debt will make managers more disciplined in their investment decisions. While the benefits from debt are low to non-existent, the costs are immense. The company is still young and losing money, and adding a contractual commitment to make interest payments on top of all of the other capital needs that the company has, strikes me as imprudent, with the possibility that one bad year could put its promise at risk. Finally, in a company like Tesla, making large and risky bets in new businesses, the chasm between lenders and equity investors is wide, and lenders will either impose restrictions on the company or price in their fears (as higher interest rates). So, why is Tesla borrowing money? I can think of two reasons and neither reflects well on the finance group at Tesla or the bankers who are providing it with advice.
      1. The Dilution Bogeyman: The first is that the company or its investment bankers are so terrified of dilution, that a stock issue is not even on the table. Once the dilution bogeyman enters the decision process, any increase in share count for a company is viewed as bad, and you will do everything in your power to prevent that from happening, even if it means driving the company into bankruptcy. 
      2. Inertia: Auto companies have generally borrowed money to fund assembly plants and the bankers may be reading the capital raising recipe from that same cookbook for Tesla. That is incongruent with Elon Musk’s own story of Tesla as a company that is more technology than automobile and one that plans to change the way the auto business is run.
      Tesla’s strengths are vision and potential and while equity investors will accept these as down payments for cash flows in the future, lenders will not and should not. In fact, I cannot think of a better case of a company that is positioned to raise fresh equity to fund growth than Tesla, a company that equity investors love and have shown that love by pushing stock prices to record highs. Issuing shares to fund investment needs will increase the share count at Tesla by about 3-4% (which is what you would expect to see with a $1.5 billion equity issue) but that is a far better choice than borrowing the money and binding yourself to make interest payments.  There will be a time and a place for Tesla to borrow money, later in its life cycle, but that time and place is not now. If Tesla is dead set on not raising its share count, there is perhaps one way in which Tesla may be able to eat its cake and have it too, and that is to exploit the dilution bogeyman's blind spot, which is a willingness to overlook potential dilution (from the issuance of convertibles and options). In fact, why not issue long term, really low coupon convertible bonds, very similar to this one from 2014, a bond only in name since almost all of its value came from the conversion option (which is equity with delayed dilution)?

      Conclusion

      The Tesla story continues to evolve, and there is much in the story that I like. It is changing the automobile business, a feat in itself, and it is starting to deliver on its production promises. The next year may be manufacturing hell, but if the company can make its through that hell and find ways to deliver the tens of thousands of Tesla 3s that it has committed to delivering, it will be well on its way. I still find the stock to be too richly priced, even given its promise and potential, for my liking, but I understand that many of you may disagree. That said, though, I do think that the company's decision to use debt to fund its operations makes no sense, given where it is in the life cycle.

      YouTube Video



      Previous Blog Posts
      1. Tesla: It's a story stock, but what's the story? (July 2016)

      Spreadsheet Attachments
      1. Tesla Valuation: August 2017
      2. Tesla Valuation: July 2016



      The Crypto Currency Debate: Future of Money or Speculative Hype?

      When it comes to any finance-related questions, I am fair game, and those questions usually span the spectrum, from what I think about Warren Buffett (or why I don't agree with everything he says) to whether tech stocks are in a bubble (a perennial question for worry warts). In the last few months, though, I have noticed that I have been getting more and more questions about crypto currencies, especially Bitcoin and Ether, and whether the price surges we have seen in these currencies are merited. While I have an old post on bitcoin, I have generally held back from talking about crypto currencies in this blog or in my other teaching for two reasons. First, I find that any conversation about bitcoin quickly devolves into an argument rather than a discussion, since both proponents and critics tend to hold strong views on its use (or uselessness). Second, I find that some of the technical underpinnings of bitcoin, ether and other cryptocurrencies are beyond my limited understanding of block chains and technology and I risk saying something incredibly ill informed. While both reasons still persist, I am going to throw caution to the winds and put down my thoughts about the rise, the mechanics and the future, at least as I see it, of crypto currencies in this post.

      The Market Boom
      Any discussion of crypto currencies has to start with the recognition that the experiment is still young.  Satoshi Nakamoto's paper on bitcoin was made public in October 2008 and implemented as open source in January 2009. Less than ten years later, the market capitalization of bitcoin alone is in excess of $40 billion and the success story, at least in terms of bitcoin as an investment, can be seen in the graph below:

      The initial rise could have been a flash in the pan, a fad attracting speculators, but in the last two years, Bitcoin seems to have found new fans, as can be seen below:

      Bitcoin's success, at least in the financial markets, has attracted a host of competitors, with Ethereum (Ether) being the most successful. Ether's rise in market price, since its introduction in 2015 has been even more precipitous that Bitcoin's, though it has pulled back in recent weeks:

      The list of crypto currencies gets added to, by the day, with a complete list available here, with the market caps of each (in US dollars) listed. At least from a market perspective, there is no doubting the fact that crypto currencies have arrived, and enriched a lot of people along the way.

      The Mechanics 
      While the crypto currencies emphasize their differences, the most successful ones share a base architecture, the block chain. A block chain is a shared digital ledger of transactions in an asset where the validation of transactions is decentralized. I know that sounds mystical, but the picture below (using bitcoin to illustrate) should provide a better sense of what's involved:

      The key features of a block chain are:
      1. Decentralized verification: The validation and verification of a transaction is sourced to members, called miners in the crypto currency world. Verification usually involves trying different algorithms (hashes) to find the unique one that matches the transaction block, and the successful miner is rewarded, currently with the crypto currency. At least, as I understand it, this process requires more brute force (powerful processors trying different algorithms before you find a match) than intellectual firepower.
      2. Complete and open records: Every transaction, once validated and verified, is converted into a block of data that is recorded in the block chain ledger, which is accessible to everyone in the network. If you are worried about privacy, the transaction records do not include personal data but take the form of encrypted data (hashes).
      3. Incorruptible: A block chain, once recorded and shared, cannot be changed since those changes are visible to everyone in the network and are quickly tagged as fraudulent. Thus, the ledger, once created, becomes almost incorruptible.
      In effect, a block chain is a digital intermediation process where transactions are checked by members of the network, and recorded, and once that is done, cannot be altered fraudulently. As you can see from its description, the block chain technology is about far more than crypto currencies. It can be used to record transactions in any asset, from securities in financial markets to physical assets like houses, and do so in a way that replaces the existing intermediaries with decentralized models. It should come as no surprise that banks and stock exchanges, which make the bulk of their money from intermediation, not only see block chains as a threat to their existence but have been early investors in the technology, hoping to co-opt it to their own needs.  

      The Currency Question
      If you define success as a rise in market capitalization and popular interest, crypto currencies have clearly succeeded, perhaps more quickly than its original proponents ever expected it to. But the long term success of any crypto currency has to answer a different question, which is whether it is a "good" currency.  Harking back to Money 101, you measure a currency's standing by looking at how well it delivers on its three purposes:
      1. Unit of account: A key role for a currency is to operate as a unit of account, allowing you to value not just assets and liabilities, but also goods and services. To be effective as a unit of account, a currency has to be fungible (one unit of the currency is identical to any other unit), divisible and countable. 
      2. Medium of exchange: Currencies exist to make transactions possible, and this is best accomplished if the currency in question is easily accessible and transportable, and is accepted by buyers and sellers as legal tender. The latter will occur only if people trust that the currency will maintain its value and if transactions costs are low.
      3. Store of value: To the extent that you hold some or all of your wealth in a currency, you want to feel secure about leaving it in that currency, knowing that it will not lose its buying power while stored.  
      Given these requirements, you can see why there are no perfect currencies and why every currency has to measured on a  continuum from good to bad. Broadly speaking, currencies can take one of three forms, a physical asset (gold, silver, diamonds, shells), a fiat currency (usually taking the form of paper and coins, backed by a government) and crypto currencies. Gold's long tenure as a currency can be attributed to its strength as a store of value, arising from its natural scarcity and durability, though it falls short of fiat currencies, in terms of convenience and acceptance, both as a unit of account and as medium of exchanges. Fiat currencies are backed by sovereign governments and consequently can vary in quality as currencies, depending upon the trust that we have in the issuing governments. Without trust, fiat currency is just paper, and there are some fiat currencies where that paper can become close to worthless.  For crypto currencies, the question then becomes how well they deliver on each of the purposes. As units of account, there is no reason to doubt that they can function, since they are fungible, divisible and countable. The weakest link in crypto currencies has been their failure to make deeper inroads as mediums of exchange or as stores of value. Using Bitcoin, to illustrate, it is disappointing that so few retailers still accept it as payment for goods and services. Even the much hyped successes, such as Overstock and Microsoft accepting Bitcoin is illusory, since they do so on limited items, and only with an intermediary who converts the bitcoin into US dollars for them. I certainly would not embark on a long or short trip away from home today, with just bitcoins in my pocket, nor would I be willing to convert all of my liquid savings into bitcoin or any other crypto currency. Would you?

      So, why has crypto currency not seen wider acceptance in transactions? There are a few reasons, some of which are more benign than others:
      1. Inertia: Fiat currencies have a had a long run, and it is not surprising that for many people, currency is physical and takes the form of government issued paper and coins. While people may use credit cards and Apple Pay, their thinking is still framed by the past, and it may take a while, especially for older consumers and retailers, to accept a digital currency. That said, the speed with which consumers have adapted to ride sharing services and taken to social media suggests that inertia cannot be the dominant reason holding back the acceptance of crypto currencies.
      2. Price volatility: Crypto currencies have seen and continue to see wild swings in prices, not a bad characteristic in a traded asset but definitely not a good one in a currency. A retailer or  service provider who prices his or her goods and services in bitcoin will constantly have to reset the price and consumers have little certitude of how much the bitcoin in their wallers will buy a few hours from now.
      3. Competing crypto currencies: The crypto currency game is still young and the competing players each claim to have found the "magic bullet" for eventual acceptance. As technologies and tastes evolve, you will see a thinning of the herd, where buyers and sellers will pick  winners, perhaps from the current list or maybe something new. It is possible that until this happens, transactors will hold up, for fear of backing the wrong horse in the race.
      Ultimately, though, I lay some of the blame on the creators of the crypto currencies, for their failure, at least so far, on the transactions front. As I look at the design and listen to the debate about the future of crypto currencies, it seems to me that the focus on marketing crypto currencies has not been on transactors, but on traders in the currency, and it remains an unpleasant reality that what makes crypto currencies so attractive to traders (the wild swings in price, the unpredictability, the excitement) make them unacceptable to transactors. 

      The Disconnect
      You can see the disconnect in how crypto currencies have been greeted, by contrasting the rousing reception that markets have given them with the arms length at which they have been held by merchandisers and consumers. In the graph below, I focus on the divergence between the market price rise of bitcoin and the increase in the number of transactions involving bitcoin:

      While the price of bitcoin has increase more than a thousand fold, since the start of 2012, the number of transactions involving bitcoin was only about thirty two times larger in July 2017 than what it was at the start of 2012. In my view, there are three possible explanations for the divergence, and they are not mutually exclusive:
      1. Markets are forward looking: If you are a believer in crypto currencies, the most optimistic explanation is that markets are forward looking and that the rise in the prices of Bitcoin and Ether reflects market expectations that they will succeed as currencies, if not right away, in the near future. 
      2. Speculative asset: I am second to none in having faith in markets, but there is a simpler and perhaps better explanation for the frenzied price movements in crypto currencies. I have long drawn a distinction between the value game (where you try to attach a value to an asset based upon fundamentals) and the pricing game, where mood and momentum drive the process. I would argue, based upon my limited observations of the crypto currency markets, that these are pure pricing games, where fundamentals have been long since forgotten. If you don't believe me, visit one of the forums where traders in these markets converse and take note of how little talk there is about fundamentals and how much there is about trading indicators.
      3. Loss of trust in centralized authorities (governments & central banks): There can be no denying that the creators of Bitcoin and Ether were trying to draw as much inspiration for their design from gold, as they were from fiat currencies. Thus, you have miners in crypto currency markets who do their own version of prospecting when validating transactions and are rewarded with the currency in question. For ages, gold has held a special place in the currency continuum, often being the asset of last resort for people who have lost faith in fiat currencies, either because they don't trust the governments backing them or because of debasement (high inflation). While gold will continue to play this role, I believe that for some people (especially younger and more technologically inclined), bitcoin and ether are playing the same role. As surveys continue to show depleting trust in centralized authorities (governments and central banks), you may see more money flow into crypto currencies. 
      The analogy between gold and crypto currency has one weak link. Gold has held its value through the centuries and is a physical asset. For better or worse, it is unlikely that we will decide a few years from now that gold is worthless. A crypto currency that few people use as currency ultimately will not be able to sustain itself, as shiner and newer versions of it pop up. Ironically, if traders in bitcoin and ether want their investments in the crypto currencies to hold their value, the currencies have to become less exciting and lucrative as investments, and become more accepted as currencies. Since that will not happen by accident, I would suggest that the winning crypto currency or currencies will share the following characteristics;
      1. Transaction, not trading, talk: From creators and proponents of the currency, you will hear less talk about how much money you would make by buying and selling the currency and more on its efficacy in transactions.
      2. Transaction, not trading, features: The design of the crypto currency will focus on creating features that make it attractive as a currency (for transactions), not as investments. Thus, if you are going to impose a cap (either rigid like Bitcoin or more flexible, as with other currencies), you need to explain to transactors, not traders, why the cap makes sense. 
      3. Trust in something: I know that we live in an age where trust is a scarce resource and I argued that that the growth in crypto currencies can be attributed, at least partly, to this loss of trust. That said, to be effective as a currency, you do need to be able to trust in something and perhaps accept compromises on privacy and centralized authority (at least on some dimensions of the currency). 
      It is also worth noting that the real tests for crypto currencies will occur when they reach their caps (fixed or flexible). After all, bitcoin and ether miners have been willing to put in the effort to validate transactions because they are rewarded with issues of the currency, feasible now because there is slack in the currency (the current number is below the cap). As the cap becomes a binding constraint, the rewards from miners have to come from transactions costs and serious thought has to go into currency design to keep these costs low. Hand waving and claiming that technological advances will allow this happen are not enough. I know that there are many in the crypto currency world who recognize this challenge, but for the moment, their voices are being drowned out by traders in the currency and that is not a good sign.

      If you expected a valuation of bitcoin or ether in this post, you are probably disappointed by it, but here is a simple metric that you could use to determine whether the prices for crypto currencies are "fair". Currencies are priced relative to each other (exchange rates) and there is no reason why the rules that apply to fiat currencies cannot be extended to crypto currencies. A fair exchange rate between two fiat currencies will be on that equalizes their purchasing power, an old, imperfect and powerful theorem. Consequently, the question that you would need to address, if you are paying $2,775 for a bitcoin on August 1, 2017, is whether you can (or even will be able to) but $2,775 worth of goods and services with that bitcoin. If you believe that bitcoin will eventually get wide acceptance as a digital currency, you may be able to justify that price, especially because there is a hard cap on bitcoin, but if you don't believe that bitcoin will ever acquire wide acceptance in transactions, it is time that you were honest with yourself and recognized that is just a lucrative, but dangerous, pricing game with no good ending.

      Conclusion
      Crypto currencies, with bitcoin and ether leading the pack, have succeeded in financial markets by attracting investors, and in the public discourse by garnering attention, but they have not succeeded (yet) as currencies. I believe that there will be one or more digital currencies competing with fiat currencies for transactions, sooner rather than later, but I am hard pressed to find a winner on the current list, right now, but that could change if the proponents and designers of one of the currencies starts thinking less about it as a speculative asset and more as a transaction medium, and acting accordingly. If that does not happen, we will have to wait for a fresh entrant and the most enduring part of this phase in markets may be the block chain and not the currencies themselves.

      YouTube Video



      Bitcoin Backlash: Back to the Drawing Board?

      My last post on Bitcoin got me some push back and I am glad that it did. I would rather be read, and disagreed with, than not read at all. I have been told that I know very little about crypto currencies and that I have much to learn, and I agree. The crux of the disagreements though lay in my classifying Bitcoin as a currency, not as an asset or as a commodity. Since this classification is central to how you should think about investing versus trading, and value versus price, and goes well beyond Bitcoin, I decided to dig deeper into the classification and provide even more ammunition for those who disagree with me to tell me how wrong I am.

      Classifying Investment: The What and the Why
      We are products of our own world views, and mine, for better or worse, are built around my interest in valuation. It is that perspective that led me to classifying investments into cash flow generating assets, commodities, currencies and collectibles. To value an investment, I need that investment to generate future cashflows (at least on an expected basis) and that was my basis for separating cash flow generating assets (which range the spectrum from a bond to a stock to a business) from the rest.

      The pushback that I got did not surprised me, partly because my definition may be at odds with the definitions used by other entities. Accountants, for instance, classify items as assets that I think are pure fiction, such as goodwill. There are others who argue that any investment on which you can make money is an asset, broadening it to include just about everything from baseball cards to government bonds. In fact, crypto currencies have been at the center of many of these disagreements, with the SEC recently deciding to treat ICOs as securities (and thus assets) and the Korean central bank categorizing Bitcoin as a commodity. Since the judgment made by these entities have regulatory and tax consequences, I am sure that they will be debated, discussed and disagreed with.  

      Why Bitcoin is a currency and not an asset..
      One reason that people are uncomfortable drawing the line between currency, commodity and asset is that the line can sometimes shift quickly. Take the US dollar, for instance. Its primary purpose is to serve as a medium of exchange and as a store of value, and it is thus a currency. However, you can lend US dollars to a business or individual and generate interest income. That is true, but it is not the currency that is then the asset, but the loan that you make with it, or the bond that is denominated in it. Building further, if I create a bank that takes in deposits in dollars (and pays an interest rate on them) and lends out those dollars as loans, I have a business and that business is an asset. I can value the loan and the bond based upon the interest rate you earn and the default risk that you face, or the bank, based upon the interest rate spread it earns and the risk of default that it faces on its collective portfolio, but I cannot value the US dollar.

      Can I construct investments denominated in Bitcoin or another crypto currency that earn me interest or a return? Of course, but I can do that in any currency, and it is in fact one of the functions of a currency. That does not make Bitcoin an asset! You can already see that the question of whether Initial Coin Offerings (ICO) are currencies or assets becomes trickier, because an ICO can be constructed to give you a share of the ownership in a business (and the cash flows from that business), making it more of an asset than a currency (thus giving credence to the SEC's view that it is a security). The lack of standardization in ICO structures, though, makes it difficult to generalize, since loosely put, an ICO can be constructed to be anything from a donation (at least, according to Kathleen Breitman at Tezos) to quasi common stock (without the voting rights).

      A few of you have pointed to the networking benefits that might create value for Bitcoin, but I am afraid that I don't see that as a basis for assigning value to it. A network can become an asset, but only when you can make money off the network. The value of Facebook to me, as an investor, is not that I am part of the Facebook network (I am not, since I have not posted on Facebook in almost three years) but that I get a share of the money made from selling advertising to those on the network. Unless you can trace monetary benefits to being part of the Bitcoin network, there is no value to being part of the network. (Visa and MasterCard are assets, not because they have wide networks and are accepted globally, but because every time they are used, they make 1-2% of the transaction value.) To the argument that Bitcoin miners can make money as the network expands, that value is for providing a service, not for holding Bitcoin.

      Why Bitcoin is more currency than commodity
      The essence of a currency is that its primary uses are as a medium of exchange or as a store of value. The key to a commodity is that it is an input into a process that has a utilitarian function. Oil and coal are clearly commodities, since they derive their value from the fact that they can be used to produce energy. It is true, as with currencies, that you can create an asset based upon a commodity. A share of an oil well is an asset not because you like or even need oil, it is because you hope to sell the oil to generate cash flows. It is also true that gold is a commodity, but as I noted in the prior post, I think it is more currency than commodity, because the quantity of gold that we have on the face of the earth vastly exceeds whatever utilitarian needs it might serve. It is shiny, durable, makes beautiful jewelry and has some industrial uses, but if that is all we valued gold for, it would be worth a lot less than it is trading for, and there would be less of it around. 

      The question with Bitcoin then becomes whether it can become (or perhaps already is) like gold. Here is my test: If tomorrow, humanity collectively decided to abandon its attachment to gold as a value store, would its price go to zero? I don't think so, because it does have uses and while its price will drop, it will be priced based on those uses. Applying the same test to Bitcoin, I am left nonplussed about what value to attach to a digital currency if at the end, no one uses it in transactions, it has no aesthetic value and it produces nothing utilitarian.

      A Commodity Argument for Crypto Currencies (but perhaps not for Bitcoin)
      Some of you have pointed to Bitcoin's scarcity (created by the hard cap on production) and the fact that time and energy are spent on its production. Scarcity is neither a sufficient nor even a necessary condition for something to be a commodity. Sand is a scarce resource but it is not a commodity because I cannot think of a good use for it; so is bull manure, but that is a discussion for another time and day. The fact that time and energy went into the production of Bitcoin cannot be used to justify paying for it unless you can show that it is necessary for something that does create utility or value.   If, as argued by someone who commented on my last post, Bitcoin is a synthetic commodity, I can see that it is synthetic but what conceivable use does it have that makes it a commodity? Therein lies an opening for a “crypto currency as commodity” defense, though it works better for crypto currencies like Ethereum than it does for Bitcoin, and it require three building blocks: 
      1. Block Chains and Smart Contracts will create large disruptions in businesses: You have to believe that block chains and the smart contracts that emerge from them will replace conventional contracts in many businesses, and that will generate cash flows to the contract providers. Your argument can be based upon either economic (that the transactions costs willl be lower) or security (that the contracts will be more secure) rationales.
      2. Crypto Currencies are the lubricants for smart contracting: The discussion of block chains and crypto currency have become entangled into one discussion, but it is worth remembering that block chains predate crypto currencies and can work with fiat currencies. Thus, you will have to argue that crypto currencies are a necessary ingredient to make smart contracts work efficiently, and that the demand for them will then rise as smart contracting expands. 
      3. “Your” crypto currency will be one of the winners: Even if you can make the first two legs of this argument, it remains an argument for growth in digital or crypto currencies, not an argument for a specific one. To seal the deal, you will have to explain why your crypto currency of choice (Bitcoin, Ethereum etc.) will become the winner or at least one of the winners in the smart contracting currency race, perhaps because it has the “best technology” for smart contracting or has the most buy in by the institutional players in the game.
      I think that the first leg of this argument will be easy to make, the second leg a little more difficult and the third leg will need the most convincing. Even if you can show, based upon today's technology, that you have the "best" smart contracting currency, how do you build barriers to entry that prevent you being pre-empted by another innovation or technology down the road? 

      Conclusion
      The game is still early, and there is much that we do not know about crypto currencies. I remain willing to learn both from people who know more than I do (and there are many out there) as well as events on the ground. As you listen to arguments for or against crypto currencies, my only advice is that you go back to basics about the needs that they are filling and that you ask questions about their long term staying power. I think it is also time for us to separate arguments about block chains/smart contracts from arguments about crypto currencies, since you can have one without the other, and to differentiate between crypto currencies, rather than defend them or abandon them all, as a bundle. To me, Bitcoin, Ethereum, Ripple and  ICOs are different enough from each other, not only in structure but also in terms of end game, that they need to be assessed independently.

      YouTube Video


      Past Blog Posts on Crypto Currencies




      The Bitcoin Boom: Asset, Currency, Commodity or Collectible?

      As I have noted with my earlier posts on crypto currencies, in general, and bitcoin, in particular, I find myself disagreeing with both its most virulent critics and its strongest proponents.  Unlike Jamie Dimon, I don't believe that bitcoin is a fraud and that people who are "stupid enough to buy it" will pay a price for that stupidity. Unlike its biggest cheerleaders, I don't believe that crypto currencies are now or ever will be an asset class or that these currencies can change fundamental truths about risk, investing and management. The reason for the divide, though, is that the two sides seem to disagree fundamentally on what bitcoin is, and at  the risk of raising hackles all the way around, I will argue that bitcoin is not an asset, but a currency, and as such, you cannot value it or invest in it. You can only price it and trade it.

      Assets, Commodities, Currencies and Collectibles
      Not everything can be valued, but almost everything can be priced. To understand the distinction between value and price, let me start by positing that every investment that I will look at has to fall into one of the following four groupings:
      1. Cash Generating Asset: An asset generates or is expected to generate cash flows in the future. A business that you own is definitely an asset, as is a claim on the cash flows on that business. Those claims can be either contractually set (bonds or debt), residual (equity or stock) or even contingent (options). What assets share in common is that these cash flows can be valued, and assets with high cash flows and less risk should be valued more than assets with lower cash flows and more risk. At the same time, assets can also be priced, relative to each other, by scaling the price that you pay to a common metric. With stocks, this takes the form of comparing pricing multiples (PE ratio, EV/EBITDA, Price to Book or Value/Sales) across similar companies to form pricing judgments of which stocks are cheap and which ones are expensive.
      2. Commodity: A commodity derives its value from its use as raw material to meet a fundamental need, whether it be energy, food or shelter. While that value can be estimated by looking at the demand for and supply of the commodity, there are long lag and lead times in both that make that valuation process much more difficult than for an asset. Consequently, commodities tend to be priced, often relative to their own history, with normalized oil, coal wheat or iron ore prices being computed by averaging prices across long cycles.
      3. Currency: A currency is a medium of exchange that you use to denominate cash flows and is a store of purchasing power, if you choose to not invest. Standing alone, currencies have no cash flows and  cannot be valued, but they can be priced against other currencies. In the long term, currencies that are accepted more widely as a medium of exchange and that hold their purchasing power better over time should see their prices rise, relative to currencies that don't have those characteristics. In the short term, though, other forces including governments trying to manipulate exchange rates can dominate. Using a more conventional currency example, you can see this in a graph of the US $ against seven fiat currencies, where over the long term (1995-2017), you can see the Swiss Franc and the Chinese Yuan increasing in price, relative to the $, and the Mexican Peso, Brazilian Real, Indian Rupee and British Pound, dropping in price, again relative to the $.
      4. Collectible: A collectible has no cash flows and is not a medium of exchange but it can sometimes have aesthetic value (as is the case with a master painting or a sculpture) or an emotional attachment (a baseball card or team jersey). A collectible cannot be valued since it too generates no cash flows but it can be priced, based upon how other people perceive its desirability and the scarcity of the collectible.  
      Viewed through this prism, Gold is clearly not a cash flow generating asset, but is it a commodity? Since gold's value has little to do with its utilitarian functions and more to do with its longstanding function as a store of value, especially during crises or when you lose faith in paper currencies, it is more currency than commodity. Real estate is an asset, even if it takes the form of a personal home, because you would have had to pay rental expenses (a cash flow), in its absence. Private equity and hedge funds are forms of investing in assets, currencies, commodities or collectibles, and are not separate asset classes. 

      Investing versus Trading
      The key is that cash generating assets can be both valued and priced, commodities can be priced much more easily than valued, and currencies and collectibles can only be priced. So what? I have written before about the divide between investing and trading and it is worth revisiting that contrast. To invest in something, you need to assess its value, compare to the price, and then act on that comparison, buying if the price is less than value and selling if it is greater. Trading is a much simpler exercise, where you price something, make a judgment on whether that price will go up or down in the next time period and then make a pricing bet. While you can be successful at either, the skill sets and tool kits that you use are different for investing and trading, and what makes for a good investor is different from the ingredients needed for good trading. The table below captures the difference between trading (the pricing game) and investing (the value game).

      The Pricing Game
      The Value Game
      Underlying philosophy
      The price is the only real number that you can act on. No one knows what the value of an asset is and estimating it is of little use.
      Every asset has a fair or true value. You can estimate that value, albeit with error, and price has to converge on value (eventually).
      To play the game
      You try to guess which direction the price will move in the next period(s) and trade ahead of the movement. To win the game, you have to be right more often than wrong about direction and to exit before the winds shift.
      You try to estimate the value of an asset, and if it is under(over) value, you buy (sell) the asset. To win the game, you have to be right about value (for the most part) and the market price has to move to that value
      Key drivers
      Price is determined by demand & supply, which in turn are affected by mood and momentum.
      Value is determined by cash flows, growth and risk.
      Information effect
      Incremental information (news, stories, rumors) that shifts the mood will move the price, even if it has no real consequences for long term value.
      Only information that alter cash flows, growth and risk in a material way can affect value.
      Tools of the game (1) Technical indicators, (2) Price Charts (3) Investor Psychology (1) Ratio analysis, (2) DCF Valuation (3) Accounting Research
      Time horizon
      Can be very short term (minutes) to mildly short term (weeks, months).
      Long term
      Key skill
      Be able to gauge market mood/momentum shifts earlier than the rest of the market.
      Be able to “value” assets, given uncertainty.
      Key personality traits
            (1) Market amnesia (2) Quick Acting (3) Gambling Instincts
            (1) Faith in “value” (2) Faith in markets (3) Patience (4) Immunity from peer pressure
      Biggest Danger(s)
      Momentum shifts can occur quickly, wiping out months of profits in a few hours.
      The price may not converge on value, even if your value is “right”.
      Added bonus
      Capacity to move prices (with lots of money and lots of followers).
      Can provide the catalyst that can move price to value.
      Most Delusional Player
      A trader who thinks he is trading based on value.
      A value investor who thinks he can reason with markets.

      As I see it, you can play either the value or pricing game well, but being delusional about the game you are playing, and using the wrong tools or bringing the wrong skill set to that game, is a recipe for disaster.

      What is Bitcoin?
      The first step towards a serious debate on bitcoin then has to be deciding whether it is an asset, a currency, a commodity or collectible. Bitcoin is not an asset, since it does not generate cash flows standing alone for those who hold it (until you sell it).  It is not a commodity, because it is not raw material that can be used in the production of something useful. The only exception that I can think off is that if it becomes a necessary component of smart contracts, it could take on the role of a commodity; that may be ethereum's saving grace, since it has been marketed less as a currency and more as a smart contracting lubricant.  The choice then becomes whether it is a currency or a collectible, with its supporters tilting towards the former and its detractors the latter. I argued in my last post that Bitcoin is a currency, but it is not a good one yet, insofar as it has only limited acceptance as a medium of exchange and it is too volatile to be a store of value. Looking forward, there are three possible paths that I see for Bitcoin as a currency, from best case to worst case.
      1. The Global Digital Currency: In the best case scenario, Bitcoin gains wide acceptance in transactions across the world, becoming a widely used global digital currency. For this to happen, it has to become more stable (relative to other currencies), central banks and governments around the world have to accept its use (or at least not actively try to impede it) and the aura of mystery around it has to fade. If that happens, it could compete with fiat currencies and given the algorithm set limits on its creation, its high price could be justified.
      2. Gold for Millennials: In this scenario, Bitcoin becomes a haven for those who do not trust central banks, governments and fiat currencies. In short, it takes on the role that gold has, historically, for those who have lost trust in or fear centralized authority. It is interesting that the language of Bitcoin is filled with mining terminology, since it suggests that intentionally or otherwise, the creators of Bitcoin shared this vision. In fact, the hard cap on Bitcoin of 21 million is more compatible with this scenario than the first one. If this scenario unfolds, and Bitcoin shows the same staying power as gold, it will behave like gold does, rising during crises and dropping in more sanguine time periods.  
      3. The 21st Century Tulip Bulb: In this, the worst case scenario, Bitcoin is like a shooting star, attracting more money as it soars, from those who see it as a source of easy profits, but just as quickly flares out as these traders move on to something new and different (which could be a different and better designed digital currency), leaving Bitcoin holders with memories of what might have been. If this happens, Bitcoin could very well become the equivalent of Tulip Bulbs, a speculative asset that saw its prices soar in the sixteen hundreds in Holland, before collapsing in the aftermath.
      I would be lying if I said that I knew which of these scenarios will unfold, but they are all still plausible scenarios. If you are trading in Bitcoin, you may very well not care, since your time horizon may be in minutes and hours, not weeks, months or years. If you have a longer term interest in Bitcoin, though, your focus should be less on the noise of day-to-day price movements and more on advancements on its use as a currency. Note also that you could be a pessimist on Bitcoin and other crypto currencies but be an optimist about the underlying technology, especially block chain, and its potential for disruption.

      Reality Checks
      Combining the section where I classified investments into assets, commodities, currencies and collectibles with the one where I argued that Bitcoin is a "young" currency allows me to draw the following conclusions:
      1. Bitcoin is not an asset class: To those who are carving out a portion of their portfolios for Bitcoin, be clear about why you are doing it. It is not because you want to a diversified portfolio and hold all asset classes, it is because you want to use your trading skills on Bitcoin to supercharge your portfolio returns. Lest you view this as a swipe at cryptocurrencies, I would hasten to add that fiat currencies (like the US dollar, Euro or Yen) are not asset classes either.
      2. You cannot value Bitcoin, you can only price it: This follows from the acceptance that Bitcoin is a currency, not an asset or a commodity. Any one who claims to value Bitcoin either has a very different definition of value than I do or is just making up stuff as he or she goes along.
      3. It will be judged as a currency: In the long term, the price that you attach to Bitcoin will depend on how well it will performs as a currency. If it is accepted widely as a medium of exchange and is stable enough to be a store of value, it should command a high price. If it becomes gold-like, a fringe currency that investors flee to during crises, its price will be lower. Worse, if it is a transient currency that loses all purchasing power, as it is replaced by something new and different, it will crash and burn.
      4. You don't invest in Bitcoin, you trade it: Since you cannot value Bitcoin, you don't have a critical ingredient that you need to be an investor. You can trade Bitcoin and become wealthy doing so, but it is because you are a good trader.
      5. Good trader ingredients: To be a successful trader in Bitcoin, you need to recognize that moves in its price will have little do with fundamentals, everything to do with mood and momentum and big price shifts can happen on incremental information.
      Would I buy Bitcoin at $6,100? No, but not for the reasons that you think. It is not because I believe that it is over valued, since I cannot make that judgment without valuing it and as I noted before, it cannot be valued. It is because I am not and never have been a good trader and, as a consequence, my pricing judgments are suspect. If you have good trading instincts, you should play the pricing game, as long as you recognize that it is a game, where you can win millions or lose millions, based upon your calls on momentum. If you win millions, I wish you the best! If you lose millions, please don't let paranoia lead you to blame the establishment, banks and governments for why you lost. Come easy, go easy!

      YouTube Video


      Past Blog Posts on Crypto Currencies



      Deconstructing Amazon Prime: Loss Leader or Value Creator?


      Update (October 17, 2017): One of the things that I enjoy most about posting my valuations online is the feedback and how much I can use that feedback loop to improve my valuation. There are three changes that I have made to my Amazon valuation, though the end number that I get is not that different. First, as many Prime members outside the US have pointed out, the cost of Amazon Prime is less than $99/year in many countries, ranging from $22/year in Italy to just over $50/year in Germany to only $8/year in India. That lower annual cost will bring down the value of a member (existing and new). To allow for that, I have replaced the $99 annual fee that I had used in my valuation with $93.78, a  weighted average of the fees, allowing for the one quarter of Prime customers in the US who have monthly subscriptions (and pay more) and the 20% of customers outside the US (my estimate), who pay, on average, about $50/year.  Second, as some of you have noted, my operating margin was computed prior to just shipping costs and that I am double counting the customer service and media costs, which should also be added back. That increases my operating margin to 12.11% from 9.19% and I will assume that it improves to 13% over time. Third, and this was entirely my mistake, my value per existing member did not factor in the drop out rate and that has been fixed. 

      I am an Amazon Prime member and have been one for a long time, and I am completely hooked. Not only do I (and my family) use Amazon Prime for items ranging from tissue paper to big screen televisions, but it has become my go-to for every possession that I need in my working and personal life. In fact, I know (and am completely at peace with the fact) that it has subtly affected my buying, as I substitute slightly more expensive Prime items for non-Prime equivalents, even when I shop on Amazon. It is not just the absence of shipping costs that draws me to Prime, but the reliability of delivery and the ease of return. In short, it makes shopping painless. As I tally how much we save each year because of Prime and weigh it against the $99 that we pay for it, I am convinced that we are getting far more value from it than what we pay, and that leads to an interesting follow up. If many of the 85 million other Prime members in October 2017 are getting the same bargain that we are, is this not an indication that Amazon has not just under priced Prime, but is perhaps selling it below cost? As someone who has wrestled with valuing Amazon over the last 20 years, I have learned never to under estimate the company. In this post, I would like to take the process I used to value a user at Uber and apply it to value not just a Prime member to Amazon but the collective value of Amazon Prime to the company.

      The Growth of Amazon Prime
      Amazon introduced Prime in 2005 and the service was slow to take off. At the end of 2011, only about 4% of Amazon customers were Prime members. In the years since, though, the service has seen explosive growth:
      In fact, the jump in members in the last three years is particularly impressive, given how much bigger the base has become. In 2016, the company added almost 20 million new members and is on pace to add a similar number this year. In October 2017, the company’s mammoth Prime user base meant that almost 60% of all US households had memberships, suggesting that a non-Prime member is more the exception than the rule for Amazon’s US operations. Growth has been slower outside the US, slowed both by competitive/regulatory pressures and logistical challenges.

      The Economics of Amazon Prime
      To understand how Amazon Prime works, let’s break down the mechanics. Any one (in the countries where Prime is offered) can become a Prime member, either on a monthly or an annual basis. In the US, in 2017, the annual fee for membership was $99, as it has been for the last few years, and the monthly fee was $10.99. With 85 million members, that translates into a total revenue for the company of over $8.5 billion; the monthly members pay more but there is a portion of the membership (including students) who get discounted memberships. The other benefit for Amazon, though, comes from the fact that Amazon Prime members spend more on Amazon than non-Prime members. While the exact numbers are known only to Amazon, the most recently leaked reports suggest that the typical Prime member spends approximately $1,300/year on Amazon products, as opposed to the $700 spent by a non-Prime member. While it seems obvious, then, that Prime membership leads to more spending ($600, if you believe these two numbers), the statisticians will raise red flags about sampling bias since the true incremental revenue is unobservable; it is the difference between what the existing Prime members are spending ($1300/year) and what those same members would have spent, if they did not have Prime memberships. That is a reasonable point, but there is clearly a Prime impact, where Prime members choose Prime items over less expensive non-Prime offerings on Amazon, just as I do.

      The biggest cost, by far, to Amazon is the shipping cost that the company now bears on Prime items. In 2016, the company reported net shipping subsidy costs of $7.2 billion (in the footnotes to the 10K) and assuming that almost all of these costs were related to servicing the 60 million members that Amazon had in 2016 leads to a per-member shipping cost of close to $120/ member. The other free services that Amazon offers its Prime members also create costs, though those costs are embedded in larger company-wide items and are more difficult to separate out. 
      There is one final component of cost that we would like to know, but have to guess at and that is the cost to Amazon of acquiring a new member. That promotional/marketing cost is part of the total marketing cost of $7,233 million that Amazon reported in 2016 and we will assume that this cost is $100/member; in 2016, this would have translated into a total cost of $2 billion to acquire 20 million new members, leaving the remaining $5.2 billion in marketing costs as conventional advertising/marketing cost.  Pulling all these numbers, real and imagined, into a picture, here is what we get as the economics of an Amazon Prime member.

      The closing statistic that is worth emphasizing here is that once someone becomes an Amazon Prime member, they tend to stay as members with an annual renewal rate of 96%.

      The Value of an Existing Prime Member
      Using the numbers from the previous section as a starting point, we are on our way to valuing an existing Prime member. To get to that value, we have to make some estimates for the future that reflect how the base numbers will evolve over time:
      1. Renewal Rate: We will assume that annual renewal rates will stay high, at 96%, since the subscription model and the dependence on free shipping makes dropping the service difficult to do. 
      2. Incremental Revenue/ Member Growth: As Amazon looks for new products and services to sell its Prime members, we will assume that the company’s legendary marketing skills will work and that the incremental revenue (which we estimated to be $600 and attributed entirely to Prime membership) will grow 10% a year for the next five years. That growth rate will scale down to the inflation rate (1.50%) in year 10, but that cumulated effect will result in incremental sales of $1,275/member in 2027. 
      3. Operating Margins on revenues: To estimate the operating margin on revenues, I started with Amazon's operating margin but then added back the shipping, customer service and Prime media acquisition costs, since I treat them as separate costs. The resulting margin is 12.11%.
      4. Shipping Costs: The biggest cost to Amazon is shipping and much of what the company seems to be doing both in terms of new investments (in distribution centers, trucks and drop off locations) and acquisitions (Whole Foods) seems to be designed to keep these costs in check. We will assume that shipping costs will grow 3% a year for the next five years (well below the incremental revenue growth), before settling into growing at the inflation rate thereafter. 
      5. Customer Service Costs: The cost of Prime member customer service will increase 5% a year for the next 5 years and the inflation rate thereafter.
      6. Risk and Cost of Capital: I will assume that Amazon’s overall cost of capital applies as the right risk adjusted rate to use on all of its member valuations, since they partake in its entire product line. That cost of capital, in October 2017, given a US treasury bond rate of 2.35% was 8.00%.
      With those assumptions in place, we can estimate the value of a Prime member:
      With our estimates, the value per prime member is approximately $486 and the total value of 85 million prime members is $41.3 billion.  While you may view this value as built on a mountain of guesstimates, and you would be right, the analysis does provide guidance on the drivers of Prime member value. The two biggest are:
      1. Growth in incremental revenues: Getting Amazon Prime members to buy more products and services is key to their value and it should be no surprise to see stories like this one. As revenue growth climbs from 10% to 15%, for instance, the value of an existing member becomes $744 and the value of member base increases almost 65%.
      2. Keeping shipping costs contained: The key to extracting value from Prime members is checking shipping costs. To illustrate, if shipping costs grow at the same rate as incremental revenues do, the value per member collapses to $71.50. 
      Viewing Prime members through this prism makes it easier to explain the Whole Foods acquisition, by Amazon, for about $14 billion. Rather than think of it as Amazon’s entrée into a low-margin, intensely competitive grocery business, it would make more sense to view it as an acquisition of a distribution system (of 460 Whole Foods stores, in prime locations) that will reduce shipping costs in the future, while also providing a new menu of products/services that can be offered to Prime members. That is bad news for a whole host of other players in the market but that is a story for another day.

      The Value of a New Member
      To get from the value of an existing member to that of a new member, you need to have a measure of how much Amazon is spending to acquire new members. As I noted earlier, the company is opaque on this issue, though I would hazard a guess that it is a much more onerous number outside the United States. If you work with my guess of $100/new member as the base year number, we need only one more estimate to get to the value of new members and that is the growth in the membership base. Given the success that the company has shown on this front in the last five years, we will assume a growth rate of 15% for the next five years (which will bring Prime membership to 155 million in 2022). Given that large base, we will scale growth down to 5% a year from years 6-10 and to 2.25% a year thereafter.
      Download spreadsheet
      Again, with our estimates, the value of new Prime Members is approximately $53.9 billion and that number, in addition to being sensitive to our estimates of growth in members, magnifies the effects of incremental revenue and shipping cost growth that affected the value of an existing member. Thus, setting shipping costs to grow at the same rate as incremental revenues makes the value of new members a negative number, suggesting that growth will become value destructive if shipping costs are not brought under control.

      The Corporate Drag
      While it is tempting to stop and add the value of existing members and new members to arrive at the value of Amazon Prime, you would be missing a significant cost that we will term the corporate drag. To feed its ambitions with Prime, Amazon is spending far more on media content (books, movies, TV shows) than it would otherwise have and those costs will continue to grow with Prime. Earlier, we assume that 10% of the company’s current technology/media costs are attributable to Prime, yielding a base year cost of $1,609 million. We will assume that these costs will grow with the number of Prime members, yielding the following value for future costs:
      Download spreadsheet
      In effect, we will lower the value of Amazon Prime by $32.8 billion to reflect these additional costs. Note that though I treat this cost as a drag, it is not wasted, since it is the additional media that is being offered as a sweetener for existing Prime members to stay on and new ones to join.

      The Value of Amazon Prime
      Now that we have valued Amazon Prime’s existing members, its new members and the corporate drag, it is a matter of bringing them all together into a consolidated value. In our judgment, Amazon Prime is worth $62.2 billion to Amazon:   

      CategoryValue/Cost todayDetails
      Value of Existing Members$41,334.69Value of 85 million members @$486/each
      Value of New Members$52,792.78Value of new members added
      - PV of Corporate Expenses$32,845.63 Value of additional media/tecnology costs
      Value of Prime Membership$61,281.83Overall value of Amazon Prime
      I know that I have made a multitude of assumptions along the way to get to this value and that you may disagree with many of them. As always, you can download my spreadsheet and make the changes that you think need to be made. If you work at Amazon or view yourself as an expert on Amazon (I am not), your numbers should be much better than mine, and I would hope that your valuation will reflect the better information. While I have made a few optimistic assumptions to get to the value of Amazon Prime, I believe that there is an additional value that I have not counted in. Amazon is building a base of loyal, intense members that it can draw on to promote whatever its next product or service is, whether it be in retailing, technology, entertainment or cloud computing. That value is what you could call a real option, though those words are used far too frequently in places where they should not be, and that real option may be Amazon’s ultimate wild card.

      Conclusion
      I have long described Amazon as a Field of Dreams company, one that goes for higher revenues first and then thinks about ways of converting those revenues into profits; if you build it, they will come. In coining this description, I am not being derisive but arguing that the market's willingness to be patient with the company is largely a the result of the consistency with Jeff Bezos has told the same story for the company, since 1997, and acted in accordance with it. Amazon Prime symbolizes how Amazon plays the long game, an investment that has taken a decade to bear fruit, but one that will be the foundation on which Amazon launches into new businesses. I know that there are many companies that model themselves after Amazon, but unless these "Amazon Wannabes" can match its narrative consistency and long time horizon, it will remain a one of a kind.

      YouTube Video


      Attachments
      1. Amazon Prime Valuation
      2. Amazon 10K (2016)
      Previous (related) blog posts



      January 2018 Data Update 8: Debt and Taxes

      In the United States, as in much of the rest of the world, and as has been true for most of the last century, the tax code has been tilted towards debt, rewarding firms that borrow money with tax savings, relative to those that use equity to fund their operations. While the original rationale for this debt bias was to allow the large infrastructure companies of the equity markets (railroads, followed by phone and natural resource companies) to raise financing to fund their growth, that reason has long dissipated, but a significant segment of the economy is built on debt. The most revolutionary component of the US tax reform package that passed at the end of last year is that it reduces the benefits of debt in multiple ways, and by doing so, challenges companies that have long depended on debt to reexamine their financing policies. 

      The Trade Off on Debt and the Tax Reform Package
      In last year’s update on debt, I summarized the trade off on debt, listing both the real pluses and minuses of debt as well as what I called the illusory benefits. In the latter group, I included reasons like debt is cheaper than equity and dilution benefits:

      The bottom line is that it is the tax advantage of debt that makes it attractive to equity, and the benefits to borrowing were greater in the United States than in any other country last year, for a simple reason. The US had the highest marginal corporate tax rate in the world, at 40%, and companies that borrowed effectively claimed their tax benefits at that rate. To the oft touted counter that no US companies pay 40%, that is true, but it actually makes the tax benefit of debt even more perverse. Companies in the United States have been able to pay effective tax rates well below 40%, while maximizing their tax benefits from debt. As an example, consider Apple, which paid an effective tax rate of less than 25% on its global income last year, partly because it left so much of its foreign income off shore (as trapped cash). Apple still managed to borrow almost $110 billion in the United States, and claim the interest expenses on that debt as a tax deduction against its highest taxed income (its US income). For those of you who find this unethical, please spare me the moralizing since your disdain should be directed at those who wrote the tax code.

      As I noted in my post on the changes that tax reform is bringing, the biggest are going to be to the tax benefits of debt, which will be dramatically decreased starting this year, for two reasons:
      1. Lower marginal tax rate: The marginal tax rate for the United States has gone from being the highest in the world to close to the middle. At a 24% marginal tax rate, which is where I think we will end up with state and local taxes added to the new federal tax rate of 21%, you are effectively reducing the tax benefit of debt by about 40% (from 40% to 24%). In the heat map below, I have highlighted marginal tax rates of countries, with a highlighting in shades of rec of those that will have lower marginal tax rates than the US after 2018. To provide a contrast, this picture would have been entirely in shades of red last year, before the tax rate change, since there was no other country with a corporate tax higher than 40%.

      2. via chartsbin.com
      3. Limits on interest tax deductions: Until last year, as has been the case for much of the last century, US companies have been able to claim their interest expenses as tax deductions, as long as they have the income to cover these expenses. With the new tax code, there is a limit to how much interest you can deduct, at 30% of adjusted taxable income. Any excess interest expenses that cannot be deducted can be carried forward and claimed in future years, and that provision will help companies with volatile earnings, since they will be able to claim back deductions lost in a bad year, in good years. As is its wont, Congress has chosen to make up its own definitions of adjusted taxable income, with EBITDA standing on for operating income until 2021 and then transitioning to earnings before interest and taxes (EBIT). 
      There are two other provisions in the tax code which will also indirectly affect the debt trade off.
      1. Capital Expensing: Attempting to encourage investments in physical assets, especially at manufacturing companies, the tax code will allow companies to expense their capital investments for a temporary period. The resulting tax deductions may be large enough to reduce the benefit to having the interest tax deduction. That effect will be magnified by the fact that the companies that are most likely to be using the capital expensing provisions are also the companies that have used debt the most in funding their operations.
      2. Un-trapped Cash: As companies are allowed to pay a one-time tax and bring trapped cash back to the United States, the cash will be now available for other uses and reduce the need for debt as a funding source. Note that estimates of this trapped cash, collectively held by US companies, exceed $3 trillion and that even if only half of this cash is brought back, it would still be a substantial amount.
      All in all, there are multiple provisions in the tax code that handicap the use of debt and very few, perhaps even none, that would make debt a more attractive source of financing. 

      Optimal Capital Structure
      To quantify the impact of the tax code’s change on how much debt a company should have and how much value it adds, I used an old but flexible optimizing tool: the cost of capital. It is, of course, the number around which a post looking at how it varies around the world and sectors. In the follow up post, I used the cost of capital as a hurdle rate to judge the quality of a company’s investments. In this one, I will use it to talk about the right mix of debt and equity, and how it affects value:

      Note that as you borrow more money, your costs of equity and debt go into motion, increasing as the debt increases and the trade off from the last section plays out, with the tax benefits showing up as an after-tax cost of debt and the bankruptcy costs partially captured in the higher costs of both equity and debt and partially as drops in operating income. Note that the key changes in the 2017 tax reform package, at least as they relate to the trade off, are highlighted. I used Disney as an illustrative example, and computed the costs of capital at every debt ratio under the old tax regime and the new one and the results are in the graph below:
      Disney Capital Structure Spreadsheet
      The cost of capital is a driver of the value of the operating assets, and since the costs of capital are higher at every debt ratio than they used to be, it should come as no surprise that the value added by debt has dropped at every debt ratio, with the new tax code.
      Download spreadsheets: DisneyFacebook & Ford
      The easiest way to see the effects of the new tax code are to look at how it plays out in the cost of capital and values of real companies. I will use Facebook, Disney and Ford as my examples, partly because they are all high profile and partly because they have widely divergent current debt policies, with Facebook having almost no debt, Disney a moderate amount and Ford more debt. With each firm, I computed the schedule of cost of capital, holding all else constant (both micro variables like EBIT and EBITDA and macro variables like the risk free rate and ERP.), with the old and new tax codes. I do this, not because I believe that these numbers will not be affected by the tax code, but because I want to isolate its impact on debt. 
      For all three firms, the effect of the new tax code is unambiguous. The value added by debt drops with the new tax code and the change is larger at higher debt ratios. Taking away 40% of the tax benefits of debt (by lowering the marginal tax rate from 40% to 24%) has consequences. Note, though, that the lost value is almost entirely hypothetical, for Facebook, since it did not borrow money even under the old code and did not have much capacity to add value from debt in the first place. It is large, for Disney and Ford, as existing debt becomes less valuable, with the new tax reform. Note, though, that both companies will also benefit from the tax code changes, paying lower taxes on income both domestically, with the lowering of the US tax rate, and on foreign income, from the shift to a regional tax model. Ford, in particular, could also benefit from the capital expensing provision. My guess is that both firms will see a net increase in value, with all changes incorporated. With these three firms, at least, the cap on the interest expense deduction (set at 30% of EBITDA for the near term) does not affect value at their existing debt ratios and is not a binding constraint until they get to very high debt ratios. 

      Debt Ratios- Cross Sectional Distributions
      If you accept my reasoning that the new tax code will lower the value of debt in capital structure, and that the effect will be most visible at firms that borrowed a lot of money under the old tax regime, the only way to assess the tax code’s impact is to look how debt ratios vary across companies, and what type of firms and in what sectors borrow the most.

      To get a measure of what comprises a high debt ratio, I started by looking at the distribution of debt ratios across companies, for both US and global companies:
      I was surprised by how many firms in the global sample have little or no debit their capital structure, with more than half of all firms in the sample having total debt to capital ratios of less than 10%. In fact, netting cash out from debt would lead to even lower net debt ratios. That said, there is enough debt at the largest firms that the aggregated debt ratios across all firms is significantly higher. Looking at these aggregated debt ratios, you would expect US companies to have been borrowing more money than companies in other parts of the world, and to see if they did, I looked at measures of financial leverage, from debt scaled to capital to debt to EBITDA globally:

      Sub GroupDebt/Capital (Book)Debt/Capital (Market)Net Debt/ Capital (Book)Net Debt/ Capital (Market)Debt/EBITDA
      Africa and Middle East45.23%34.00%30.27%21.31%5.99
      Australia & NZ61.66%43.48%57.82%39.60%8.57
      Canada55.35%42.42%52.46%39.60%7.16
      China51.63%39.34%41.83%30.40%8.52
      EU & Environs60.75%47.17%53.68%40.07%7.78
      Eastern Europe & Russia31.02%38.05%21.35%27.05%2.47
      India54.89%20.85%50.58%18.15%3.92
      Japan56.16%49.11%27.64%22.35%7.61
      Latin America & Caribbean51.67%40.01%46.23%34.90%5.74
      Small Asia44.04%34.76%36.01%27.59%4.54
      UK63.74%46.39%53.68%36.33%7.94
      United States64.06%37.11%60.86%33.99%7.09
      The results are mixed. While US companies look like they are the most highly levered in the world, if you scale debt (gross and net) to book value, US companies don’t look like outliers on any of the dimensions. In fact, the only real outliers seem to be East European companies that borrow far less than the rest of the world, relative to EBITDA, and Indian companies, that borrow less, relative to market value. Looking across sectors, you do see clear differences, with some sectors almost completely unburdened with debt and others less so. While you can get the entire list from clicking on this link, the most highly levered sectors in the US are highlight below, relative to both market capital and EBITDA.
      Download full sector spreadsheet
      I removed financial service firms from this list, since debt to them is a raw material, not a source of capital, and real estate investment trusts, since they do not pay corporate taxes, under the old and new tax regimes. As I noted in my post on tax reform, it is the most highly levered sectors that will be exposed to loss of value and it is entirely possible that the net effect of the tax change can be negative for them. 

      Implications
      You seldom get to observe a real world experiment of the magnitude that we will be faced with in 2018, with the tax code in change and the loss in value added from debt. Given the changes, I would expect the following:
      1. Deleveraging at firms that have pushed to their optimal debt ratios, under old tax code: While there are many firms, like Facebook. where debt was never a source of added value, where the tax code will affect that component of value very little, there will be other highly levered firms where the value change will be substantial. In fact, many of these firms, which would have been at the right mix of debt and equity, under the old tax regime, will find themselves over levered and in need of paying down debt. Given that inertia is the primary force in corporate finance, it may them a while to come to this realization.
      2. Go slow at firms that have held back: For firms like Facebook that have held back from borrowing, under the old tax code, the new tax code reduces the incentive to add to debt, even as they mature. As you can see from the numbers on Facebook, Disney and Ford, the benefits of debt have been significantly scaled down.
      3. Transactions that derive most of their value from leverage will be handicapped: Since the mid-1980s, leveraged transactions have been favored by many private equity investors. While one reason was that they were equity constrained (and that reason remains), the bigger reason was that it allowed them to generate added value from recapitalization. At the risk of over generalizing, I will argue that for a large segment of private equity investors, this was the primary source of their value added and for these investors, the new tax code is unequivocally bad news, and I will shed no tears for them. 
      As I noted at the start of this post, debt is part of the fabric of business in the United States, and there are some businesses and asset classes that have been built on debt. Real estate and infrastructure businesses have historically not only used debt as a primary source of funding but as a value addition, with the added value coming from the tax code. Now that the added value is much lower, it remains to be seen whether asset values will have to adjust.
      Conclusion
      From financial first principles, there is nothing inherently good or bad about debt. It is a source of financing that you can use to build a business, but by itself, it neither adds nor detracts from the value of the business. It is the addition of tax benefits and bankruptcy costs that makes the use of debt a trade off between its benefits (primarily tax driven) and its costs (from increased distress and agency costs). The new tax code has not removed the tax benefits of debt but it has substantially reduced them, and we should expect to see less debt overall at companies, as a consequence. In my view, that is a positive for the economy, since debt magnifies economic shocks to businesses and not only creates more volatile earnings and value, but deadweight costs for society.

      YouTube Video


      Datasets
      1. Debt Ratios by Sector, US (January 2018)
      2. Debt Ratios by Sector, Global (January 2018)
      Spreadsheets



      January 2018 Data Update 7: Growth and Value

      I have spent the last few posts trying to estimate what firms need to generate as returns on investments, culminating in the cost of capital estimates in the last post. In this post, I will look at the other and perhaps more consequential part of the equation, by looking at what companies generate as profits and returns. Specifically, as I have in prior years, I will examine whether the returns generated by firms are higher than, roughly equal to or lower than their costs of capital, and in the process, answer one on the fundamental questions in investing. Does growth add or destroy value?

      Profitability
      The simplest and most direct measures of profitability remain profit margins, with profits scaled to revenues for most firms. That said, there are variants of profit margins that can be computed depending on the earnings measure used:

      At the risk of stating the obvious, the margins you compute will look larger and healthier, for any firm, as you climb up the income statement. As to which of these various measures of profitability you use, the answer depends on the following:
      • What are you trying to value? If your focus is on just equity investors and you are either doing a DCF built around equity cash flows (Dividends or Free Cash Flow to Equity) or using an equity multiple (PE, Price to Sales or Price to Book), your focus will be on profits to equity investors, i.e,, net margin. In a DCF valuation built around pre-debt cash flows (FCFF) or if you are working with enterprise value multiples EV/FCFF, EV/EBITDA or EV/Sales), your focus will shift to income prior to interest expenses, leaving you with a choice between operating income and EBITDA multiples.
      • What are you trying to measure? If you are attempting to compare production efficiency across firms, the gross margin is your best measure, because it looks at the profits you will generate, per unit sold, after you have covered the direct cost of production. If you are attempting to compare operating efficiency, at the business level, the operating margin is a better device. That is because for companies that have to spend substantially on sales, marketing and other structural operating costs, the operating income can be substantially lower than the gross income. The net margin is almost never a good measure of operating efficiency, simply because it is affected significantly by how you finance your business, with more debt leading to lower net profits and net margins.
      • Where are you in the life cycle?  I use the corporate life cycle as a vehicle for talking about transitions in companies, from the right type of CEO for a firm to which pricing metric to use. The profit margins you focus on, to measure success and viability, will also shift as a company moves through the life cycle:
      • What are you selling? For better or worse, business people who are seeking your capital try to frame the profitability of their businesses by pointing to the profit margins. Since margins look better as you move up the income statement, business promoters are more inclined to use gross and EBITDA margins to make their cases than after-tax operating or net margins. While that is perfectly understandable, and even justifiable, for a young company that is scaling up (see life cycle bullet above), it is a sign of desperation when companies continue to point to gross margins as their measures of profitability as they age. 
      With that long set up, let's look at the profitability of publicly traded companies around the world on three dimensions: across time, across companies and across sectors. At the start of 2018, as I have in prior years, I computed gross, EBITDA, operating (pre and post-tax) and net profit margins for every publicly traded company in my sample. The distribution of net and pre-tax operating margins, across all companies globally, can be seen below:

      Not only are there no surprises here, but it is not easy to use this cross sectional distribution to pass judgment on your company's relative profitability for a simple reason. The median operating margin across all companies is 4.16% bu it varies widely across different businesses, partly because of differences in operating structure and scaleablity, partly because of competition and partly because of differences in the use of financial leverage (at least for net margins. The picture below reports gross, operating and net margins, by sector, for global companies at the start of 2018:
      I find profit margins to be extraordinarily useful, when valuing companies, both for comparison purposes and as the basis for my forecasts for the future. If you look at almost every valuation that I have done on this blog or in my classes, a key input that drives my forecast of earnings in future years is a target margin (either operating or net). It is also the metric that lends itself well to converting stories to numbers, another obsession of mine. Thus, if your story is that your company will benefit from economies of scale, I reflect that story by letting its operating margins improve over time, and if your narrative is that of a company with a valuable brand name, I endow it with much higher operating margins than other companies in the sector, but there is one limitation of profit margins. If your focus is on answering the question of whether your company is a "good" or a "bad" company, looking at margins may not help very much. There are "low-margin" good companies, like Walmart, that make up for low margins with high sales turnover and "high-margin" bad companies, that invest a great deal and sell very little, with many high-end retailers and manufacturers falling into this grouping. It is to remedy these problems that I will turn to measuring profitability with accounting returns, in the next section.

      The Excess Return Picture - Global
      Unlike profit margins, where profits are scaled to revenues, accounting returns scale profits to invested capital. Here, while there are multiple measures that people use, there are only two consistent measures. The first is to scale net income to the equity invested in a  company, measured usually by book value of equity, to estimate return on equity. The other is divide operating income, either pre-tax or post-tax, by the capital invested in a company, to estimate return on invested capital. While you will see both in user, there are two key factors that should color which one you focus on and how much to trust that number.
      • Claimholder Consistency: As to which measure of accounting return you should use to measure investment quality, the answer is a familiar one. It depends on whether you are measuring returns from an equity or from a business perspective:
      • Accounting Numbers: The first is that no matter how carefully you work with the numbers, the return on equity and return  on capital are quintessentially accounting numbers, with both the numerator (earnings) and denominator (book value of equity or invested capital) being accounting numbers.
        Consequently, any accounting actions, no matter how well intentioned, will affect your return on invested capital. For instance, an accounting write off of a past investment will reduce book value of both equity and invested capital and increase your return on capital. If you want to delve into the details, my condolences, but you can read this really long, really boring paper that I have on measurement issues with the return on equity and capital.
      Since accounting returns can vary, depending upon your estimation choices, it is important that I be transparent in the choices I made to compute the returns for the 43,884 firms in my sample:

      Once I have the measures of these returns, I can compare them with the costs of equity and invested capital that I have estimated already for these companies to estimate excess returns (ROIC - Cost of Capital) for each firm. The distribution across all firms is reported below:
      With all the caveats about accounting returns in place, this comparison is one of the most important ones in valuation and finance, for a simple reason. If the accounting return is a good measure of what you actually earn on your invested capital, and the cost of capital is the rate of return that you need to make on that invested capital to break even, a "good" company should generate positive excess returns, a "neutral" company should earn roughly its cost of capital and a " bad" company should have trouble earning its cost of capital. Using 2017 numbers, 22,062 companies, representing 61.7% of the 35,738 companies that I was able to estimate returns on capital for, would have fallen into the "bad" company category. It is true that my accounting returns are based upon one year's earnings, and that even good companies have bad years, and using a normalized return on capital (where I use the average return on capital earned over 10 years) does brighten the picture a bit:
      Note, that this is a comparison biased significantly towards finding good news, since by using a ten-average for the return on invested capital, I am reducing my sample to 14,502 survivor firms, more likely to be winners than losers. Even in this more optimistic picture, 2524 firms (30.2%) earn less than the cost of capital and have done so for a decade. Put simply, there are lots of companies that are bad companies, either because they are in bad businesses or because they are badly managed, and many of these companies have been bad for a long time. If there is a better reason for pushing for stronger corporate governance and more activist investors, I cannot think of it.

      Exploring the Differences in Returns
      As you digest the bad news in the cross section, if you are a manager or investor, you are probably already looking for reasons why your company or business is the exception. After all, excess returns can vary across parts of the world, different business or company size. It is in pursuit of that variation that I decided to look at excess returns, broken down on these dimensions.
      1. Geographical
      Are companies in some parts of the world likely to earn better returns on investments than others? Generally, you would expect companies in markets that are more protected from competition (either domestic or global) to do better than companies in markets where competition is fierce. In the table below, I look at excess returns, broken down by region:
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      Sub GroupNumber of firmsReturn on CapitalCost of CapitalROIC - Cost of Capital% with +ve Excess Returns
      Africa and Middle East2,2775.88%8.76%-2.88%34.55%
      Australia & NZ1,7774.71%7.97%-3.26%31.88%
      Canada2,8505.69%8.39%-2.70%19.07%
      China5,5525.11%8.13%-3.02%45.57%
      EU & Environs5,3995.50%7.74%-2.24%43.80%
      Eastern Europe & Russia5589.63%9.03%0.60%41.67%
      India3,51110.33%8.96%1.38%40.24%
      Japan3,7555.63%7.74%-2.11%45.06%
      Latin America & Caribbean8806.68%8.80%-2.12%43.63%
      Small Asia (wo China, India & Japan)8,6307.21%9.33%-2.12%32.60%
      UK1,4125.53%7.78%-2.24%47.62%
      United States7,2476.75%7.50%-0.75%36.41%
      If you are holding out hope that your region is the exception to the rule, this table probably dispels that hope. One of the two regions of the world where companies earn more than their cost of capital is India, which the cynics will attribute to accounting game playing, but may also reflect the protection from competition that some sectors in India, especially retail and financial services, have been offered from foreign competition. The sobering note, though, is that as India opens these sheltered businesses up for competition, these excess returns will come under pressure and perhaps dissipate. It is interesting that the other part of the only other region of the world where companies earn more than their cost of capital is Eastern Europe and Russia, where competitive barriers to entry remain high. China, the other big market in terms of population, does not seem to offer the same positive excess returns, and that should be a cautionary note for those who tell the China story to justify sky high valuations for companies growing there. With US companies, the returns on capital reflect the effective tax rate paid last year (about 26%) and, if you hold all else constant, you should see an increase in the return on capital in 2018, a point I made in my post on taxes.

      2. Business or Sector
      It stands to reason that it is easier to earn excess returns in some businesses than others, mostly because there are barriers to entry. Thus, you should expect businesses built on patents and exclusive licenses to offer more positive excess returns than businesses where there are no such barriers. To examine differences across sectors, I looked at excess returns, by sector, for US companies, in January 2018, and classified them into good businesses (earning more than the cost of capital) and bad businesses (earning less than the cost of capital). While the entire sector data is available for both US and Global companies, the list below highlights the non-financial service sectors that earn less than the cost of capital:

      Industry NameROCCost of Capital(ROC - WACC)
      Electronics (Consumer & Office)
      -5.54%
      7.67%
      -13.21%
      Oil/Gas (Production and Exploration)
      0.09%
      7.76%
      -7.67%
      Oil/Gas (Integrated)
      2.15%
      8.45%
      -6.30%
      Green & Renewable Energy
      1.94%
      5.77%
      -3.83%
      Shipbuilding & Marine
      4.88%
      8.26%
      -3.38%
      Real Estate (Development)
      2.27%
      5.21%
      -2.93%
      Insurance (General)
      2.82%
      5.38%
      -2.55%
      R.E.I.T.
      3.08%
      4.43%
      -1.35%
      Real Estate (General/Diversified)
      4.32%
      5.58%
      -1.26%
      Auto & Truck
      3.97%
      5.06%
      -1.09%
      Oilfield Svcs/Equip.
      6.42%
      7.44%
      -1.02%
      Telecom (Wireless)
      5.43%
      5.72%
      -0.29%
      Some of the sectors that fall into the bad business column did not surprise me, since they have been long standing members of this club. The automobile and shipbuilding businesses have been bad businesses,almost every year that I have looked at it for the last decade. Some of the sectors on this list will attribute their place on the list to macro concerns, with oil companies pointing to low oil prices. There are still others, though, that are recent entrants to this club, and  represent the dark side of disruption, where their businesses have been altered by either technology or new entrants. The electronics business is one example, where margins have collapsed and returns have followed The telecommunications business, was for long a solid business, where big infrastructure investments were funded with debt, but the companies (whether they be phone or cable) were able to use their quasi or regulated monopoly status to pass those costs on to their customers, but it has now slipped into the bad business column, as technology has undercut its monopoly powers. With financial service firms, where the excess returns are better measured by looking at the difference between ROE and cost of equity, the excess returns remain positive for the moment, but the future hold sthe terrifying prospect of unbridled competition from the fin tech startups.

      3. Size
      Are smaller companies likely to earn larger or smaller excess returns than large companies? I could tell you stories that can answer this question differently, but the answer lies in the numbers. I broke global companies down into deciles, based upon market capitalization, to see if I could eke out some answers:

      Market Cap ClassNumber of firmsReturn on CapitalCost of CapitalROIC - Cost of Capital% with +ve Excess Returns
      Smallest4,384-8.37%8.38%-16.75%9.97%
      2nd decile4,366-9.71%8.71%-18.42%14.13%
      3rd decile4,388-3.93%8.53%-12.46%20.58%
      4th decile4,399-0.34%8.38%-8.72%27.66%
      5th decile4,3872.15%8.32%-6.17%32.86%
      6th decile4,3843.94%8.27%-4.33%39.65%
      7th decile4,3842.74%8.07%-5.33%44.30%
      8th decile4,3865.50%8.05%-2.55%48.22%
      9th decile4,3856.08%7.90%-1.81%54.12%
      Largest4,3855.75%7.48%-1.73%62.24%

      For proponents of small companies, the results in this table are depressing. Small companies constantly earn much more negative excess returns than large companies. In fact, the largest companies earn positive excess returns, and while I am loath to make too much of one year's results, and recognize that there is some circularity in this table (since the companies with the highest excess returns should see their values go up the most), there is reason to believe that in more and more sectors, we are seeing winner-take-all games played out, where a few companies win, and find it easier to keep winning as they get larger. The Amazon phenomenon, which has so thoroughly upended the retail business, seems to be coming to other businesses as well. It also has implications for investing, and specifically for small cap investing, where investors have historically earned a return premium. The disappearance of this small cap premium, that I have pointed to in this post, may be a reflection of the changing business dynamics.

      4. Growth
      The excess returns that we computed are particularly relevant when we think about growth, since for growth to create value, it has to be accompanied by excess returns. If more than 60% of companies have trouble earning their cost of capital, it follows that growth in a company is more likely to destroy value than  to add to it. If companies are taking this maxim to heart and responding accordingly, you should expect to see companies with the highest growth also have the most positive excess returns and the companies that are shrinking or have the lowest growth to be the ones that have the most negative returns. I broke companies down into deciles, based upon revenue growth over the last five years, and looked at excess returns, by decile:

      Growth ClassNumber of firmsReturn on CapitalCost of CapitalROIC - Cost of Capital% with +ve Excess Returns
      Lowest Growth2,7961.68%8.65%-6.98%10.04%
      2nd decile2,8236.03%8.48%-2.46%21.47%
      3rd decile2,8145.60%8.07%-2.48%30.79%
      4th decile2,8036.33%7.88%-1.54%36.72%
      5th decile2,8154.93%7.94%-3.01%44.19%
      6th decile2,8086.39%7.97%-1.58%49.17%
      7th decile2,8166.44%8.06%-1.62%52.35%
      8th decile2,7666.59%8.09%-1.50%53.27%
      9th decile2,8504.13%8.22%-4.09%53.76%
      Top decile2,8219.54%8.20%1.33%45.49%
      There is a semblance of good news in this table. Companies in the highest growth class have the most positive excess returns, but as you can see in the table, the results are mixed as you look at the other deciles. The excess returns, in deciles six through nine are about as negative as excess returns, in deciles two through five. It behooves us, as investors, to be wary of growth in companies.

      Conclusion
      This post has extended way beyond what I initially planned, but the excess returns across companies are such a good window into so many of the phenomena that are convulsing companies today that I could not resist. Not only do the numbers here cast as a lie the notion that growth is always good, but they also let us see how disruption is changing businesses around the world. If there is a common theme, it is that change is now par for the course in almost every business and that inertia on the part of management can be devastating. As I look, in my next two posts, at how companies set debt ratios and decide how much to pay in dividends, where policy seems to be driven by inertia and me-toois, do keep this in mind.

      YouTube Video


      Data Links
      1. Profit Margins, by Sector (US)
      2. Profit Margins, by Sector (Global)
      3. Excess Returns (ROIC-Cost of Capital and ROE - Cost of Equity), by Sector (US)
      4. Excess Returns (ROIC-Cost of Capital and ROE - Cost of Equity), by Sector (Global)
      Spreadsheet
      1. Accounting Return Calculator



      January 2018 Data Update 6: A Cost of Capital Primer

      I have long described the cost of capital as the Swiss Army Knife of finance, since it shows up in so many places in finance, albeit in different forms. In corporate finance, it is not only the cost of raising funding for a business but also the hurdle rate to use in capital budgeting and an optimizing tool for capital structure and dividend policy. In valuation, it is the discount rate that we use to value a business and the only mechanism for incorporating the risk of a business into its value. Along the way, it picks up a variety of other names that are used to describe it (with my least favorite one being the WACC acronym) and gets confused or used interchangeably with the cost of equity. In short, it is not surprising that there seems to be little consensus on how to estimate the cost of capital for a business.

      The Cost of Capital: Definition
      It is unfortunate that the name that we have attached to this ubiquitous number is the cost of capital, since it seems to suggest that it is the cost of raising funding for a company. While that definition may sometimes fit, it often leads to destructive consequences, where companies that are safe and can raise equity or borrow money at low rates (and hence have a low cost of funding) think that they are adding value when they go out and take risky investments that earn more than that cost. A company that has a 5% cost of capital is not always adding value if it takes an investment that generates an 8% return, if the investment is risky enough to require a much higher return. A healthier definition of the cost of capital is to think of it as an opportunity cost, i.e., a rate of return that you (as an investor or by extension, a company that the investor has put money in) can make on an investment of equivalent risk. The key words in this definition are "equivalent risk", because that effectively eliminates the subsidy mistake that occurs when a safe company's cost of capital is used to justify taking a risky investment. This is, of course, one of the first principles of finance and it is astonishing that it is open for debate and that so many companies violate it, in their practices. If you are skeptical of my claim, consider the following manifestations of this malpractice:
      1. Many multi-business companies continue to have a "single" hurdle rate in capital budgeting: In a survey of "best" practices across companies and advisors, the authors note that almost half of all companies (and advisors) surveyed used a single cost of capital across all investments.  That is not only not good practice, but over time, it will ensure that your entire company will become a riskier company that takes bad investments. While I appreciate the work that went into this survey, I would suggest that the authors seriously reconsider using the word "best" to describe many of the horrendous practices that companies use in computing cost of capital. Looking at surveys of how companies compute costs of capital around the world, it seems clear to me that  bad practices drive out good ones, a manifestation of Gresham's law in corporate finance practice.
      2. In acquisitions, it is routine for companies (and bankers) to use the acquiring company's cost of capital to value the target company: While I cannot point to surveys to back up this statement, in my experience, this happens in more than 60% of acquisitions, with the logic being that it is the acquiring firm that raises the capital and that its costs should therefore be covered. The fact that will lead safe firms to find any risky firm that they look at to be cheap is glossed over. If you are waffling, let me be absolutist. Valuing a target company using an acquiring company's cost of capital is valuation malpractice, and if you do it, you should be stripped of your license to do valuation.
      3. Cash is viewed as a value destroying asset: If you follow GAAP or IFRS, for an asset to be categorized with cash and short term investments, it has to be invested in liquid and close to riskless assets. In the last decade, these investments, not surprisingly, have generated extraordinarily low returns, but it is true, no matter what interest rate environment you are in, that cash will earn lower returns than operating investments. There are analysts, and I use the word loosely, who compare the returns generated on cash to the cost of capital of the firm to conclude that cash is a value-destroying asset and that it should be returned. While there are legitimate arguments that can be made that companies should return cash to stockholders, this is not one of them. In fact, cash, if invested in treasury bills or commercial paper, is a value-neutral investment, earning exactly the return that you need it to earn, given its liquid, diskless status.
      4. A company that earns a higher return on its projects (higher ROIC) should be valued more highly than a company that earns a lower return on its projects: Without controlling for risk, this is not true. In fact, the right assessment would require comparing the ROIC to the cost of capital to estimate an excess return and a company that earns a higher positive excess return should be valued more highly than one that earns a lower excess return.
      The key, then, to estimating cost of capital is to to link it directly to a risk measure that can be computed not just for entire companies but for individual projects. It is that pursuit that will drive my estimation process for cost of capital, described in the next section.

      The Cost of Capital: Estimation Process
      There are ultimately only two ways of raising funds to finance a business. One is to borrow the money (debt) and the other is to use your own money (equity). This is captured in one of my favorite corporate finance devices, the financial balance sheet:

      With a small private business, the debt will take the form of a bank loan and the equity will be your savings, but as businesses scale up, debt may expand to include corporate bonds and equity may transition to venture capital, private equity and publicly traded stock. The structure also allows us to boil the cost of capital down to its three ingredients: a cost of equity, an after-tax cost of debt and the weights to attach to the two.

      Cost of equity
      The End game: In principle, the cost of equity is the rate of return that equity investors in your business need to make to compensate for the risk that they are exposed to.
      The Practice:  For the last few decades, corporate finance has tried, with mixed success, to devise a risk and return model to estimate the cost of equity. While these models vary in complexity and inputs, they generally share a common theme. They estimate the cost of equity to the marginal investors in the business, i.e., investors who own and trade large blocks of shares, and assume that these investors are diversified. These models all share a common structure; they start with a risk free rate and then estimate a risk premium for an investment, by measuring its relative risk (on one or more market risk factors) and the price of risk or risk premiums (for these factors). While it is the subject of substantial abuse, the capital asset pricing model continues to be the default model that most practitioners use in estimating cost of equity. The resulting inputs are shown below:
      I still use the capital asset pricing model in my valuations and I offer no apologies for doing so, since I find it simple, intuitive and at least as effective as the next best alternative models, most of which add more complexity and deliver little in results.  For those who are truly disturbed by the CAPM's limitations, there is an alternative approach worth considering that is agnostic in its assumptions about investor diversification and risk aversion. It is to back out the "implied" cost of equity for stocks within a sector and to use that implied number as the cost of equity in individual companies. If you are puzzled about what this implies, take a look at how I estimated the implied equity risk premium for the S&P 500 in my second data post from a couple of weeks ago and consider extending that approach to the banking index, to get an implied cost of equity for banks, and the energy sector, to estimate the cost of equity for oil companies.

      Cost of Debt
      The End Game: The cost of debt for a firm is the rate at which it can borrow money, long term and today. The after-tax cost of debt is this borrowing rate, adjusted for any tax benefits that accrue to borrowing money.
      The Practice: By defining the cost of debt as a current cost of borrowing, rather than the rate at which the firm has borrowed money in the past, I have simplified my estimation problem, since the cost of debt can then be written as the sum of the riskless rate and a default spread, reflecting the company's credit risk:
      Pre-tax cost of debt = Risk free Rate + Default Spread for the Company
      To estimate the default spread, you can use one of three approaches, in order of ease.
      • If the firm in question has corporate bonds outstanding, you can use the interest rate on the bond as your pre-tax cost of debt for the firm since it is a current, market-set rate. 
      • If a firm has corporate bonds and they are not traded enough or have features that skew the interest rate, you can use the bond rating for the company to estimate a default spread. 
      • If the firm has neither bonds nor a rating, a combination that holds for most companies, I would assess a "synthetic rating" for the company, based upon the strength of its financials and its capacity to repay debt.
      To bring the tax benefit of debt into the after-tax cost of debt, you should use the marginal tax rate, since interest expenses save you taxes at the margin:
      After-tax cost of debt = (Risk free Rate + Default Spread) (1- Marginal Tax Rate)
      This cost of debt will be much lower than your cost of equity, for almost all firms.

      Debt & Equity Weights
      Market or Book? This choice, at least for me, is an easy one. The cost of capital is a measure for what it will cost you to raise money to fund the business, investment or project today, and since you can raise money only at market value, it is the only relevant number. 
      Current or Target? This is an argument that often consumes analyst time and often misses the point. It is true that the debt ratio for a company can change over time, and if management does have a target, the actual debt ratio may move to the target. Unless this change is instantaneous, it is likely to occur over time and my answer to the question is to use the current debt ratio to estimate the cost of capital at the start of the investment and as the debt ratio is changed over time to the optimal, to change the cost of capital as well.

      Cross Sectional Estimation
      In choosing my estimation approach to getting cost of capital, do keep in mind that there are 43,848 firms in my sample and since looking at each one individually is out of the question, I will have to make some bludgeon assumptions (that I would not have made if I were estimating the cost of capital for an individual company). The table below summarizes my estimation choices, with the limitations of each:

      Estimation Approach usedPossible limitations
      Risk Free RateUS T.Bond RateCost of equity estimated in US dollars.
      BetaStarted with unlevered beta for sector & levered up using company's D/E (including leases as debt)Used only the primary business that the company was in. With multi-business companies, I am missing the effect of oither businesses on beta.
      ERP ERP of country that the company is incorporated in.If company operates in other countries, the ERP should be a weighted average.
      Default SpreadUsed bond rating, if available, to estimate the default spread. Used interest coverage ratio to estimate ratings and default spread, otherwise.Interest coverage ratios may not capture default risk fully, Bringing in other ratios might have provided more refined estimate.
      Marginal tax rateUse the statutory tax rate of the country in which the company is incorporated.If company operates in many countries, it may be able to place its debt in a country with the higher marginal tax rae.
      WeightsCurrent market value of equity and debt (including leases) used for weights.Insufficient information to estimate market value of interest-bearing debt.

      If you want to estimate the cost of capital, using more refined estimates (country weightings for ERP and business mixes for betas), you are welcome to try my cost of capital calculator. If you are working in another currency, converting my estimates of cost of capital to an alternate currency should be a simple exercise of adding the differential inflation rate between the currency in question and the US dollar to my estimate.

      The Cost of Capital - Going Concern Concept
      There is one important caveat to add about cost of capital specifically and discount rates, in discounted cash flow valuations, more generally. In a discounted cash flow valuation, we are implicitly assuming that the business that we are valuing is a going concern that will either survive for a long time or is on its path to a specified and clearly determined liquidation point.
      So what? The reality is that business is risky and the essence of risk is that it can sometime deal out bad enough outcomes to put a company out of business. With a young start up, this may take the form of running out of cash and access to capital. With a declining company, it can be the failure to make a debt payment and the resulting financial distress. With a bank, it can take the form of a drop in regulatory capital below levels acceptable to the regulatory authorities and a shutting down of the bank. With an emerging market company, even a healthy company may see its survival threatened by a nationalization. These are risks that I call truncation risks and analysts often struggle with how best to bring them into value. One path that they try is to push discount rates (or costs of capital) higher for companies that face significant amounts of truncation risk, but discount rates are blunt instruments for dealing with this type of risk and my suggestion is that you not try to adjust them for the risk. Instead, you should consider using a decision tree front on your valuation, where you can bring in your truncation risk concerns separately from your DCF. With a distressed firm or start up, for instance, where you worry about survival risk, the decision tree will look as follows:

      This will not only relieve you of the stress of trying to adjust discount rates for risk that they were never meant to convey but will allow you to focus on the truncation risk more directly. Thinking about the probability that you will not survive as a firm and what you will get, if you don't, is a much healthier exercise than arbitrarily pushing up your discount rate another 2%, because you feel the firm is riskier.

      The Cost of Capital - Perspective
      The cost of capital discussion is permeated with rules of thumb about what comprises reasonable, high or low numbers, many developed in a different time, and for a different market. These rules of thumb skew estimates, since analysts feel the urge to adjust the costs of capitals that they get from models or metrics to match their preconceptions about what they should be. It is my primary objection to the build-up approach for the cost of capital, where analysts add multiple premiums (small cap, illiquidity, company specific) to arrive at a cost of capital that matches what they would have liked to see in the first place. It is to counter this temptation that I will compute costs of capital for US and global companies and present both sector averages as well as the entire distributions for the market. 

      US Companies
      To provide perspective on what the cost of capital for the median US company will look like, start with the US 10-year T.Bond rate of 2.41% on January 1, 2018, as the risk free rate and my estimate of the implied ERP of 5.08% for the US on the same date. For an average risk stock, with a beta of one, that would translate into a cost of equity of 7.49%. Bringing in the debt ratio of 23.51% for the typical US firm and a pre-tax cost of debt of 3.91% (1.5% higher than the risk free rate), results in a cost of capital of 6.43%, if we use the marginal tax rate of 24%, post tax reform:
      Cost of capital for median US firm = (2.41%+5.08%)(1-.2351)+3.91%(1-.24) (.2351) = 6.43%
      Using the sector-specific debt ratios and betas yields costs of capital for US companies in individual sectors and the resulting costs of capital are reported in the table below:
      Download full sector cost of capital spreadsheet
      You can download the spreadsheet with the details of the cost of capital calculation by clicking on the link below. There is information in the company-specific costs of capital estimates that I have for 7.247 US firms in my sample that I try to capture in a histogram:

      To the question of what comprises a high, low or average cost of capital, I would offer the deciles for the cost of capital estimation in 2018, also shown in the histogram. 

      Global Companies
      I estimate the costs of capital for global companies, in US dollars, and using the same template that I use for the US. There are two key differences. The first is that I shift from using the US ERP of 5.08% to a GDP-weighted global average ERP of 6.20%, from a US-average debt ratio of 23.51% to to a global-average debt to capital ratio of 26.67%, from a pre-tax cost of debt of 3.91% to 4.91% (reflecting country default risk) and from a marginal tax rate of 24% to a weighted average of 24.63%. The resulting cost of capital for a median global firm is higher than for the US:
      Cost of capital for median global firm = (2.41%+6.20%)(1-.2667)+4.91%(1-.2463) (.2667) = 7.30%
      As with the US data, I compute sector averages, using sector average betas and debt ratios and the results are summarized in the picture below:
      Download full sector cost of capital spreadsheet
      Finally, the distribution of costs of capital across global companies are captured in the histogram, with deciles specified:

      Here again, I would use this distribution to make judgments of what a high, low or average cost of capital would look like in January 2018, and adding inflation differentials would provide analogous numbers in other currencies.

      The Conclusion
      Notwithstanding the length of this post, and the ones leading up to it, I do not believe that the cost of capital is the biggest driver of the value of companies. When you make mistakes in valuation, it is almost always true that the big mistakes are in your cash flow and growth estimates, rather than in your cost of capital. This is especially true when you value young companies, and it is one reason that I am almost casual in my choice of costs of capital in my valuation of Twitter, Uber and Snap, where I have attached costs of capital reflective of the 90th percentile in risk. It is true that as companies mature, the cost of capital becomes a more critical input, but even in these valuations, I would argue that if you are spending more than 20% to 25% of your time estimating it, you have lost your way.

      YouTube Video


      Paper
      1. Cost of Capital - The Swiss Army Knife of Finance\
      Datasets
      1. Cost of Capital, by Industry Group - US data
      2. Cost of Capital, by Industry Group - Global
      3. Cost of Capital Calculator (Spreadsheet)



      January 2018 Data Update 5: Country Risk Update


      In my last post, I looked at the currency confusions that globalization has brought into financial analysis, and how to clean up for them. In this post, I discuss the other aspect of globalization that is forcing analysts to change long accepted practices in estimating equity risk premiums for companies. Taking what they have learned from finance textbooks blindly, practitioners have taken what they learned about equity risk premiums to emerging and frontier equity markets, often with disastrous results. Not only have they practiced denial when it comes to the additional risk that investors face in many markets, from political, economic and legal sources, but they have also considered risk by looking at where a company is incorporated, instead of where it does business. In this post, I will update my country risk measures for the start of 2018, and build on them to measure the equity risk premiums for companies.


      Country Default Risk
      The more widely measured and accessible measures of sovereign risk are related to sovereign default, and as we noted in the post on currency risk free rates, there are three ways in which default risk in countries can be measured. The first is to use government bonds, denominated in US dollars or Euros, issued by sovereigns and to compare the rates on these bonds to a US treasury or German Euro bond rate. The second is to use the sovereign CDS spreads for countries, market-driven numbers, as default risk measures. The third is to use the sovereign ratings of countries as proxies of default risk and to convert these ratings to default spreads. 

      1. Sovereign Rating/Spread
      The leading ratings agencies including S&P, Moody’s and Fitch have long since expanded their business of rating bonds for default risk from corporations to looking at entire countries. These “sovereign” ratings are estimated on both foreign currency and local currency terms, with the ratings spectrum ranging from Aaa to D, just as with corporate bonds. One way of capturing the default risk variations across the world is with a heat map, based upon local currency sovereign ratings:

      via chartsbin.com

      Note that while there are clear differences across regions, with Latin America and Africa containing more risky (red) areas than Europe and North America, there are also differences within regions. You can download the S&P and Moody's ratings, by country, at the start of 2018, by clicking on this link.

      2. Sovereign CDS Spreads
      While sovereign ratings provide accessible measures of default risk in countries, they come with limitations. The ratings agencies are not only sometimes wrong in their default risk assessments, but they are often late in reassessing default risk (and sovereign ratings), when conditions change quickly in countries. It is these weaknesses that are remedied, at least partly, by the sovereign credit default swap (CDS) market, where investors can buy insurance against sovereign default. The market-set prices for sovereign credit default swaps provide updated measures of default risk, at least for the 70 countries that they exist for, and the levels of these spreads are in the table below:
      Download spreadsheet
      I don’t want to oversell these CDS spreads as better proxies of default risk. While they are certainly more dynamic and reflective of current risk that sovereign ratings, they are market numbers and like all market numbers, they are volatile and reflect market mood and momentum, as much as they do fundamentals.

      Country Equity Risk
      Sovereign or country equity risk measures are more difficult to come by than sovereign default spreads. First, there are services that try to measure the political and economic risk in countries with scores, albeit with no standardization. Second, the default risk measures can be converted into equity risk measures by scaling them for the additional risk in equities.

      a. Risk Scores
      The World Bank, Political Risk Services (PRS) and the Economist, among others, try to measure the total risk in countries. Those scores have no standardization and cannot be compared across services, but they still represent more comprehensive measures of risk than sovereign ratings or CDS spreads. In the heat map below, you can see the country risk scores reported by PRS, with higher scores indicating lower risk.

      via chartsbin.com

      Comparing this picture to the sovereign ratings map, there are clearly overlaps, where the country risk scores from PRS and the ratings deliver the same message; Latin America, Eurasia and Africa remain high risk zones and European countries have lower risk. 

      b. Equity Risk Premiums
      The problem with risk scores is that they cannot be easily converted into risk premiums to use in cost of equity calculations. It is to overcome this problem that I return to sovereign default spreads, not as measures of equity risk, as is often the practice, but to use them as starting points for measuring the equity risk in countries. In particular, I estimate the relative equity market volatility, computed by scaling the volatility or standard deviation in equity to the standard deviation of government bond, and use that to scale up sovereign default risk to sovereign equity risk:
      Using this approach does require traded government bonds, available for only a handful of countries. To generalize this approach, I use the ratio of the volatility in an emerging market equity index to the volatility of an emerging market government bond index, using the most recent five years of data. That ratio, which is 1.12 at the start of January 2018, is used to convert sovereign default spreads to country risk premiums. 
      These country risk premiums, when added to the implied US equity risk premium of 5.08%, yield equity risk premiums for countries. The picture below summarizes equity risk premiums around the world.

      via chartsbin.com

      If the heat map does not provide enough specifics, this picture may be better:

      Finally, if you prefer the data as a table, you can download the spreadsheet with the data or my more detailed country risk premium dataset

      Company Equity Risk
      A company's risk does not come from where it is incorporated, but where it does business. If we adopt this perspective, it is clear that to value a company, you need to see its risk exposure to different countries, either because it has its production and operations in those countries or because it sells its products or services there. That risk exposure, in conjunction with the equity risk premiums of the countries estimated in the earlier section, can be used to compute the company's equity risk premium. To illustrate this concept, consider LATAM, the Chile-based airline. To compute its equity risk premium, I would compute the weighted average of the countries that LATAM derives revenues from which includes most of Latin America and the US. For companies like Coca Cola, which may be in too many countries for this approach to be easily applied or where the country breakdowns are not available, you can use regional equity risk premiums. In the table above, I report on the GDP-weighted average ERP for regions of the world. If you accept this rationale, the following implications follow:
      1. A company cannot change its risk profile by delisting in one market and resisting in another: It is a common play for emerging market companies to delist on their "risky" local markets and to re-list on a more developed markets. While there are some good reasons for doing so, which can potentially increase value, like increased liquidity and transparency, one reason that does not stand up to scrutiny is that the company has become safer, just because of the listing change. A South African mining company that delists in Johannesburg and lists on the London Stock Exchange is still exposed to South African country risk, after the move.
      2. A company's equity risk premium should change, as its geographic exposure changes: In estimating the equity risk premium for a company today, we need to consider where it operates today. If we expect that geographic mix to change over time, as it usually will, the equity risk premium that we use in future years should reflect these expected changes. And yes, that will mean that your cost of equity and capital can change over time. Welcome to globalization!
      3. When multinationals assess projects, their hurdle rates should vary across geographies: When multinationals assess hurdle rates for projects, those hurdle rates should vary, depending upon where a project will be, even if the hurdle rates are estimated in the same currency. Thus, the US dollar cost of equity that Coca Cola should use for a Canadian beverage expansion should be far lower than the US dollar cost of equity for a Russian investment.
      It is a pity that accounting disclosure requirements have been so focused on trivial matters that have little effect on value and have not really paid attention to the type of information companies should be disclosing to investors on geographic operations.

      Conclusion
      If, as the Chinese symbol (危机) for crisis suggests, danger plus opportunity equals risk, it is not surprising that the most risky parts of the world also often provide the most potential for growth. By demanding higher equity risk premiums for investing in these parts of the world, I am not suggesting that you hold back from investing in these risky regions, but only that you demand enough of a premium for exposing yourself to additional risk. After all, investing should never be bungee jumping, where you take risk for the sake of taking risk!

      YouTube Video



      Datasets
      1. Country Ratings, PRS scores and Equity Risk Premiums (January 2018)
      2. Equity Risk Premiums, by Country - Detailed (January 2018)
      3. Company Risk Premium Calculator (Spreadsheet)
      Papers



      Testing Times: Market Turmoil and Investment Serenity

      The last week has been a roller coaster ride, though more down than up, and investors have done what they always do during market crises. The fear factor rises, some investors sell and head for the safer pastures, some are paralyzed not knowing what to do, and some double down as contrarians, buying into the sell off. In the last week, I found myself drawn to each of three camps, often at different points in the same day, as the market went through wild mood swings. These are my most vulnerable moments as an investor, since good sense is replaced by "animal spirits", and I feel the urge to abandon everything I know about investing, and go with my gut, never a good idea. I know that I have to step back from the action, regain perspective and return to what works for me in markets, and it is for that reason that I find myself going through the same sequence, each time I face a market crisis.

      Step 1: Assess the damage and regain perspective
      The first casualty in a crisis is perspective, as drawn into the news of the day, we tend to lose any sense of proportion. The last week has been an awful week for stocks, with many major indices down by 10% since last Thursday. If your initial investment in stocks was on February 1, 2018, I feel for you, because the pain has no salve, but most of us have had money in stocks for a lot longer than a week. In the table below, I look at the change in the S&P 500 last week and then compare it to the changes since the start of the year (which was less than 6 weeks ago) to a year ago and to ten years ago.

      2/1/082/1/171/1/182/1/18
      S&P 500 on date
      1355
      2279
      2674
      2822
      S&P 500 on 2/8/18
      2581
      2581
      2581
      2581
      % Change
      90.48%
      13.25%
      -3.48%
      -8.54%
      I know that this is small consolation, but if you have been invested in stocks since the start of the year, your portfolio is down, but by less than 3.5%. If you have been invested a year, you are still ahead by 13.25%, even after last week, and if you've been in stocks, since February 2008, you've not only lived through an even bigger market crisis (with the S&P 500 down 38% between September 2008 and March 2009), but you have seen your portfolio climb 90.48% over the entire period, and that does not even include dividends. That is why when confronted by perpetual bears, with their "I told you so" warnings, I try to remember that most of them have been bearish since time immemorial.

      Returning the focus to the last week, let's first look across sectors to see which ones were punished the most and which ones endured. Using the S&P classification for sectors, here is how the sectors performed between February 2, 2018 and February 9, 2018;
      Not surprisingly, every sector had a down week, though energy stocks did worse than the rest of the market, with an oil price drop adding to the pain.  Continuing to look at equities, let's now look geographically at returns in different markets over the last week.
      While the S&P 500 had a particularly bad week, the rest of the world felt the pain, with only one index (Colombo, Sri Lanka) on the WSJ international index list showing positive returns for the week. In fact, Asia presents a dichotomy, with the larger markets (China, Japan) among the worst hit and the smaller markets in South Asia (Thailand, Indonesia, Malaysia and Philippines) showing up on the least affected list. 

      While equities have felt the bulk of the pain, it is interest rates that have been labeled as the source of this market meltdown, and the graph below captures the change in treasury rates and corporate bonds in different ratings classes (AAA, BBB and Junk) over the last week and the last year:
      The treasury bond rate rose slightly over the week, at odds with what you usually see in big stock market sell offs, when the flight to safety usually pushes rates down. The increases in default spreads, reflected in the jumps in interest rates increasing with lower ratings, is consistent with a story of a increased risk aversion. Here again, taking a look across a longer time period does provide additional information, with treasury rates at significantly higher levels than a year ago, with a flattening of the yield curve. In summary, this has been an awful week for stocks, across sectors and geographies, and only a mildly bad week for bonds. Looking over the last year, it is bonds that have suffered a bad year, while stocks have done well. That said, the rates that we see on treasuries today are more in keeping with a healthy, growing economy than the rates we saw a year ago.

      Step 2: Read the tea leaves
      It is natural that when faced with large market moves, we look for logical and rational explanations. It is in keeping then that the last week has been full of analysis of the causes and consequences of this market correction. As I see it, there are three possible explanations for any market meltdown over a short period, like this one:
      Market Meltdowns: Reasons, Symptoms and Consequences
      Explanation
      Symptoms
      Market Consequences
      Panic Attack
      Sharp movements in stock prices for no discernible reasons, with surge in fear indices.
      Market drops sharply, but quickly recovers back most or all of its losses as panic subsides
      Fundamentals
      Event or news that causes expected cash flows, growth or perceived risk in equities to change significantly.
      Market drops sharply and stays down, with price moves tied to the fundamental(s) in focus.
      Repricing of Risk
      Event or news that leads to repricing of risk (in the form of equity risk premiums or default spreads).
      As price of risk is reassessed upwards, market drops until the price of risk finds its new equilibrium.
      The question in any meltdown is which explanation dominates, since stock market crisis has elements of all three. As I look at what's happened over the last week, I would argue that it was triggered by a fundamental (interest rates rising) leading to a repricing of risk (equity risk premiums going up) and to momentum & fear driven selling. 
      1. The Fundamentals Trigger: This avalanche of selling was started last Friday (February 1, 2018) by a US unemployment report that contained mostly good news, with 200,000 new jobs created, a continuation of a long string of positive jobs reports. Included in the report, though, was a finding that wages increased 2.9% for US workers, at odds with the mostly flat wage growth over the last decade. That higher wage growth has both positive and negative connotations for stock fundamentals, providing a basis for strong earnings growth at US companies that is built on more than tax cuts, while also sowing the seeds for higher inflation and interest rates, which will make that future growth less valuable.  
      2. The Repricing of Equity Risk: That expectation of higher interest rates and inflation seems to have caused equity investors to reprice risk by charging higher equity risk premiums, which can be chronicled in a forward-looking estimate of an implied ERP. I last updated that number on January 31, 2018,  and I have estimated that premium, by day, over the five trading days between February 1 and February 8, 2018. There is little change in the growth rates and base cash flows, as you go from day to day, partly because neither is updated as frequently as interest rates and stock prices, but holding those numbers, the estimated equity risk premium has increased over the last week from 4.78% at the start of trading on February 1, 2018 to 5.22% at the close of trading on February 8, 2018. 
      3. Implied ERP, by Day: January 31, 2018 (Close) to February 8, 2018 (Close)
        Date (Close)
        S&P 500
        T.Bond Rate
        Implied ERP
        Link to spreadsheet
        31-Jan-18
        2823.81
        2.74%
        4.78%
        1-Feb-18
        2821.98
        2.77%
        4.78%
        2-Feb-18
        2762.13
        2.85%
        4.88%
        5-Feb-18
        2648.94
        2.79%
        5.09%
        6-Feb-18
        2695.14
        2.77%
        5.00%
        7-Feb-18
        2681.66
        2.84%
        5.02%
        8-Feb-18
        2581.00
        2.83%
        5.22%
      4. The Panic Response: Most market players don't buy or sell stocks on fundamentals or actively think about the price of equity risk. Instead, some of them trade, trying to take advantage of shifts in market mood and momentum, and for those traders, the momentum shift in markets is the only reason that they need, to go from being stock buyers to sellers. Others have to sell because their financial positions are imperiled, either because they borrowed money to buy stocks or because they fear irreparable damage to their retirement or savings portfolios. The rise in the volatility indices are a clear indicator of this panic response, with the VIX almost tripling in the course of the week. Just in case you feel the urge to blame millennials, with robo-advisors, for the panic selling, they seem to be staying on the side lines for the most part, and it is the usual culprits,  "professional" money managers, that are most panicked of all.
      At this point, you are probably confused about where to go next. If you are trying to make that judgment, you have to find answers to three questions:
      1. Where are interest rates headed? There has been a disconnect between the equity and the bond market, since the 2016 US presidential election, with the equity markets consistently pricing in more optimistic forecasts for the US economy, than the bond markets. Stocks prices rose on the expectation that tax cuts and more robust economic growth, but bond markets were more subdued with rates continuing to stay at the 2.25%-2.5% range that we have seen for much of the last decade. As I noted in my post at the start of this year on equity markets, the gap between the US 10-year T.Bond rate and an intrinsic measure of that rate, computed by adding inflation to real GDP growth, has widened to it's highest level in the last decade. The advent of the new year seems to have caused the bond market to notice this gap, and rates have risen since. If you are optimistic about the US economy and wary about inflation, there is more room for rates to rise, with or without the Fed's active intervention.
      2. Is the ERP high enough? Is the repricing of equity risk over? The answer depends upon whether you believe the numbers that underlie my estimates, and if you do, whether you think 5.22% is a sufficient premium for investing in equities. The only way to address that question is to examine it in the context of history, which is what I have done in the picture below:
        Download historical ERP data
        With all the caveats about the numbers that underlie this graph in place, note that the premium is now solidly in the middle of the distribution. There is always the possibility that the earnings growth estimates that back it up are wrong, but if they are, the interest rate rise that scares markets will also be reversed.
      3. When will the panic end? I don't know the answer to the question but I do know that it rests less on economics and more on psychology. There will be a moment, perhaps early next week or in two weeks or in two months, where the fever will pass and the momentum will shift. If you are a trader, you can get rich playing this game, if you play it well, or poor in a hurry, if you play it badly. I choose not to play it all.
      Is there a way that we can bring this all together into a judgment call in the market. I think so and I will use the same framework that I used for my implied equity risk premium to make my assessment. You will need three numbers, an expected growth rate in earnings for the S&P 500, you estimate of where the 10-year treasury bond rate will end up and what you think is a fair equity risk premium for the S&P 500. For instance, if you accept the analyst forecasted growth in earnings of 7.26% for the next five years as a reasonable estimate, that the the T.Bond rate will settle in at about 3.0% and that 5.0% is a fair value for the equity risk premium, your estimate of value for the S&P 500 is below:
      Download spreadsheet
      With these estimates, you should be okay with how the market is valuing equities at the close of trading February 8, 2018; it is slightly under valued at 3.90%. To provide a contrast, if you feel that analysts are over estimating the impact of the tax cuts and that the historical earnings growth rate over the last decade (about 3.03%) is a more appropriate forecast for future growth, holding the risk free rate and ERP at 3% and 5% respectively, the value you will get for the index is 2233, about 16% below the index level of February 8, 2018. If you want put in your own estimates of earnings growth, T.Bond rates and equity risk premiums, please download this spreadsheet. In fact, if you are inclined to share your estimates with a group, I have created a shared google spreadsheet for the S&P 500. Let's see what we can get as a crowd valuation.

      Step 3: Review your investment philosophy
      I firmly believe that to be a successful investor, you need a core investment philosophy, a set of beliefs of not just how markets work but who you are as a person, and you need to stay true to that philosophy. It is the one common ingredient that you see across successful investors, whether they succeed as pure traders, growth investors or value investors. The best way that I can think of presenting the different choices you have on investment philosophies is by using my value/price contrast:
      To the question of which of these is the best philosophy, my answer is that there while there is one philosophy that is best for you, there is no one philosophy that is best for all investors. The key to finding that "best" philosophy is to find what makes you tick, as an individual and an investor, not what makes Warren Buffett successful.

      I see myself as an investor, not a trader, and that given my tool kit and personality, what works for me is to be a investor grounded in value, though my use of a more expansive definition of value than old-time value investors, allows me to buy both growth stocks and value stocks. I am not a market timer for two reasons.

      • First, the overall market has too many variables feeding into it that I do not control and cannot forecast, making my valuations inherently too noisy to be useful. 
      • Second, I see little that I bring to the overall market in terms of tools or information that will give me an edge over others.  
      The truest test of whether you have a solid investment philosophy is a week like the last one, where you will be tempted to or panicked into abandoning everything that you believe about markets. I  would lying if I said that I have not been tempted in the last week to time markets, either because of fear (driving me to sell) or hubris (where I want to play market contrarian), but so far, I have been able to hold out.

      Step 4: Act consistently
      During every market crisis, you will be tempted to look and ask that ever present question of "What if?", where you think about all of the money you could have saved, if only you had sold last Thursday. Not only is this pointless, unless you have mastered time travel, but it can be damaging to your future returns, as your regrets about past actions taken and not taken play out in new actions that you take.  My suggestion is that you return to your core investment philosophy and start to think about the actions that you can take on Monday, when the market opens, that would be consistent with that philosophy. I am taking my own suggestion to heart and have started revisiting the list of companies that I would love to invest in (like Amazon, Netflix and Tesla), but have been priced out of my reach, in the hope that the correction will put some of them into play. More painfully, I have been revaluing every single company in my existing portfolio, with the intent of shedding those that are now over valued, even if they have done well for me. If nothing else, this will keep me busy and perhaps stop me from being caught up in the market frenzy!

      YouTube Video


      Spreadsheets

      1. S&P 500 Intrinsic Value Spreadsheet
      2. Google Shared Spreadsheet of Intrinsic Valuations




      January 2018 Data Update 10: The Price is Right!

      In my first nine posts on my data update for 2018, I focused on the costs that companies face in raising equity and debt, and their investment, financing and dividend decisions. In assessing those decisions, though, I looked at their actions through the lens of value creation, arguing that investing in projects that earn less than their cost of capital is not a good use of shareholder capital. While this may seem like a reasonable conclusion, it is built on the implicit assumption that financial markets reward value creation and punish value destruction. As any market observer will tell you, markets have minds of their own, sometimes rewarding companies for bad behavior and punishing companies that take the right actions. In this post, I look at market pricing around the world, and point to potential inconsistencies with the fundamentals.

      Value vs Price
      In multiple posts on this blog, I have argued that we need to stop using the words, value and price, interchangeably, that they not only can be very different for the same asset, at any point in time, but that they are driven by different forces, require different mindsets to understand, and give rise to different investment philosophies. The picture below summarizes the key distinctions:

      Understanding the difference between value and price, at least for me, is freeing, because it not only makes me aware of the assumptions that I, as an investor who believes in value and convergence, am making, but also makes me respect and recognize those who might have a different perspective. The bottom line, though, is that the pricing process can sometimes reward firms that take actions that no tonly have no effect on value, but may actually destroy value, and punish firms that are following financial first principles. Even though I believe that value ultimately prevails, it behooves to me to try to understand how the market is pricing stocks, since it will help me be a better investor.

      The Pricing Process
      I will begin with what sounds like a over-the-top assertion. Much of what we see foisted on us as valuation, including those that you see backing up IPOs, acquisitions or big investment decisions, are really pricing models, masquerading as valuations. In many cases, bankers and analysts use the front of estimating cash flows for a discounted cashflow valuation, while slipping in a multiple to estimate the biggest cash flow (the terminal value) in what I call Trojan Horse DCFs. I am not surprised that pricing is the name of the game in banks and equity research, but I am puzzled at why so much time is wasted on the DCF misdirection play. There are four steps to pricing an asset or company well, and done well, there is no reason to be ashamed of a pricing.

      1. Similar, Traded Assets
      To price an asset, you have to find "similar" assets that are traded in the market. Note the quote marks around similar, because with publicly traded stocks, you will be required to make judgment calls on what you view as similar. The conventional practice in pricing seems to be country and sector focused, where an Indian food processing company is compared to other food processing companies in India, on the implicit assumption that these are the most comparable companies. That practice, though, can not only lead to very small samples in some countries, but also can yield companies that have very different fundamentals from the company that you are valuing.
      1.1: With equities, there are no perfect matches: If you are valuing a collectible (Tiffany lamp or baseball card), you might be able to find identical assets that have been bought and sold recently. With stocks, there are no identical stocks, since even with companies that are close matches, differences will persist.
      1.2: Small, more similar, sample or large, more diverse, sample: Given that there are no stocks identical to the one that you are trying to value in the market, you will be faced with two choices. One is to define "similar" narrowly, looking for companies that are listed on the same market as yours, of similar size and serving the same market. The other is to define "similar" more broadly, bringing in companies in other markets and perhaps with different business models. The former will give you more focus and perhaps fewer differences to worry about and the latter a much larger sample, with more tools to control for differences.  

      2. Pricing Metric
      To compare pricing across companies, you have to pick a pricing metric and broadly speaking, you have three choices:
      Post on differences in value
      The market capitalization is the value of equity in a business, the enterprise value is the market value of the operating assets of the firm and the firm value is the market value of the entire firm, including any cash and non-operating assets. While firm value is lightly used, because non-operating assets and cash can skew it, both enterprise value and equity value are both widely used. In computing these metrics, there are three issues that do complicate measurement. One is that market capitalization (market value of equity) is constantly updated, but debt and cash numbers come from the most recent balance sheets, creating a timing mismatch. The second is that the market value of equity is easily observable for publicly traded companies, but debt is often not traded (if bank debt) and book debt is used as a stand in for market debt. Finally, non-operating assets often take the form of holdings in other companies, many of which are private, and the values that you have for them are book values. 
      2.1: When leverage is different across companies, go with enterprise value: When comparing pricing across companies, it is better to focus on enterprise value, when debt ratios vary widely across the companies, because equity value at highly levered companies is much smaller and more volatile and cannot be easily compared to equity value at lightly levered companies.
      2.2: With financial service companies, stick with equity: As I have argued in my other posts, debt to a bank, investment bank or insurance company is more raw material than source of capital and defining debt becomes almost impossible to do at financial service firms. Rather than wrestle with his estimation problem, my suggestion is that you stick with equity multiples.

      3. Scaling Variable
      When pricing assets that come in standardized units, you can compare prices directly, but that is never the case with equities, for a simple reason. The number of shares that a company chooses to have will determine the price per share, and arguing that Facebook is more expensive than Twitter because it trades at a higher price per share makes no sense. It is to combat this that we scale prices to  a common variable, whether it be earnings, cash flows, book value, revenues or a driver of revenues (users, riders, subscribers etc.).


      3.1: Be internally consistent: If your pricing metric is an equity value, your scaling variable has to be an equity value (net income, book value of equity). If your pricing metric is enterprise value, your scaling variable has to be an operating variable (revenues, EBITDA or book value of invested capital). 
      3.2: Life cycle matters: The multiple that you use to judge pricing will change, as a company moves through the life cycle.
      Early in the life cycle, the focus will be on potential market size or revenue drivers, since the company's own revenues are small or non-existent and it is losing money. As it grows and matures, you will see a shift to equity earnings first, since growth companies are mostly equity funded, and then to operating earnings and EBITDA, as mature companies use debt, ending with a focus on book value as a proxy for liquidation value, in decline.

      4. Control for differences
      As we noted, when discussing similar companies, no matter how carefully you pick comparable firms, there will be differences that persist between the company that you are trying to value and the comparable firms. The test of good pricing is whether you detect the variables that cause differences in pricing and how well you control for the differences. In much of equity research, the preferred mode for dealing with these differences is to spin them to justify whatever pre-conceptions you have about a stock.
      4.1: Check the fundamentals: In intrinsic value, we argued that the value of a  company is a function of its cash flows, growth and risk. If you believe that the fundamentals ultimately prevail in markets, you should tie the multiples you use to these fundamentals, and using algebra and a basic discounted cash flow model will lead you to fundamentals drivers of any multiple.

      4.2: Let the market tell you what matters: If you are a pure trader, who has little faith that the fundamentals will prevail, you can can take a different path. You can look at other data, related to the companies that you are pricing, and look for correlation. Put simply, you are trying to use the data to back out what variables best explain differences in market pricing, and using those variables to price your company.
      To illustrate the differences between the two approaches, take a look at my pricing of Severstal, where I used fundamentals to conclude that it was under priced, and my pricing of Twitter, at the time of its IPO, where I backed out the number of users as the key variable driving the market pricing of social media companies and priced Twitter accordingly.

      Pricing around the Globe
      Assuming that you have had the patience to get to this part of the post, let's look at the pricing numbers at the start of 2018, around the world, starting with earnings multiples (PE and EV/EBITDA), moving on to book value multiples (Price to Book, EV to Invested Capital) and ending with revenue multiples (EV/Sales).

      1. Earnings Multiples
      Earnings multiples have the deepest roots in pricing, with the PE ratio still remaining the most used multiple in the world. In the last two to three decades, there has been a decided shift towards enterprise value multiples, with EV/EBITDA leading the way. While I am skeptical of EBITDA as a measure of accessible cash flow, since it is before taxes and capital expenditures, I understand its pull, especially in aging companies with significant depreciation charges. If you assume that depreciation will need to go back into capital expenditures, there is an intermediate measure of pricing, EV to EBIT.

      In the chart below, I look at the distribution of PE ratios globally, and report on the PE ratio distributions, broken down region, at the start of 2018.


      I know that it is dangerous to base investment judgments on simple comparisons of pricing multiples, but at the start of 2018, the most expensive market in the world on a PE ratio basis, is China, followed by India, and the cheapest market is Eastern Europe and Russia. If you would like to see the values for earnings multiples, by country, please click at this link.

      If you are more interested in operating earnings multiples, the chart below has the distribution of EV/EBIT and EV/EBITDA multiples:
      China again tops the scale, with the highest EV/EBITDA multiples, and Eastern Europe and Russia have the lowest EV/EBITDA multiples. Earnings multiples also vary across sectors, with some of the variation attributable to fundamentals (differences in growth, risk and cash flows) and some of it to misplacing. The sectors that trade at the highest and lowest PE ratios are identified below:
      Download industry spreadsheet
      You can download the full list of earnings multiples for all of the sectors, by clicking on this link

      2. Book Value Multiples
      The delusion of fair value accounting is that balance sheets will one day provide better estimates of how much a business in worth than markets, and while I believe that day will never come, even accountants are entitled to their dreams. That said, there are investors who still put their faith in book value and compare market prices to book value, either in equity terms or operating asset terms:

      • Price to Book Equity = Market Value of Equity / Book Value of Equity
      • EV to Invested Capital = (Market Value of Equity + Market value of Debt - Cash)/ (Book value of equity + Book value of Debt - Cash)
      In the table below, I report on price to book and enterprise value to invested capital ratios, by sub-region of the world:


      The most expensive sub-region of the world is  India, on both a price to book and EV/Invested capital basis, and the lowest priced stocks are again in Eastern Europe and Russia. If you would like to see book value multiples, by country, click at this link.  With book value multiples, the differences you observe across sectors not only reflect differences in fundamentals and pricing errors, but also accounting inconsistencies on how capital expenditures in non-manufacturing companies are dealt with, as opposed to manufacturing firms. I tried to correct for these inconsistencies, by capitalizing R&D at all firms, but that correction goes only part way and the most expensive and cheapest sectors, with my corrected book values, are listed below:
      Download industry PBV spreadsheet
      You can download the book value multiple data, by sector, by clicking here.

      3. Revenue Multiples
      To the question of why investors and analysts look at multiples of revenues, my one word answer is "desperation". When every other number in your income statement is negative, you have to keep climbing the statement until you hit a positive value. That said, there is value in focusing on a variable that accountants have the least influence over, and the heat map below captures differences in the enterprise value to sales ratios across the globe.

      Unlike earnings and book value multiples, which have a pronounced peak in the middle of the distribution, revenue multiples are more evenly distributed, with quite a few firms trading at more than ten times revenues. As with earnings and book value multiples, I report revenue multiples, by country at this link and  by sector at this link. Note that there no revenue multiples reported for financial service firms, where neither enterprise value nor revenues can be meaningfully measured or estimated.

      Conclusion
      I am an investor, who believes in value, but it would be foolhardy on my part to ignore the pricing game, since I am dependent upon it ultimately to cash out on my value gains. In this post, I have looked at the pricing differences around the globe, at least based upon market prices at the start of 2018. Of all of my data posts, this is the one that is the most dynamic and likely to change over short periods, since markets can react to change far more quickly than companies can. 

      YouTube Video


      Datasets



      January 2018 Data Update 9: Dividends, Stock Buybacks and Cash Holdings

      If success for a farmer is measured by his or her harvest, success in a business, from an investors' standpoint, should be measured by its capacity to return cash flows for its owners. That is not belittling the intermediate steps needed to get there, since to be able to generate these cash flows, businesses have to find ways to treat employees well, satisfy customers and leave society at ease with their existence, but the end game does not change. That is why I find it surprising that when companies pay dividends, or worse still, buy back stock, there are so many who seem to view them as failures. Perhaps, that flows from the misguided view that reinvesting cash is good, not just for the company but also for the economy, because it creates growth and returning cash is bad, because it is somehow wasted, both flawed arguments. A company that reinvests cash in a bad business is destroying value, not adding to it, and as we saw in my post on excess returns, a preponderance of companies globally earn less than their costs of capital. Cash that is returned is not lost to the economy, but much of it is reinvested back into other businesses that often have much better investment opportunities. That said, the way companies determine how much to return to shareholders, either as dividends or in the form of buybacks, is grounded in inertia and me-tooism.

      Dividends' Place in the Big Picture
      In my corporate finance classes, I present what I term the big picture of corporate finance and the first principles that should govern how a business is run:
      If you view dividends as residual cash flows, which is what they should be, the sequence that leads to dividends is simple. Every business should start by looking at its investment opportunities first, then finding a financing mix that minimizes its hurdle rate and then based upon its investment and financing choices, determine how much to pay out as dividends.

      Note that this sequence holds only if capital markets (debt and equity) remain open, accessible and fairly priced, and companies have no self imposed constraints on raising capital or dividend payments. Those are clearly big and perhaps unrealistic assumptions for most companies, especially so for small firms and companies in emerging market, and that is why I have titled it Dividend Utopia. In the real world, there are multiple constraints, some external and some internal, that change the sequence.
      1. Capital markets are not always open and accessible: In utopian corporate finance, a company with a good investment opportunity, i.e., one that earns more than the cost of capital can always  raise capital from equity or debt market, quickly, at a fair price and with little or no issuance costs. In the real world, capital markets are not that accommodating. Raising capital can be a costly exercise, investors may under price your debt and equity, and the process can take time. It should come as no surprise then that if a company pays too much in dividends in this setting, it will find itself rejecting good investments.
      2. Banks may be the only lending option: For many companies, the only option when it comes to borrowing money is to go to a bank, and to the extent that banks face their own constraints on lending, companies may be unable to borrow at what they perceive to be fair rates. This will effectively play out in both investing and financing decisions.
      3. Dividends are sticky: If there is one word that characterizes dividend policy around the world, it is that it is "sticky". Companies, once committed to paying dividends, are unwilling to either cut or stop paying dividends, for fear of market punishment. That stickiness translates into companies continuing to pay dividends, even as earnings collapse and/or investment opportunities expand. 
      In a world with these constraints, dividends are no longer a residual cash flow, determined by choices you make on investments and financing, but a determinative cash flow, driving investment and financing decisions. If you add the desire of companies to pay dividends similar to those that they have in the past (inertia) and to be like the rest of the sector (me-too-ism) and irrational fears of dilution and debt, you have the makings of dysfunctional dividends.

       In this circular universe,  by putting dividend and financing decisions first, companies can end up with too much or too little capital available for projects, and in this dysfunctional universe, they adjust discount rates to make investment demand equate to supply. I never cease to be surprised by companies that claim to use hurdle rates as high as 20% and as low as 3%, both numbers that are out of the range of any reasonable cost of capital computation. In extreme cases, you can have dividend insanity, where companies that are losing money and are already over levered borrow even more money to pay dividends, making their cash flow deficits worse, leading to more losses, more debt and more dividends. 

      Dividends across the Life Cycle
      If dividends are, in fact, a residual cash flow, estimating how much you can afford to pay is a simple exercise of starting with the cash flows from operations that equity investors generate and netting out investment cash flows and cash flows to and from debt.

      In effect, everything you need to estimate this potential dividend or free cash flow to equity (FCFE) should be in the statement of cash flows for a firm. This measure of potential dividends can be utilized, with my corporate life cycle framework, to frame how dividend policy should evolve over a company's life, if it were truly residual.
      Note that the FCFE is the cash that is available for return and that companies can choose to return that cash as traditional dividends or in buybacks. If they choose not to do so, the cash will accumulate as a cash balance at the company.

      The Compressed Life Cycle and Consequences
      In this post from a while back, I argued that as we have shifted from the smoke stack and manufacturing sectors of the last century to the technology and service companies of the modern era, life cycles have compressed, creating challenges for both managers and investors.

      That compressed life cycle has consequences for both how much companies can return to shareholders and in what form:
      1. Once mature, companies will return more cash over shorter periods: The intensity of both the growth and the decline phases, with compressed life cycles, will mean that companies will become larger much more quickly than they used to, both in terms of revenues and earnings, but once they hit the "growth wall", they will find investment opportunities shrinking much faster, thus allowing for more cash to be returned over shorter time periods.
      2. Those cash returns will be more likely to be in buybacks or special dividends, not regular dividends: The sweet spot for conventional dividends is the mature phase, where companies get to enjoy their dominance and rest on their competitive advantages, with large and predictable earnings. With the life cycle shortening and becoming more intense, this sweet spot period has become much briefer. Think of how little time Yahoo! and Blackberry got to enjoy being mature companies, before decline kicked in. Even the rare tech companies, like Microsoft and Apple, that have managed to extend their mature phases have to reinvent themselves to keep generating their earnings, making these earnings more uncertain. Paying large regular dividends in this setting is foolhardy, since investors expect you to keep paying them, in good times and bad.
      3. Companies that fight aging will see bigger cash build ups: No company likes to age, and it should not come as a surprise that many tech companies fight the turn in their life cycles, deluding themselves into believing that a rebirth is around the corner and not returning cash., even as free cash flows to equity turn positive. At these companies, cash balances quickly balloon, attracting activist investors.
      In short, much of what managers and investors know or expect to see in dividend policy reflects a different age and time. It should come as no surprise that older investors, especially ones that grew up with Graham and Dodd as their investing bible find this new world bewildering. I can offer little consolation, since globalization and disruption will only make things more unstable and less suited to paying large, stable dividends. 

      Cash Return Numbers
      Having laid the foundations for understanding the shifts that are occurring in dividend policy, we have a structure for putting the numbers that we will see in this section in perspective. I will start this section by looking at regular dividends and conventional measures of these dividends (dividend yield and payout ratios) but then expand cash return to include stock buybacks and how metrics that capture its magnitude and close by looking at cash balances at companies.

      Regular Dividends
      There are two widely used measures of dividends paid. One is to scale the dividends to the earnings, resulting in a payout ratio. That number, to the extent that you trust accounting income and dividends are the only way of returning cash to stockholders plays a dual role, telling cash-hungry investors how much the company will pay out to them, and growth-seeking investors how much is being put back into the business, to generate future growth (with a retention ratio = 1 - payout ratio). The picture below captures the distribution of payout ratios across the globe, with regional sub-group numbers embedded in a table in the picture:

      Note that the payout ratio cannot be computed for companies that pay dividends, while losing money, and that it can be greater than 100% for companies that pay out more than their earnings. Japan has the lowest dividend payout ratio, across regions, a surprise given the lack of growth in the Japanese economy., and Australian companies pay out the higher percentage of their earnings in dividends.

      The other measure of dividends paid is the dividend yield, obtained by dividing dividends by the market capitalization. This captures the dividend component of expected return on equities, with the balance coming from expected price appreciation. To the extent that dividends are sticky and thus more likely to continue over time, stocks with higher dividend yields have been viewed as safer investments by old time value investors. The picture below has the distribution of dividend yields for global companies at the start of 2018, with regional sub-group numbers embedded:
      As with the payout distribution, there are outliers, with companies that deliver dividends yields in the double digits. While these companies may attract your attention, if you are fixated on dividends, these are companies that are almost certainly paying far more dividends that they can afford, and it is only a question of when they will cut dividends, not whether. With both measures of dividends, there is a hidden statistic that needs to be emphasized. While these charts look at aggregate dividends paid by companies and present a picture of dividend plenty, the majority of companies in both the US (75.8%) and globally (57.6%) pay no dividends. The median company in the US and globally pays no dividends.

      Buybacks
      There is a great deal of disinformation out there about stock buybacks and I tried to deal with them in this post from a couple of years ago. The reality is that stock buybacks have largely replaced dividends as the primary mechanism for returning cash to stock holders, at US companies. In 2017, buybacks represented 53.69% of all cash returned by US companies, but the shift to stock buybacks is starting to spread to other parts of the globe, as can be seen in the regional breakdown below:

      Sub GroupNumber of firmsDividends Dividends + Buybacks Buybacks as % of Cash Returns
      Africa and Middle East
      2,277
      $65,767
      $70,530
      6.75%
      Australia & NZ
      1,777
      $50,194
      $56,034
      10.42%
      Canada
      2,850
      $49,544
      $80,470
      38.43%
      China
      5,552
      $317,678
      $342,282
      7.19%
      EU & Environs
      5,399
      $320,027
      $514,279
      37.77%
      Eastern Europe & Russia
      558
      $21,761
      $23,522
      7.49%
      India
      3,511
      $20,701
      $27,121
      23.67%
      Japan
      3,755
      $101,760
      $134,087
      24.11%
      Latin America 
      880
      $40,395
      $47,907
      15.68%
      Small Asia
      8,630
      $128,066
      $148,607
      13.82%
      UK
      1,412
      $101,605
      $128,161
      20.72%
      United States
      7,247
      $486,009
      $1,049,487
      53.69%
      While US companies still return more cash in the form of buybacks than their global counterparts, European and Canadian companies also return approximately 38% of cash returned in buybacks, and even Indian companies are catching on (with about 24% returned in buybacks). If you are interested in how much cash companies in different countries return, and in what form, you can check this list, or the heat map below (you can see the dividend yield and payout ratios, by country, in the live version of the map):

      via chartsbin.com

      There are differences in how companies return cash, across sectors, and the table below lists the ten sectors that return the most and the least cash, in the form on buybacks, as a percent of cash returned.
      Download full sector data
      Commodity companies and utilities are still more likely to return cash in the form of dividends, while software and technology companies are more likely to use buybacks. If you are interested, you can download the entire sector list, with dividends, buybacks and associated statistics.

      Cash Balance
      There is one final loose end to tie up on dividends. If companies don't return their FCFE (potential dividends) to stockholders, it accumulates as a cash balance. One way to measure whether companies are returning enough cash is to look at cash balances, scaled to either the market values of these firms or market capitalization. The table below provides the regional statistics on cash balances:

      Sub GroupCash Balance Cash/Firm ValueCash/ Market Cap
      Africa and Middle East
      $490,475
      16.13%
      24.43%
      Australia & NZ
      $175,578
      6.43%
      11.37%
      Canada
      $183,204
      4.66%
      8.10%
      China
      $2,724,851
      12.84%
      21.16%
      EU & Environs
      $2,935,769
      11.85%
      22.43%
      Eastern Europe & Russia
      $112,480
      15.08%
      24.34%
      India
      $99,190
      3.31%
      4.18%
      Japan
      $4,185,572
      34.47%
      67.73%
      Latin America 
      $239,664
      7.84%
      13.06%
      Small Asia
      $841,230
      9.91%
      15.19%
      UK
      $1,087,286
      15.80%
      29.48%
      United States
      $2,206,548
      4.73%
      7.52%
      Japan is clearly the outlier, with cash representing about 34% of firm value, and an astonishing 68% of market capitalization. It may be a casual empiricism, but it seems to me that Japan is filled with walking dead companies, aging companies whose business models have crumbled but are holding on to cash in desperate hope of reincarnation. It is the Japanese economy that is paying the price for this recalcitrance, as capital stays tied up in bad businesses and does not find it way to younger, more vibrant businesses.

      Conclusion
      If the end game in business, for investors, is the generation and distribution of cash flows to them, many companies and investors seem to be stuck in the past, where long corporate life cycles and stable earnings allowed companies to pay large, steady and sustained dividends. Facing shorter life cycles, global competition and more unpredictable earnings, it should come as no surprise that companies are looking for more flexible ways of returning cash, than paying dividends and that buybacks have emerged as an alternative. As companies take advantage of the new tax law and bring back trapped cash, some will undoubtedly use the cash to buy back stock, and be loudly declaimed by the usual suspects, for not putting the cash to "productive" uses.  I would offer two counters, the first being my post on excess returns where I note that more than 60% of global companies destroy value as they try to reinvest and growth, and the second being  that it is better for economies, for aging companies to give cash back to stock holders, to invest in better businesses.

      YouTube Video

      Data Links
      1. Dividend, Buyback and Cash Balance statistics, by Country
      2. Dividend, Buyback and Cash Balance statistics, by Sector



      Spotify Loose Ends: Pricing, User Value and Big Data!

      In my last post, I valued Spotify, using information from its prospectus, and promised to come back to cover three loose ends: (1) a pricing of the company to contrast with my intrinsic valuation, (2) a valuation of a Spotify subscriber and, by extension, a subscriber-based valuation of the company, and (3) the value of big data, seen through the prism of what Spotify can learn about its subscribers from their use of its service, and convert to profits.

      1. The Pricing of Spotify
      I won't bore you by going through the full details of the contrast that I see between pricing an asset and valuing it, since it has been at the heart of so many of my prior posts (like this, this and this). In short, the value of an asset is determined by its expected cash flows and the risk in these cash flows, which you can estimate imprecisely using a discounted cash flow model. The price of an asset is based on what others are paying for similar assets, requiring judgments on what comprises similar.  My last post reflected my attempt to attach an intrinsic value to Spotify, but the pricing questions for Spotify are two fold: the companies that investors in the market will compare it to, to make a pricing judgment, and the metric that they will base the pricing on.

      Let's start with the simplest version of pricing, a one-on-one comparison. With Spotify, the two companies that are likeliest to be offered as comparable firms are Pandora, a company that is in the same business (music streaming) as Spotify, deriving its revenues from advertising and subscription, and Netflix, a company that is also subscription-driven, and one that Spotify would like to emulate in terms of market success. Since Spotify and Pandora are reporting operating losses, there are only three metrics that you can scale the pricing of these companies to: the number of subscribers, total revenues and gross profits. I report the numbers for all three companies in the table below, in conjunction with the enterprise values for Pandora and Netflix:
      For Pandora and Netflix, the numbers for users and revenues/profits come from their most recent annual reports for the year ending December 31, 2017, and for Spotify, the numbers are from the prospectus covering the same year. To use the numbers to price Spotify, I first estimate pricing multiples for Pandora and Netflix. and then use these multiples on Spotify's metrics:
      To illustrate the process, I price Spotify, relative to Pandora and based on subscribers, by first computing the enterprise value/subscriber for Pandora (EV/Subscriber= 1135/74.70 = 15.19). I then multiply this value by Pandora's total subscriber count of 159 million to arrive at a pricing of $2,416 million for Spotify. I repeat this process for Netflix, and then repeat it again with both companies, using revenues and gross profit as my scaling variables. The table of pricing estimates that I get for Spotify explains why those who are bullish on the company will try to avoid comparisons to Pandora and encourage comparisons to Netflix. If, as is rumored, Spotify's equity is priced at between $20 and $25 billion, it will look massively over priced, if compared to Pandora, but be a bargain, relative to Netflix. As you can see, each of these comparisons has problems. Spotify not only has a more subscription-based revenue model than Pandora, yielding higher overall revenues, but its more global presence (than Pandora) has insulated it better from competition from Apple Music. Netflix has an entirely subscription-based model and generates more revenues per subscriber, while facing less intense competition.  The bottom line is that the pricing range for Spotify is wide, because it depends on the company you compare it to, and the metric you base the pricing on. That may come as no surprise for you, but it will explain why there will wide divergences in pricing opinion when the stock first starts to trade, resulting in wild price swings. If you are not adept at the pricing game, and I am not, you should stay with your value judgment, flawed though it might be. I will consequently stick with my intrinsic value estimate for the equity in the company.

      2. A Subscriber-Based Valuation of Spotify
      Last year, I did a user-based valuation of Uber and used it to understand the dynamics that determine user value and then to value Amazon Prime. That framework can be easily adapted to value Spotify subscribers, both existing and new. To value Spotify's existing subscribers, I started with the base revenue per subscriber and content costs in 2017, made assumptions about growth in each item and used a renewal rate of 94.5%, based again upon 2017 numbers (all in US dollar terms):
      Download spreadsheet
      Note that revenues/subscriber grow at 3% a year, faster than the growth rate of 1.5%/year in content costs, reducing content costs to 70% of subscriber revenues in year 10, consistent with the assumption I made in the top down valuation in the last post. The value of a premium subscriber, allowing for the churn in subscriptions (only 43% make it through 15 years) and reduced content costs, is $108.65, and the total value of the 71 million premium subscriptions works out to about $7.7 billion.

      To estimate the value of new users, I first had to estimate how much Spotify was spending to acquire a new user. To obtain this value, I took the total marketing costs in 2017 (567 million Euros or $700 million) and divided that by the number of new subscribers added in 2017:
      Cost of acquiring new user = 700 / (71 - 48*.945) = $27.30
      While the number of premium subscribers grew from 48 million to 71 million, I reduced the former value by the churn reported (5.5% of subscribers canceled in 2017). The value of new subscribers then can be computed, assuming that the number of net subscribers grows 25% a year from years 1-5, 10% a year from years 6-10 and 1% a year thereafter (The weakest link in this calculation is the churn rate, which as some of you pointed out is measured in monthly terms. I read this section of the prospectus multiple times to get a better sense of renewal and cancellation rates and here is what I get out of that reading. If the true monthly churn rate is 5.5%, the annual churn rate should more than 50%, meaning that 25 million of the 48 million subscribers that Spotify had at the start of the year left during the year. I don't think that happened, because the total subscribers would not have jumped to 71 million. My guess is that the monthly churn rate reflects how new subscribers become established subscribers, with many trying the service for a month, dropping it, and then coming back again. The annualized churn rate is probably closer to 15%-20% overall and much lower for established Spotify subscribers. I considered using a lower renewal rate in the early years and increasing it in later years, but gave up on it since my information is still hazy. I do believe that will be a key factor in whether Spotify can deliver value, and while the trend lines on the churn rate are good, they need to make their subscribers as sticky as Netflix has made its subscribers.)
      Download spreadsheet
      In valuing the cash flows from new users, I use a 10% US$ cost of capital, the 75th percentile of global companies, reflecting the higher risk in this component of Spotify's value, and derive a value of about $13.6 billion for new users. (I thank the readers who noticed that I was misestimating my subscriber count, starting in year 2. The numbers should now gel, with the growth rate in net subscribers matching up.)

      Spotify does get about 10% of its revenues from advertising, and I will assume that this component of revenue will persist, albeit growing at a lower rate than premium subscription revenues; the revenues will grow 10% a year for the next ten year and content costs attributable to these revenues will also show the same downward trend that they do with premium subscriptions. The value of the advertising revenues is shown to be about $2.9 billion:
      Download spreadsheet
      The final component of value is mopping up for costs not captured in the pieces above. Specifically, Spotify has R&D and G&A costs that amounted to 660 million Euros in 2017 (about $815 million), which we assume will grow 5% a year for the next 10 years, well below the growth rate of revenues and operating income, reflecting economies of scale. Allowing for the tax savings, and discounting at the median cost of capital (8.5%) for a global company, I derive a value for this cost drag:
      Download spreadsheet
      The value for Spotify, on a user-based valuation, can then be calculated, adding in the cash balance (1,5091.81 million Euros or $1,864 million) and a cross holding in Tencent Music that I had overlooked in my DCF (valued at 910 million Euros or $1,123 million), and netting out the equity options outstanding (valued at 1344 million Euros or $1660 million):
      Download spreadsheet
      The operating asset value is slightly lower than the value that I obtained in my top-down DCF (by about a billion), and there are two reasons for the difference. The first is that I did not incorporate the benefits of the losses that Spotify has to carry forward (approximately $1.7 billion) in my subscriber-based valuation, with the resulting lost tax benefit at a 25% tax rate, of about $300 million. The second reason is that I used a composite cost of capital of 9.24% on all cash flows in top down valuation, whereas I used a lower (8.5%) cost of capital for existing users and a higher (10% cost of capital) for new users; that translates into about $600 million in lower value. The value of equity in common stock, the number that will be most directly comparable to market capitalization on the day of the offering, is $19.6 billion.

      3. The Big Data Premium?
      There is one final component to Spotify's value that I have drawn on only implicitly in my valuations and that is its access to subscriber data. As Spotify adds to its subscriber lists, it is also collecting information on subscriber tastes in music and perhaps even on other dimensions. In an age where big data is often used as a rationale for adding premiums to values across the board, Spotify meets  the requirements for a big data payoff, listed in this post from a while back. It has exclusivity at least on the information it collects from its subscribers on their musical tastes & preferences and it can adapt its products and services to take advantage of this knowledge, perhaps in helping artists create new content and customizing its offerings. That said, I do no feel the urge to add a premium to my estimated value for three reasons:
      1. It is counted in the valuations already: In both my top down and user-based valuations, I allow Spotify to grow revenues well beyond what the current music market would support and lower content costs as they do so. That combination, I argued, is a direct result of their data advantages, and adding a premium to my estimated valued seems like double counting.
      2. Decreasing Marginal Benefits: The big data argument, even if based on exclusivity and adaptive behavior, starts to lose its power as more and more companies exploit it. As Facebook reviews our social media posts and tailors advertising, Amazon uses Prime to get into our shopping carts and Alexa to track us at home, and uses that data to launch new products and services and Netflix keeps track of the movies/TV that we watch, stop watching and would like to watch, there is not as much of us left to discover and exploit.
      3. Data Backlash: Much as we would like to claim victimhood in this process, we (collectively) have been willing participants in a trade, offering technology companies data about our private lives in return for social networks, free shipping and tailored entertainment. This week, we did see perhaps the beginnings of a reassessment of where this has led us, with the savaging of Facebook in the market. 
      The big data debate has just begun, and I am not sure how it will end. I personally believe that we are too far gone down this road to go back, but there may be some buyers' remorse that some of us are feeling about having shared too much. If that translates into much stricter regulations on data gathering and a reluctance on our part to share private data, it would be bad news for Spotify, but it would be worse news for Google, Facebook, Netflix and Amazon. Time will tell!
      YouTube Video


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      Stream On: An IPO Valuation of Spotify!

      In the last few weeks, we have seen two high profile unicorns file for initial public offerings. The first out of the gate was Dropbox, a storage solution for a world where gigabyte files are the rule rather than the exception, with a filing on February 23. Following close after, on February 28, Spotify, positioning itself as the music streaming analog to Netflix, filed its prospectus. With it's larger potential market capitalization and unusual IPO structure, Spotify has attracted more attention than Dropbox, and I would like to focus this post on it.

      Spotify: The Back Story
      Spotify was founded in 2008 in Sweden, by Daniel Ek and Martin Lorentzon, as a music streaming service. The timing was opportune, since the company caught and contributed to a shift in the music business, as users have moved away from paying for physical (records, CDs) to digital, as evidenced in the graph below:
      Source: IFPI
      Note that not only has the move towards streaming, in proportional terms, been dramatic, but disruption has come with pain for the music business, with a drop in aggregate revenues from $24 billion in 1999 to about $16 billion in 2016.  In a bright spot, revenues have started rising again in 2016 and 2017, and it is possible that the business will rediscover itself, with a new digital model. Spotify was not the first one in the business, being preceded by both Pandora and Soundcloud, but its success is testimonial to the proposition that the spoils seldom go to the first movers in any business disruption.

      The Spotify business model is a simple one. Listeners can subscribe to a free version, with limited customization features (playlists, stations etc.) and online ads. Alternatively, they can subscribe to a premium version of the service, paying a monthly fee, in return for a plethora of customization options, and no ads. The company's standard service cost $9.99/month in the United States in 2018, with a family membership, where up to six family members living at the same address, can share a family service for $14.99/month, while preserving individualized playlists and stations. Prices vary globally, ranging from a high of $16.94 in the UK (for standard service) to much lower prices in Eastern Europe and Latin America. (You can check out the variations in this fascinating link that reports the prices across the world for Spotify, in dollar terms.) Spotify pays for its music content, based upon how often a song is streamed, but the rates vary depending on whether it is on the free or premium service and where in the world, creating some complexity in how it is computed.  To get a sense of where Spotify stands right now and how it got there, I looked the prospectus, with the intent of catching broad trend lines. I came up with the following:

      1. Explosive Growth: Spotify is coming off a growth burst, especially since 2015, in both number of users and revenues, as can be seen in the graph below. Revenues have increased from 1.94 billion Euros to 4.09 billion Euros, reflecting both a growth in subscribers from 91 million to 159 million, and a change in the composition, with premium members climbing from about 31% of total subscribers in 2015 to 45% of subscribers in 2017.
        Source: Spotify Prospectus
      2. Subscription Revenue dominates Ad Revenue: Spotify's focus on improving its premium subscriptions is explained easiest by looking at the breakdown of revenues each year, where subscription revenues have accounted for 90% of revenues each year from 2015 to 2017. The one discordant note is that average revenue per premium subscriber has dropped over the same period 7.06 Euros/month to 5.24 Euros/month, a change that the company ascribes to family memberships, but a problematic trend nevertheless:
        Source: Spotify Prospectus
      3. Content Costs are coming down: While Spotify insists that it is not scaling back payouts to music labels and artists, the company has been able to lower its content costs as a percent of revenues each year from 88.7% of revenues in 2015 to 79.2% of revenues in 2017. In fact, Spotify has conveyed to investors that its intent is to earn gross margins of 30%-35%, implying that it sees content costs dropping to 65%-70% of revenues. There is an inherent tension here between what Spotify has to convince its investors it can do and what it tells the music industry  it is doing and the tension will only intensify, after the company goes public.
        Source: Spotify Prospectus
      4. Other costs are trending up: There are three other buckets of cost at Spotify -R&D, Selling & Marketing and G&A- and these costs are not only growing but eating up larger proportion of revenues. If there are economies of scale, as you would expect in most businesses,  they are not manifesting themselves in the numbers yet. The collective load of these expenses are creating operating losses, and while margins have become less negative, it is primarily through the content cost controls.

        Source: Spotify Prospectus

      At this stage of its story, Spotify is a growth company with lots of potential (no irony intended) but lots of rough spots to work out.

      The Spotify IPO
      I have posted ahead of IPOs for many companies in the last decade, ranging from Facebook to Twitter to Alibaba to Snap, but Spotify's IPO is different for two reasons:
      1. No Banks: In a typical IPO, the issuing company seeks out an investment bank, which not only sets an offering price (backed up by a guarantee) but also creates a syndicate with other banks  to market the IPO, in roadshows and private client pitches. The Spotify IPO will dispense with the bankers and go directly to the market, letting demand and supply set the price on the opening day.
      2. Cashing Out: In most IPOs, the cash that comes in on the offering, from the shares that are bought by the public, is kept in the company, either to retire existing financing that is not advantageous to the firm, or to cover future investment needs. Spotify is aiming to raise about $1 billion from its offering, but none of it will go to company. Instead, existing equity investors in the company will be receiving the cash in return for their holdings.
      As a potential investor, I am less concerned about the "no banker" part of the IPO than I am by the "cash out:" part of the transaction: 


      • No bankers, no problem: I think that the banking role in IPOs is overstated, especially for a company as high profile as Spotify. Bankers don't value IPOs; they price them, usually with fairly crude pricing metrics, though they often reverse engineer DCFs to back up their pricing. Their guarantee on the offering price is significantly diluted in value by the fact that they set offering prices 10% to 15% below what they think the market will bear, and their marketing efforts are more useful in gauging demand than in selling the securities. From an investor perspective, there is little that I learn from road shows that I could not have learned from reading the prospectus, and there is almost as much disinformation as information meted out as part of the marketing.
      • Control or Growth: I find it odd that a company like Spotify, growing at high rates and losing money while doing so, would turn away a billion in cash that could be used to cover its growth needs for the near future. The cashing out of existing owners sends two negative signals.  The first is that they (equity investors who cash out) do not feel that staying on as investors in the company, as a publicly traded entity, is worth it. Since they have access to data that I don't, I would like to know what they see in the company's future. The second is that the structure of the share offering, with voting and non-voting shares, indicates a consolidation of control with the founders, and the offering may provide an opportunity to get rid of dissenting voices.

      My Spotify Valuation
      In keeping with my view that you need a story to provide a framework for you valuation inputs, and especially so for young companies, I constructed a story for Spotify with the following elements:
      1. Continued (but Slower) Revenue Growth: Spotify's success in scaling up over the last three years also sets the stage for a slowing down of growth in the future, with competition for Apple Music (backed by Apple's deep pockets) contributing to the trend. A combination of increases in subscriber numbers and a leveling off and even a mild increase in subscription per member will translate into a revenue growth of 25% a year for the next five years, scaling down to much lower growth in the years after. Since I am projecting revenues for Spotify in 10 years that are larger than the reported global music business revenues today, implicit in this story is the assumption that the music business overall has turned the corner and that aggregate revenues will not only continue to post increases like they did in 2016 and 2017, but that streaming will be the savior of the music business, allowing it expand its reach into emerging markets and pick up more paying customers. 
      2. With Reduced Content Costs: Spotify's entire value proposition rests on improved operating margins and a large portion of the improvement has to come from continuing to reduce content costs as a percent of revenues. Since Spotify pays for its content based upon song streams, those savings have to come from either paying less per stream (which is going to and should create push back from labels and artists) or finding ways to create economies of scale on this cost component. In it's defense, Spotify can point to its track record from 2015 to 2017 in reducing content costs. I assume that they can reduce content costs to 70% of revenues, while finding a way to keep artists and labels happy. That is not going to be an easy balance to maintain, especially with the top artists, as evidenced by Taylor Swift's and Jay-Z's decisions to pull their music from Spotify. (I have been told that they have reversed their decisions, but this fight is ongoing.)
      3. And Economies of Scale on Other Costs: Of the three other costs, the marketing expenses are the ones most likely to scale down as growth declines, but for Spotify to deliver solid operating margins, it also has to bring R&D costs and G&A costs under control. I may be over optimistic on this front, but here is what my projected values yield for my target operating margin (ten years from now):
      4. With Limited Capital Investments: Spotify's business model is built for scaling, with little need for capital reinvestment, except for R&D. Consequently, I assume that small capital investments can generate large revenues, using a sales to capital ratio of 4.00 (putting it at the 90th percentile of global companies) to estimate reinvestment.
      5. Manageable Operating Risk but Significant Failure Risk: Spotify's subscription based model and low turnover rate among subscribers does lend some stability to revenues, though adding more subscribers and going for growth is a riskier proposition. Overall, allowing for their business mix (90% entertainment, 10% advertising) and their global mix of revenues yields a  cost of capital of 9.24%, at the 80th percentile of global companies; the firm is planning to convert much of its debt into equity at the time of the IPO, giving it a equity dominated capital structure. However, the company is still young, losing money and faces deep pocketed competition, suggesting that failure is a very real possibility. I assume a 20% chance of failure, with failure translating into selling the company to the highest bidder at half of its going concern value.
      6. Loose Ends: To estimate equity value in common shares, I add the cash balance of the company of 1.5 billion Euros and a cross holding in Tencent Music (valued at 910 million Euros), ignore the proceeds from the IPO because of the cash-out structure and net out the value of 20.82 million options/warrants outstanding, with an average strike price of 42.56 Euros per share. Dividing the equity value of 16.5 billion Euros by 177.17 million shares (including restricted shares) yields a value per share of 93.40 Euros per share or $115.31. The shares that you will be buying will be non-voting, implying a discount on this number, though how much you discount it will depend on how much you like and trust the company's founders.
      The entire picture, with the story embedded in it, is shown below. You can also download the spreadsheet here. (The base year numbers in the prospectus were all in Euros, but all of the valuation inputs (growth, cost of capital) are in US dollars, making it a US dollar valuation. In hindsight, I should have restated the base year numbers in US dollars. While it would not have changed the valuation, it would have reduced currency confusion. Alternatively, I could have valued the company entirely in Euros, with lower growth rates and costs of capital, and arrived at Euro valuation that yield roughly similar results):
      Download spreadsheet
      It goes without saying, but I will say it anyway, that I made lots of assumptions to get to my value and that you may (and should) disagree with me or some or even all of these assumptions. You are welcome to download the spreadsheet that contains my valuation of Spotify and make it your own.

      Bottom Line
      There are three elements missing in this post. First, I have argued in my prior IPO posts that what happens after initial public offerings is more of a pricing game than a value game. To those of you who want to play that game, I don't think that this post is going to be very helpful. In my next post, I will look at how best to price Spotify, why you will hear pessimists about the company talk a lot about Pandora and optimists about Netflix. Second, there is the argument that top down valuations, like the one in this post, are ill equipped to value user or subscriber based companies. I will also use the user-based model that I introduced last year to value an Uber rider and an Amazon Prime member to value a Spotify subscriber. Finally, there is the lurking question of what Spotify is learning about its subscriber music tastes and how that data can be used to not only modify its offerings but perhaps create content that is more closely tailored to these tastes. That too has to wait for the next post.

      YouTube

      Data Links



      Damodaran Online: There is an App for that!

      My posts over the last two months have been heavy, dealing first with my data update from January 2018, and with the market and its volatility in the last few weeks. I felt like taking a break and talking about something lighter and more personal, and giving you an update on my teaching, writing and data plans for this year, with news about an app for the iPhone or iPad that you might (or might not) find useful. I won't fault you if you are not in the least bit interested in what I am doing, and if so, please do skip this post, since it will bore you!

      Teaching Update
      As some of you may know, I have taught at the Stern School of Business at NYU since 1986, teaching two classes, a Corporate Finance class every spring and a Valuation class every fall and spring. If you have been reading this blog for a while, you also know that I invite the rest of the world to join me in these classes, through a multitude of platforms (iTunes U, Online, YouTube). If you are wondering why you have not received an invite to the classes this academic year, the answer is simple.

      I am on sabbatical this academic year, living in California, and will not be teaching at Stern at least through September 2018.  I am enjoying keeping what I call beach bum hours (8.30 am-12.30 pm), but I have to confess that I miss teaching, and my weeks feel unstructured without my Monday/Wednesday classes, but I love teaching too much to take a complete break from it. I continue to teach my compressed valuation classes, trying to fit in everything in my regular classes into one or two days, with stints coming up in Amsterdam (March 7), London (March 8-10), Mumbai (April 19,20), Manila (May 15-16), Bangkok (May 17-18), Warsaw and Prague (June 2018) just in the next few months.

      I am also planning on redoing the investments philosophies class that I have only online, but which is showing its age, in the next three months and adding to the in-practice videos that I supplement my valuation and corporate finance classes. 

      Research Writing Update
      After my most recent post on interest rates and stock prices, I received one response that made me laugh and here is what it said: “Bro, Please stop. get your head out of academia and into reality’. I assume, since I was not this person’s brother, that the “Bro” was an attempt to establish street cred (though I am not sure that it works on this audience), but it was the “academia” part that I found humorous. If I am an academic, I am one in awfully bad standing, since I have not submitted a paper for publication in close to two decades and spend little time at academic conferences.  That said, I love to write and I am continuing to do so on my sabbatical, on several fronts.
      • First, there are my blog posts, which I know are way too long and not very frequent, but I try (though I sometimes fail) to not spout off about things I do not understand or know much about. 
      • Second, I spent the last few months of last year finishing the third edition of one my books, The Dark Side of Valuation, the first edition of which was born at the peak of the dot com boom, about valuing difficult-to-value companies from start-ups to banks. The book is in its final printing stages and should be available in bookstores shortly (Amazon link). 
      • Third, I am turning my attention to what I hope will be my next project, which I hope will become a book, on the difference between pricing an asset and valuing it, a theme that I have mined for multiple posts over the last few years. Fourth, In a couple of weeks, I hope to post the updated installment of my Equity Risk Premium paper, which I first wrote and posted in 2008 (right after the crisis) and have revisited every March since. (Link to 2017 version). Later this summer, I will update my Country Risk Premium paper, focusing more closely just on country risk. (Link to 2017 version
      • Finally, during the course of the next few months, I will also be taking the work that I have done on valuing users and converting into a paper. 
      I will keep you updated as each project is complete.

      Data & Tools Update
      I maintain a number of data sets on corporate finance and valuation that I update on an annual basis at the start of the year. I wrote a series of posts on what I learned looking at the data this year, in January, and you can read all ten posts, if you are so inclined. 
      While I will not update much of this data during the course of the year, I will continue to post my estimates for the equity risk premium for the S&P 500 at the start of every month, continuing a series that started in September 2008. 

      The tools that I offer are three fold.

      • First, I have excel spreadsheets for corporate finance and valuatoion, and they are not polished, lacking formatting finesse and macro add-ons, but I view them as raw material that you can mold to your liking. 
      •  Second, my YouTube videos are classified by playlists into my class videos, tool videos and blog post videos. 
      • Finally, I do have an app for the iPhone and iPad called uValue, that I co-developed with Anant Sundaram, professor at Dartmouth, that does intrinsic valuation. Give it a shot!
      You welcome to use these tools, but please recognize that this is all they are, and it is your insight and common sense that will make them shine.

      Interface Update
      As the material that I have grows, I have struggled with how best to organize it and present it. My website has much of the material but you need to be on a computer, with an internet connection, to access much of it, and finding what you want can be a challenge. I am glad that there are some people who find the material useful and am humbled by their gratitude and their offers to help. To illustrate, a few months ago, I received an email from Taha Maddam, who had used the site, and he offered to create an app that would contain the material. I thanked him, but I pointed out that since the site was not commercial, I could not spend much to make the conversion, but he graciously offered to do it for nothing. Knowing how much work was involved, I did not expect him to follow through, especially since he works full time in Shanghai and has a young family.

      Taha surprised me just over a week ago, when he said the app was ready and that I could take it for a spin.  I did and I was dazzled, since it contained all the information in my website, on my blog and on YouTube, in one location. If you have an Apple device (iPhone or iPad), you can download the app either from the app store (type in "Damodaran" in the search box, and it should pop up) or by going to the launching page that Taha has created for the app. If you like our app (while the material is mine, this app is Taha’s doing), please pass on the word and compliment Taha for a job well done. If you are an Android user, I am truly sorry that the app does not work on your devices yet, but I will have to wait on the kindness of strangers, for that to happen. In the meantime, if you can think of what we can add on to the app to make it more useful, please let us know. 



      Interest Rates and Stock Prices: It's Complicated!

      Jerome Powell, the new Fed Chair, was on Capitol Hill on February 27, and his testimony was, for the most part, predictable and uncontroversial. He told Congress that he believed that the economy had strengthened over the course of the last year and that the Fed would continue on its path of "raising rates". Analysts have spent the next few days reading the tea leaves of his testimony, to decide whether this would translate into three or four rate hikes and what this would mean for stocks. In fact, the blame for the drop in stocks over the last four trading days has been placed primarily on the Fed bogeyman, with protectionism providing an assist on the last two days. While there may be an element of truth to this, I am skeptical about any Fed-based arguments for market increases and decreases, because I disagree fundamentally with many about how much power central banks have to set interest rates, and how those interest rates affect value.

      1. The Fed's power to set interest rates is limited
      I have repeatedly pushed back against the notion that the Fed or any central bank somehow sets market interest rates, since it really does not have the power to do so. The only rate that the Fed sets  directly is the Fed funds rate, and while it is true that the Fed's actions on that rate send signals to markets, those signals are fuzzy and do not always have predictable consequences. In fact, it is worth noting that the Fed has been hiking the Fed Funds rate since December 2016, when Janet Yellen's Fed initiated this process, raising the Fed Funds rate by 0.25%. In the months since, the effects of the Fed Fund rate changes on long term rates is debatable, and while short term rate have gone up, it is not clear whether the Fed Funds rate is driving short term rates or whether market rates are driving the Fed.

      It is true that post-2008, the Fed has been much more aggressive in buying bonds in financial markets in its quantitative easing efforts to keep rates low. While that was  started as a response to the financial crisis of 2008, it continued for much of the last decade and clearly has had an impact on interest rates. To those who would argue that it was the Fed, through its Fed Funds rate and quantitative easing policies that kept long term rates low from 2008-2017, I would beg to differ, since there are two far stronger fundamental factors at play - low or no inflation and anemic real economic growth. In the graph below, I have the treasury bond rate compared to the sum of inflation and real growth each year, with the difference being attributed to the Fed effect:
      Download spreadsheet with raw data
      You have seen me use this graph before, but my point is a simple one. The Fed is less rate-setter, when it comes to market interest rates, than rate-influencer, with the influence depending upon its credibility. While rates were low in the 2009-2017 time period, and the Fed did play a role (the Fed effect lowered rates by 0.77%), the primary reasons for low rates were fundamental. It is for that reason that I described the Fed Chair as the Wizard of Oz, drawing his or her power from the perception that he or she has power, rather than actual power. That said, the Fed effect at the start of 2018, as I noted in a post at the beginning of the year, is larger than it has been at any time in the last decade, perhaps setting the stage for the tumult in stock and bond markets in the last few weeks. 

      To examine more closely the relationship between moves in the Fed Funds rate and treasury rates, I collected monthly data on the Fed Funds rate, the 3-month US treasury bill rate and the US 10-year treasury bond rate every month from January 1962 to February 2018. The raw data is at the link below, but I regressed the changes in both short term and long term treasuries against changes in the Fed funds rate in the same month:
      Looking at these regressions, here are some interesting conclusions that emerge:
      1. Short term T.Bill rates and the Fed Funds rate move together strongly: The result backs up the intuition that the Fed Funds rate and the short term treasury rate are connected strongly, with an R-squared of 56.5%; a 1% increase in the Fed Funds rate is accompanied by a 0.62% increase in the T.Bill rate, in the same month. Note, though, that this regression, by itself, tells you nothing about the direction of the effect, i.e., whether higher Fed funds rates lead to higher short term treasury rates or whether higher rates in the short term treasury bill market lead the Fed to push up the Fed Funds rate. 
      2. T.Bond rates move with the Fed Funds rate, but more weakly: The link between the Fed Funds rate and the 10-year treasury bond rate is mush weaker, with an R-squared of 6.7%; a 1% increase in the Fed Funds rate is accompanied by a 0.19% increase in the 10-year treasury bond rate. 
      3. T. Bill rates lead, Fed Funds rates lag: Regressing changes in Fed funds rates against changes in T.Bill rates in the following period, and then reversing direction and regressing changes in T.Bill rates against changes in the Fed Funds rate in the following period, provide clues to the direction of the relationship. At least over this time period, and using monthly changes, it is changes in T.Bill rates that lead changes in Fed Funds rates more strongly, with an R squared of 23.7%, as opposed to an R-squared of 9% for the alternate hypothesis. With treasury bond rates, there is no lagged effect of Fed funds rate changes (R squared of zero), while changes in T.Bond rates do predict changes in the Fed Funds rate in the subsequent period. The Fed is more a follower of markets, than a leader. 
      The bottom line is that if you are trying to get a measure of how much treasury bond rates will change over the next year or two, you will be better served focusing more on changes in economic fundamentals and less on Jerome Powell and the Fed.

      2. The relationship between interest rates and stock market value is complicated
      When interest rates go up, stock prices should go down, right? Though you may believe or have been told that the answer is obvious, that higher interest rates are bad for stock prices, the answer is not straight forward. To understand why people are drawn to the notion that higher rates are bad for value, all you need to do is go back to the drivers of stock market value:

      As you can see in this picture, holding all else constant, and raising long term interest rates, will increase the discount rate (cost of equity and capital), and reduce value. That assessment, though, is built on the presumption that the forces that push up interest rates have no effect on the other inputs into value - the equity risk premium, earnings growth and cash flows, a dangerous delusion, since these variables are all connected together to a macro economy.
      Note that almost any macro economic change, whether it be a surge in inflation, an increase in real growth or a global crisis (political or economic) affects earnings growth, T.Bond rates and the equity risk premiums, making the impact on value indeterminate, until you have worked through the net effect. To illustrate the interconnections between earnings growth rates, equity risk premiums and macroeconomic fundamentals, I looked at data on all of the variables going back to 1961:
      The co-movement in the variables and their sensitivity to macro economic fundamentals is captured in the correlation table. Higher inflation, over this period, is accompanied by higher earnings growth but also increases equity risk premiums and suppresses real growth, making its net effect often more negative than positive. Higher real economic growth, on the other hand, by pushing up earnings growth rate and lowering equity risk premiums, has a much more positive effect on value.

      3. Value has to be built around a consistent narrative
      In my post from February 10, right after the last market meltdown, I offered an intrinsic valuation model for the S&P 500, with a suggestion that you fill in your inputs and come up with your own estimate of value. Some of you did take me up on my offer, came up with inputs, and entered them into a shared Google spreadsheet and, in your collective wisdom, the market was overvalued by about 3.34% in mid-February. While making assumptions about risk premiums, earnings growth and the treasury bond rate, I should have emphasized the importance of narrative, i.e., the macro and market story that lay behind your numbers, since without it, you can make assumptions that are internally inconsistent. To illustrate, here are two inconsistent story lines that I have seen in the last few weeks, from opposite sides of the spectrum (bearish and bullish).
      • In the bearish version, which I call the Interest Rate Apocalypse, all of the inputs (earnings growth for the next five years and beyond, equity risk premiums) into value are held constant, while raising the treasury bond rate to 4% or 4.5%. Not surprisingly, the effect on value is calamitous, with the value dropping about 20%. While that may alarm you, it is unclear how the analysts who tell this story explain why the forces that push interest rates upwards have no effect on earnings growth, in the next 5 years or beyond, oron  equity risk premiums.
      • In the bullish version, which I will term the Real Growth Fantasy, all of the inputs into value are left untouched, while higher growth in the US economy causes earnings growth rates to pop up. The effect again is unsurprising, with value increasing proportionately. 
      While neither of these narratives is fully worked through, there are three separate narratives about the market that are all internally consistent, that can lead to very different judgments on value.
      • More of the same: In this narrative, you can argue that, as has been so often the case in the last decade, the breakout in the US economy will be short lived and that we will revert back the low growth, low inflation environment that developed economies have been mired in since 2008. In this story, the treasury bond rate will stay low (2.5%), earnings growth will revert back to the low levels of the last decade (3.03%) after the one-time boost from lower taxes fades, and equity risk premiums will stay at post-2008 levels (5.5%). The index value that you obtain is about 2250, about 16.4% below March 2nd levels.
        Download spreadsheet
      • The Return of Inflation: In this story line, inflation returns, though how the story plays out will depend upon how much inflation you foresee. That higher inflation rate will translate into higher earnings growth, though the effect will vary across companies, depending upon their pricing power, but it will also cause T. Bond rates to rise. If the inflation rate in the story is a high one (3% or higher), the equity risk premium may also rise, if history is any guide. With an inflation rate of 3% and an equity risk premium of 6%, the index value that you obtain is about 2133, about 20.7% below March 2nd levels.
        Download spreadsheet
      • The Growth Engine Revs Up: In this telling, it is real growth in the US economy that surges, creating tailwinds for growth in the rest of the world. That higher real growth rate, while pushing up earnings growth for US companies (to 8% for the near term), will also increase treasury bond rates (to 3.5%), as in the inflation story, but unlike it, equity risk premiums will drift back to pre-2008 levels (closer to 4.5%). The index value that you obtain is about 3031, about 12.7% above March 2nd levels.
        Download spreadsheet
      • A Melded Version: I believe in a melded version of these stories, where inflation returns (but stays around 2%) and real growth in the economy increases, but only moderately. That will translate into higher treasury bond rates (my guess would be 3.5%), with a proportionate increase in earnings growth (at least in steady state) and an equity risk premium of 5%, splitting the difference between pre-crisis and post-crisis periods. The index value that I obtain, with these assumptions, is about 2610, about 3.1% below March 2nd levels.
      Download spreadsheet
      You can see, even from this limited list of scenarios, that to assess how stock prices will move, as interest rates change, you have to also make a judgment on why interest rates are moving. An inflation-driven increase in interest rates is net negative for stocks, but a real-growth driven increase in interest rates is a net positive. In fact, the scenario where interest rates go down sees a much bigger drop in value than two of three scenarios, where interest rates rise. 

      The Bottom Line
      When macro economic fundamentals change, markets take time to adjust, translating into market volatility. During these adjustment periods, you will hear a great deal of market punditry and much of it will be half baked, with the advisor or analyst focusing on one piece of the valuation puzzle and holding all else constant. Thus, you will read predictions about how much the market will drop if treasury bond rates rise to 4.5% or how much it will rise if earnings growth is 10%. I hope that this post has given you tools that you can use to fill in the rest of the story, since it is possible that stocks could actually go up, even if rates go up to 4.5%, if that rate rise is precipitated by a strong economy, and that stocks could be hurt with 10% earnings growth, if that growth comes mostly from high inflation. I also hope that, after you have listened to the narratives offered by others, for what markets will or will not do, that you start developing your own narrative for the market, as the basis for your investment decisions. You've seen my narrative, but I will leave the feedback loop open, as fresh data on inflation and growth comes in, and I plan to revisit my narrative, tweaking, adjusting or even abandoning it, if the data leads me to. 

      YouTube Video

      Data Links
      1. T.Bond Rates, Inflation and Real GDP Growth - 1954-2017
      2. Fed Funds Rate and Treasury Rates - 1962-2017
      3. T.Bond Rates, Earnings Growth Rates and ERP - 1961- 2017
      Spreadsheet Links
      1. Intrinsic Valuation Spreadsheet for S&P 500
      2. More of the Same: Spreadsheet
      3. The Return of Inflation: Spreadsheet
      4. The Growth Engine Revs Up: Spreadsheet
      5. The Melded Version: Spreadsheet
      Blog Post Links



      Amazon: Glimpses of Shoeless Joe?

      It was just over two weeks ago that I started my posts on the FANG stocks, starting with Facebook, which I decided to buy, because I felt that notwithstanding its current pariah status, its user base was too valuable to pass by, at the prevailing market price. I then looked at Netflix, a company that has shown a remarkable ability to adapt to the challenges thrown at it, while changing the entertainment business, but is, at least in my view, in a content cost/user cycle that will be difficult to break out of. With Alphabet, the cash cow that is its advertising business is allowing it to invest in the big new markets of tomorrow, and even with low odds and very little substance today, these bets can make or break the investment. That leaves me with the longest listed and perhaps the most intriguing of the four stocks, Amazon, a company whose reach seems to expand into new markets each year. 

      Revisiting my Amazon past
      I valued Amazon for the first time in 1998, as an online book retailer, and much of what I know about valuing young companies today came from the struggles I went through, modifying what I knew in conventional valuation, for the special challenges of valuing a company with no history, no financials and no peer group. Out of that experience was born a paper on valuing young companies, which is still on my website and the first edition of the Dark Side of Valuation, and if you want to see some horrendously wrong forecasts, at least in hindsight, you can check out my valuation of Amazon in that edition. 

      While I had a tough time justifying Amazon’s valuation, in its dot-com days, I always admired the company and the way it was managed. When I was put off balance by an Amazon product, service or corporate announcement, I re-read Jeff Bezos’ letter to Amazon shareholders from 1997, because it helped me understand (though not always agree with) how Amazon views the business world. In that letter, Bezos laid out what I called the Field of Dreams story, telling his stockholders that if Amazon built it (revenues), they (the profits and cash flows) would come. In all my years looking at companies, I have never seen a CEO stay so true to a narrative and act as consistently as Amazon has, and it is, in my view, the biggest reason for its market success.

      I have valued Amazon about once a year every year over its existence, and I have bought Amazon four times and sold it four times in that period. That said, there are two confessions that I have to make. The first is that I have not owned Amazon since 2012, and have thus missed out on its bull run since then. Second, through all of this time, I have consistently under estimated not only the innovative genius of this company, but also its (and its investors') patience. In fact, there have been occasions when I have wondered, staying true to my Field of Dreams theme, whether Shoeless Joe would ever make his appearance

      Amazon’s Market Cap Rise
      Amazon’s rise in market capitalization has had more ups and downs than either Google or Facebook, but it has been just as impressive, partly because the company came back from a near death experience after the dot-com bust in 2001.


      The more remarkable feature of Amazon’s rise has been the debris it has left in its wake, first with brick and mortar retail in the United States, but more recently in almost every business it has entered, from grocery retail to logistics. These graphs, excerpted from a New York Times article earlier this year, tells the story:


      I know that this picture is probably is too compressed for you to read, but suffice to say that no company, no matter how large or established it is is safe, when Amazon enters it's market. Thus, while you can explain away the implosion of Blue Apron, when Amazon entered the meal delivery business, by pointing to its small size and lack of capital, note that the decline in market value at Kroger, Walmart and Target on the date of the Whole Foods acquisition was vastly greater in dollar value terms, and these firms are large and well capitalized. It is also worth noting that the decline in market cap is not permanent and that firms in some of the sectors see a bounce back in the subsequent time periods but generally not to pre-Amazon entry levels.  If Amazon represents the light side of disruption, the destruction of the status quo and everything associated with it, in the businesses that it enters, is the dark side.

      Amazon: Operating History and Model
      Rather than provide an involved explanation for why I call Amazon a Field of Dreams company, I will begin with a chart of Amazon's revenues and operating income that will explain it far more succinctly and better:
      Amazon has clearly delivered on revenue growth, as its revenues have gone from $1.6 billion in 1999 to $177 billion in 2017, but its margins, after an initial improvement, went through an extended period of decline. In most companies, this would be viewed as a sign of a weak business model, but in the case of Amazon, it is a feature of how they do business, not a bug. In effect, Amazon has extended its revenue growth by expanding into new businesses, often selling its products (Kindle, Fire, Prime) at or below cost.  That, by itself, is not unique to Amazon, but what makes it different is that it has been able to get the market to go along with its "if we build it, they will come" strategy.

      The mild uptick in profitability in the last three years has been fueled by Amazon's web services (AWS) business, offering cloud and other internet related services to other businesses, and that can be seen in the graph below, showing revenues and operating profits broken down by segment:
      Amazon 10K
      Over the last five years. AWS has accounted for an increasing slice of revenues for Amazon, but it is still small, accounting for 10% of all revenues in 2017. On operating income, though, it has had a much bigger impact, accounting for all of Amazon's profitability in 2017, with AWS generating $4,331 million in operating profits and the rest of Amazon, reporting an operating loss of $225 million.

      To back up my earlier claim that Amazon's low profits are by design, and not an accident, let's look at two expenses that Amazon has incurred over this period that are treated as operating expenses, and are reducing operating profit for the company, but are clearly designed as investments for the future. The first is in technology and content, which include the investments in technology that are driving the growth in the AWS business and content, for the media business. The second is in net shipping costs, the difference between what Amazon collects in shipping fees from its customers and what it pays out, which can be viewed as the investment is making in building up Amazon Prime.
      Amazon 10K
      Not only are the technology/content and net shipping costs a large portion of overall expenses, amounting to 18.32% of revenues in 2017, but they have increased over time. The operating margin for Amazon would have been over 20%, if it had not incurred these expenditures, but with those higher, the company would have had far less revenues, no AWS business and no Amazon Prime today. To value Amazon today, I think it makes sense to break it up into at least three parts, with the first being its retail/media business globally, the second its AWS business and finally, Amazon Prime. In the table below, I attempt to deconstruct Amazon's numbers to estimate how much each of these arms is generated as revenues and created in operating expenses in 2017, as a prelude to valuing them.
      Note that I had to make some estimates and judgment calls in allocating revenues to Amazon Prime, where I have counted only the incremental revenues from Amazon Prime members, and in allocating content costs. For Amazon Prime, for instance, I have used an assumption that Prime members spend $600 more than non-Prime members, to estimate incremental revenues, and added the $9.7 billion in subscription premiums that Amazon reported in 2017. The net shipping costs have been fully allocated to Amazon Prime and all of the operating expenses that Amazon reported for AWS are assumed to be technology and content. The remaining expenses are allocated across AWS and Amazon Retail/Media, in proportion to their revenues. In my judgment, both Amazon Retail/Media and AWS generated operating profits in 2017, but the latter was much more profitable, with a pre-tax operating margin of 24.81%. Amazon Prime was a money loser in 2017, but its margins are less negative than they used to be, and at 100 million members, it may be poised to turn the corner.

      Amazon Business Model
      If there are any secrets in Amazon's business model, they are dispensed when you read Amazon's 10K, which is remarkably forthcoming about how the company approaches business. In particular, the company emphasizes three key elements in its business model:
      1. Focus on Free Cash Flow: I tend to be cynical when companies talk about free cash flows, since most use self serving definitions, where they add "stuff" to earnings to make their cash flows look more positive. Amazon does not seem to take the same tack. In fact, it not only nets out capital expenditures and working capital needs, as it should, but it even nets out acquisitions (such as the $13.2 billion it spent on Whole Foods) to get to free cash flow.
      2. Manage working capital investment: Perhaps remembering times as a start-up when mismanaging inventory brought it to its knees, the company is focused on keeping its investment in working capital as low as possible, though that does sometimes involve strong arming suppliers.
      3. Use Operating leverage: Amazon is clearly conscious about its cost structure, recognizing that its revenue growth can give it significant advantages of economies of scale, when it comes to fixed costs.
      There are two additional features to the company that I would add, from my years observing the company.
      1. Patience: I have never seen a company show as much patience with its investments as Amazon has, and while there are some who would argue that this is because of it's large size and access to capital, Amazon was willing to wait for long periods, even when it was a small company, facing a capital crunch. I believe that patience is embedded in the company's DNA and that the Bezos letter in 1997 explains why.
      2. Experimentation: In almost every business that Amazon enters, it has been willing to try new things to shake up the status quo, and to abandon experiments that do not work in favor of experiments that do.
      There is no scarier vision for a company than news that Amazon has entered its business. If you are in that besieged company, how do you survive the Amazon onslaught? We know what does not work:
      1. Imitation: You cannot out-Amazon Amazon, by trying to sell below cost and wait patiently. Even if you are a company with deep pockets, Amazon can out-wait you, since it is not only how they do business and they have investors who have accepted them on their terms.
      2. Cost Cutting: There are companies, especially in the US brick and mortar retail space, that thought they could cut costs, sell products at Amazon-level prices and survive. By doing so, they speeded their decline, since the poorer service and limited inventory that followed alienated their core customers, who left them for Amazon.
      3. Whining: Companies under the Amazon threat often resort to whining not only about fairness (and how Amazon breaks the rules) but also about how society overall will pay a price for Amazon domination. There are seeds of truth in both argument, but they will neither slow nor stop Amazon from continuing to put them out of business.
      While there is no one template for what works, here are some strategies, drawn from looking at companies that have survived Amazon, that improve your odds:
      1. Tilt the game: You can try to get governments and regulators to buy into your warnings of monopoly power and societal demise and to regulate or restrict Amazon in ways that allow you to continue in business. 
      2. Play to your strengths: If you have succeeded as a company before Amazon came into your business, you had competitive advantages and core customers who generated that success. Nourishing your competitive advantages and bringing your core customers even closer to you is key to survival, but that will require that you live through some financial pain (in the form of higher costs).
      3. And to Amazon's weaknesses: Amazon's favored markets have high growth and low capital intensity, and when they get drawn into markets that demand more capital investment, like logistics, it is because they were forced into them. If you can move the terrain to lower growth, higher capital intensity businesses, you can improve your odds of surviving Amazon.
      None of these choices will guarantee success or even survival, and there are times where you may have to seek partnerships and joint ventures to make it through, and if all else fails, you can try some witchcraft.


      Valuing Amazon
      In my prior iterations, I tried to value Amazon as a consolidated company, arguing that it was predominantly a retail company with some media businesses. The growth of AWS and the substantial spending on Amazon Prime has led me to conclude that a more prudent path is to value Amazon in pieces, with Amazon Retail/Media, AWS and Amazon Prime, each considered separately.

      1. Amazon Retail/Media
      To value the heart of Amazon, which still remains its retail and media business, I used the revenues and operating margin that I estimated based upon my allocation at the end of the last section as my starting point, and assumed that Amazon will be able to continue growing revenues at 15% a year for the next five years, while also improving its operating margin (currently 9.09%, with technology and content costs capitalized) to 12%. The revenue growth assumption is built on Amazon's track record of being able to grow and the improved margin reflect expected economies of scale. The resulting value is shown below:
      Download spreadsheet
      Based upon my assumptions, the value that I attach to the retail/media business is about $289 billion. The key driver of value is the operating margin improvement, built into the story.

      2. AWS
      If Amazon's reported numbers are right, this division is the profit machine for the company, generating an operating margin of close to 25%, while revenues grew 42.88% in 2017. While I believe that this business will stay high growth and profitable, it is also one where Amazon faces strong competitors in Microsoft and Google, just to name two, and both revenue growth rates and margins will come under pressure. I assume revenue growth of 25% a year for the next 5 years, with operating margin declining to 20% over that period. The value is shown below:
      Download spreadsheet
      The value that I estimate for AWS is about $139 billion. The key for value creation is finding a mix of revenue growth and operating margin that keeps value up, since going for higher growth with much lower margins will cause value to dissipate.

      3. Amazon Prime
      To value Amazon Prime, I use the same technique that I used last year to value it, starting with a value of a Prime member, and building up to the value of Prime, by forecasting growth in Prime membership and corporate costs (mostly content). I updated the Prime membership number to 100 million (from the 85 million that I used last August) and used the 2017 financial statements to get more specific on both content costs and on the cost of capital. The value is shown below:
      Download spreadsheet
      Based upon the layers of assumptions that I have made, especially on shipping costs growing at a rate lower than membership rolls, the value that I estimate for Amazon Prime is about $73 billion. The key input here is shipping costs, since failing to keep it in control will cause the value to very quickly spiral down to zero.

      Amazon, the Company
      With all three pieces completed, I bring them together in my valuation of the company, incorporating the total debt outstanding in the company of $42,730 (including capitalized operating leases) and cash of $30.986 million, to arrive at a value per share of $1019.

      At $1,460/share, on April 25, the stock is clearly out of my reach right now. Given that I have not been able to justify buying the stock at any time in the last five years, as it rose from $250/share to $1500, my suggestion is that you do you don't take my word, and that you make your own judgment. You can download the spreadsheets that I have for Amazon Retail/Media, AWS and Amazon Prime at the end of this post, and change those assumptions of mine that you think are wrong.

      Investment Judgment
      The FANG stocks represent great companies, but of the four, I think that Amazon has the most fearsome business model, simply because its platform of disruption and patience can be extended to almost any other business, one reason why every company should view Amazon as a potential competitor. I know that the old value adage is that if you buy quality companies and hold them forever, they will pay for themselves, but I don't believe that! There are good companies that can be bad investments and bad companies that can be terrific investments, as I noted in this post. Amazon has fallen into the first category for much of the last five years and continues to do so, at today's market price. But good things come to those who wait, and I know that there be a time and a price at which it will be back in my portfolio.

      Post-post Update: I deliberately posted this before the earnings report, and the report that came out about two hours after the post was a blockbuster, with higher revenue growth than expect, a doubling of net income and an increase in the stock price of close to $100/share in the after market. Incorporating the effects into the valuations will have to wait until the full quarterly report is available, but the biggest part of the report,  for me, was the increase in Prime Membership fees to $119/year. You can modify the Amazon Prime valuation spreadsheet to reflect the increase in membership feels to $119/year (from $99/year). Doing so increases the value of Prime to almost $116 billion, increasing value per share by almost $100/share.

      YouTube Video


      Data Links

      1. Amazon 10K
      2. Valuation of Amazon Retail/Media
      3. Valuation of AWS
      4. Valuation of Amazon Prime
      Related Blog Posts

      Blog Posts on Tech Takedown



      Alphabet Soup: Google is Alpha, but where are the Bets?

      In my last two posts, I looked first at the turn in the market against the FANG stocks, largely precipitated by the Facebook user data fiasco and then at the effect of the blowback on Facebook's value. I concluded that notwithstanding the likely negative consequences for the company, which include more muted revenue growth, higher costs (lower margins) and potential fines, Facebook looks like a good investment, with a value about 10% higher than its prevailing price. I argued that changes are coming from both outside (regulators and legislation) and inside (to protect data better), and these changes are unlikely to be just directed at Facebook. It is this perception that has probably led the market to mark down other companies that have built business models around user/subscriber data and in these next posts, I would like to look at the rest of the stocks in the FANG bundle and the consequences for their valuations, starting with Google in this one.

      The One Number
      The value of a company is driven by a myriad of variables that encompass growth, risk and cash flows, which are the drivers of value. In a typical intrinsic valuation, there are dozens of inputs that drive value but there is one variable, that more than any other, drives value and it is critical to identify that variable early in the valuation process for three reasons:
      1. Information Focus: We live in a world where we drown in data and opinion about companies and unfocused data collection can often leave you more confused about the value of a company, rather than less. Knowing the key value driver allows you to focus your information collection around that variable, rather than get distracted by the other inputs into value.
      2. Management Questions: If you have the opportunity to question management, your questions can then also be directed at the key variable and what management is doing to deliver on that variable. 
      3. Disclosure Tracking: If you are invested in a company and are tracking how it is performing, relative to your expectations, it is again easy in today's markets to get lost in the earnings report frenzy and the voluminous disclosures from companies. Having a focus allows you to zero in on the parts of the earnings report that are most relevant to value.
      In short, knowing what you are looking for makes it much more likely that you will find it. But how do you identify the key driver variable? In my template, I look for two characteristics:
      1. Big Value Effects: Changing your key driver variable should have large effects on the value that you estimate for a business. One of the benefits of asking what-if questions about the inputs into a valuation is that it can allow you to gauge this effect. 
      2. Uncertainty about Input: If an input has large effects on value, but you feel confident about it, it is not a driver variable. Conversely, if you have made an estimate of input and are uncertain about that number, because it can change either due to management decisions or because of external forces, it is more likely to be a driver input.
      If you accept this characterization, there are two implications that emerge. The first is that the key value driver can and will be different for different companies; a mechanistic focus on the same input variable with every company that you value will lead you astray. The second is that there is a subjective component to your choice, and the key value driver that I identify for a company can be different from the one you choose for the same company, reflecting perhaps the different stories that we may be telling in our valuations. In my just-posted Facebook valuation, I believe that the key variable is the cost that Facebook will face to fix its data privacy problems and it manifests itself in my forecasted operating margin, which I project to fall from almost 58% down to 42%, in the next five years. Note that revenue growth may have a bigger impact on value, but in my judgement, it is the operating margin that I am most uncertain about. I will use this post to value Google and highlight what I believe is the driver variable for the company.

      The Alphabet Story
      If Facebook is the wunderkind that has shaken up the online advertising business, Google is the original disruptor of this business and is by far the biggest player in that game today. It is ironic that the disruptor has become the status quo, but until there is another disruption, it is Google's targeted advertising model, in world, and its search engine and ad words that dominate this business. Google has had fewer brushes with controversy, with its data, than Facebook, partly because its data collection occurs across multiple platforms and is less visible and partly because it does have a tighter rein on its data. 

      1. A Short History
      Google has been a rule breaker, right from its beginnings as a publicly traded company. It used a Dutch auction process for its initial public offering, rather than the more conventional bank-backed offer pricing model, and while it has had a few stumbles, its ascent has been steep:

      The secrets to its success are neither hard to find, nor unusual. The company has been able to scale up revenues, while preserving its operating margins:

      The most impressive feature of Google's operations has been its ability to maintain consistent revenue growth rates and operating margins since 2008, even as the firm more than quadrupled its revenues.

      2. The State of the Game
      To value Google, we start with the numbers, but in order to build a story we have to assess the landscape that Google faces.
      1. A Duopoly: The advertising business, in general, and the digital advertising business, in particular, are becoming a duopoly. In 2017, the total spent on advertising globally was $584 billion, with digital advertising accounting for $228.4 billion. Google's market share in 2017 was 42.2%, and Facebook's market share was 20.9%. Even more ominously for the rest of their competitors, they got bigger during the year, accounting for almost 84% of the increase in digital advertising during the course of the year.
      2. Google is everywhere: Google's hold on the game starts with its search engine, but has been enriched by its other products, Gmail, with more than a billion users, YouTube, which dominates the online video space and Android, the dominant smart phone operating system. If you add to this Google Maps, Google shared documents and Google Home products, the company is everywhere that you are, and is harvesting information about you at each step. During the last week, a New York Times reporter downloaded the data that Facebook had on him and while what he found disturbed him, both in terms of magnitude and type, he found that Google had far more data on him than Facebook did.
      3. Alphabet is still mostly alpha, very little bet: While Google's decision to rename itself Alphabet was motivated by a desire to let it's non-advertising businesses grow, the numbers, at least so far, indicate limited progress. In fact, if there is growth it has so far come from the apps, cloud and hardware portion of Google, rather than the bets themselves, but Nest (home automation), Waymo (driverless cars), Verily (life sciences) and Google Fiber (broadband internet) are options that may (or may) not pay off big time.

      Google 2017 10K
      The bottom line is that Google has changed the advertising business  and dominates it, with Facebook representing its only serious competition. It's large market share should act as a check on its growth, but Google has been able to sustain double digit growth by growing the digital portion of the advertising business and claiming the lion's share of that growth, again with Facebook. The wild  card is whether the data privacy restrictions and regulations that are coming will crimp one or both companies in their pursuit of ad revenues. As digital advertising starts to level off, Google will have to look to its other businesses to provide it a boost.

      3. The Valuation
      As with Facebook, I was a doubter on the scalability of the Google story, but it has proved me wrong, over and over again. In valuing Google, I will assume that it will continue to grow, but I set the revenue growth rate at 12% for the next five years, below the 15% growth rate registered in the last five, for two reasons. The first is that digital advertising's rise has started to slow, simply because it is now such a large part of the overall advertising market. The second is that data privacy restrictions, if restrictive, will take away one of Google's network benefits. I do think that the profitability of Google's businesses will stay intact over time, with operating margins staying at the 27.87% recorded in 2017. With those key assumptions, I value Google at $970, close to the price of $1030 that it was trading at on April 13.
      Download spreadsheet
      As with my Facebook valuation, each of my key inputs is estimated with error, and capturing that uncertainty in distributions yields the following outcomes:
      Crystal Ball used in simulation
      No surprises here. The median value is about $957 and at a stock price of $1.030, there is a 65% chance that the stock is over valued. As with Facebook, there is a positive skew in the outcomes, and that skew will get only more positive, if you build in a bigger payoff from one of the bets. 

      4. The Value Driver
      Google's value is driven by revenue growth and operating margins, and changing one or both inputs has a significant effect on value. 
      The shaded cells represent the combinations that deliver values higher than the prevailing stock price of $1,030/share. In my judgment, Alphabet's bigger value driver is revenue growth, not margins, and it is on that input, this valuation will rise of fall. It is my view that while data privacy restrictions will translate into much higher costs for Facebook, partly because it has so little structure currently, it will result in lower growth for Alphabet. If the data privacy restrictions handicap Google so badly that it loses a big part of what has allowed it to dominate digital advertising for the next five years, Google's revenue growth and value will drop dramatically. However, Google is just starting to tap the potential in YouTube, and if it is able to position it as a competitor to Spotify, in music streaming, and Netflix, in video streaming, it could discover a new source of revenue growth, with strong operating margins.

      5. The Google Bets
      The least substantive part of Alphabet, at least in the numbers, is also its most intriguing from a value standpoint, and that is its investment in the other businesses, comprising the "bet" in Alphabet. Google has spent billions on Waymo, Verily and Nest, three of its higher profile other businesses, and while Waymo and Nest have received considerable public attention, they don't have much in revenues, and lots of losses to show for it. There are three views that one can bring to the Google bets, and which one you adopt will determine in large part, whether you will be tilted towards buy-ing Google:
      1. Founder Playthings: The most cynical view is that the billions invested in these businesses are not meant to make money, but instead were directed by founder interests in electric cars, health care technology and home automation. Those who take this view will likely point to Google Glasses, an expensive and ill-fated experiment that ended badly and to the effusive support from Brin and Page for these businesses. If you buy into this this view, not only will these businesses not add value to Alphabet, they will continue to drain value from the company, because of the spending that goes with them.
      2. Early Life, Big Market Businesses: The second and more optimistic view is that the Google bets should be viewed more as start-ups in potentially big markets, with industry-leading innovation. This is especially the case with Waymo, which if not at the cutting edge of the driverless car business is very close to it, and if successful, could be an entree into not just the driverless car market but also into ride sharing and car service. You could build business models for Waymo, Verily, Nest and Google Fiber that would resemble the models used to value young start-ups, with a bonus of access to Alphabet capital to survive for long periods, and add this value to the advertising business that remains Google's cash cow.
      3. Real Options: The third view, which splits the difference, is that while the bet businesses represent potential, that potential is not only far in the future, but may never materialize, either because of the evolution of technology, regulation or market demand. Thus, driverless cars may never quite make it into the mainstream, either because customers don't trust them or they turn out to be too risky. With this view, you can argue that the Google bets are out-of-the-money options, and since the value of an option is determined by potential revenues and uncertainty about those revenues, they are valuable, even though only one of the bets may pay off and the others will have to be written off.
      In my valuation of Alphabet, I have implicitly assumed that the company will continue to spend billions in its bets, by leaving the margin at existing levels; remember that the operating margin of 27.87% is after the company's spending on its bet businesses. By not explicitly giving credit for the revenues that the bet businesses will create, it may seem like I am taking the cynical view of these businesses as playthings, but I am not. Much as I dislike the corporate governance ethos that Brin and Page have brought to Google, and helped to proliferate across the new tech sector with their dicing and slicing of voting rights, I don't see them as individuals who would spend billions on expensive toys. That said, I do think that trying to build business models from scratch, to value Waymo, Verily and Nest is difficult to do right now, given that the markets that they are going after all still in flux. I believe that these investments are options and valuable ones at that, but I will make that claim based upon their underlying characteristics (high variance, big markets) rather than with explicit option pricing models. As an investor, looking at Alphabet, here is how it plays out in my investment decision. My intrinsic valuation for Alphabet is $968, within shouting distance of the company's stock price, and I believe that there is enough option value in the bets, that if the stock is fairly or even under valued at its current price. While I am not yet inclined to buy, I have a limit buy order on the stock, that I had initially set at $950, but have moved up to $1000 after my bet assessment, and I, like many of you, will be watching the market reaction to the Alphabet earnings report on Monday. Perverse though it may sound, I am hoping that there are enough negative surprises in it to cause a price drop that would make my limit buy execute, but if not, it will stay it in place. 

      YouTube Video


      Data Links



      Netflix: The Future of Entertainment or House of Cards?

      For better or worse, Netflix has changed not just the entertainment business, but also the way that we (the audience) watch television. In the process, it has also enriched its investors, as its market capitalization climbed to $139 billion in March 2018 and even after the market correction for the FANG stocks, its value is substantial enough to make it one of the largest entertainment company in the world. Among the FANG stocks, with their gigantic market capitalizations, it remains the smallest company on both market value and operating metrics, but it has almost as big an impact on our daily lives as its larger peers.

      The History

      This may come as a surprise to some, but Netflix has been publicly listed for longer than Facebook or Google. The difference between Netflix and these companies is that it’s climb to stardom has taken more time.

      Don't get me wrong! Netflix was a very good investment between 2003 and 2009, increasing its market capitalization by 33.36% a year and its market capitalization by about $3 billion, during that period. However, it became a superstar investment between 2010 and 2017, adding about $120 billion in value over the period, translating into an annual price appreciation of more than 50% a year.

      The fuel that Netflix has used to increase its market capitalization is its subscriber base, as with the other FANG stocks, the company seems to have found the secret to be able to scale up, as it gets larger. That subscriber base, in turn, has allowed the company to increase its revenues over time, as can be seen in the picture below, summarizing Netflix’s operating metrics.

      You can accuse me of over analyzing this chart, but it captures to me the essence of the Netflix success story. While Netflix has been able to grow revenues in each of the three consecutive five-year time periods, 2002-2006, 2007-2012 and 2013-2017, that it has been existence, the company has been faced with challenges during each period, and it has adapted.
      1. DVDs in the Mail: In the first five-year period, 2002 through 2006, the company mailed out DVDs and videos to its subscribers, challenging the video rental business, where brick and mortar video rental stores represented the status quo, and Blockbuster was the dominant player. 
      2. The Rise of Streaming: It was between 2007 and 2012, where the company came into its own, as it took advantage of changes in technology and in customer preferences. First, as technology evolved to allow for the streaming of movies, Netflix adapted, with a few rough spots, to the new technology, while its brick and mortar competitors imploded. Second, while Netflix saw a drop in revenue growth that was not unexpected, given its larger base, it also saw its content costs rise at a faster rate than revenues, as content providers (the movie studios) starting charging higher prices for content. 
      3. The Content Maker: In hindsight, the studios probably wish that they had not squeezed Netflix, because the company reacted by taking more control of its own destiny in the 2013-2017 time period, by shifting to original content, first with television series and later with direct-to-streaming movies. The results have upended the entertainment business, but more critically for Netflix, they show up in a critical statistic. For the first time in its existence, Netflix saw content costs rise at a rate slower than its growth in revenues, with operating profit margins, both before and after R&D reflecting this development. 
      The State of the Game
      We can debate whether Netflix is a good or a bad investment, but there is no argument that the way movies and television get made has been changed by the company’s practices. It is the rest of the entertainment business that is trying to adapt to the Netflix streaming model, as evidenced by Disney’s acquisition of BAM Media and Fox Entertainment. If I were to summarize where Netflix stands right now, here would be my key points:
      1. It's a big spender on content: In 2017, Netflix spent billions on the content that it delivers to its subscribers, and the extent of its spending can be seen in its financial statements. The way that Netflix accounts for its content expenditures does complicate the measurement, since it uses two different accounting standards, one for licensed content and one for productions, but it capitalizes and amortizes both, albeit on different schedules, and based upon viewing patterns. The gap between the accrual (or amortized) cost (shown in the income statement) and the cash spent (shown in the statement of cash flows) on content can be seen in the graph below.
      Netflix 10K - 2017
      In 2017, Netflix spent almost $9.8 billion on content, though it expensed only $7.7 billion in its income statement. If this divergence continues, and there is no reason to believe that it will not, Netflix’s profits will be more positive than their cash flows by a substantial amount. Note that this divergence should not be taken (necessarily) as a sign of deception or accounting game playing. In fact, if Netflix is being reasonable in its amortization judgments, one way to read the difference of $2.14 billion ($9.8 in cash expenses minus $7.66 billion in accrual expenses) is to view it as the equivalent of capital expenditures at Netflix, since it is expense incurred to attract and keep subscribers.
      2. An increasing amount of that spending goes to original content: The decision by Netflix to produce some of its own content in 2013 triggered a shift towards original content that has picked up speed since that year. In 2017, the company spent $6.3 billion on original content, putting it among the top spenders in the entertainment business:
      Biggest Spenders on Entertainment Content in 2017
      The pace is not letting up. In the first quarter of 2018, Netflix introduced 18 new television series and delivered 12 new seasons of existing series, prodigious output by any studio’s standards. There are three reasons for the Netflix move into the content business.
      • The first, referenced in the last section, is to gain more control over content costs and to be less exposed to movie studio price hikes. 
      • The second is that Netflix has been using the data that it has on subscriber tastes not only to direct content at them, but to produce new content that is tailored to viewer demands.
      • The third is that it introduces stickiness into their business model, a key reason why new subscribers come to the company and why existing subscribers are reluctant to abandon it, even if subscription fees go up.
      Netflix has moved beyond television shows to making straight-to-streaming movies, spending $90 million on Bright, a movie that notwithstanding its lackluster reviews, signaled the company’s ambitions to be a major player in the movie business.
      3. Netflix has been adept at playing the expectations game: One feature that all of the FANG stocks trade is that rather than let equity research analysts frame their stories and measure their success, they have managed to frame their own stories and make investors and analysts play on their terms. Netflix, for instance, has managed to make the expectations game all about subscriber numbers, and every earnings report of the company is framed around these numbers, with less attention paid to content costs, churn rates and negative cash flows. After its most recent earnings report in January, the stock price surged, as the company reported an increase of 8.3 million in subscribers, well above expectations.
      4. The company is globalizing: One consequence of making it a numbers game, which is what Netflix has done by keeping the focus on subscribers, is that you have to go where the numbers are, and for better or worse, that has meant that Netflix has had to go global, with Asia being the mother lode.

      At the end of 2017, Netflix had more subscribers outside the US than in the US, and it is bringing its free spending ways and its views on content development to other parts of the world, perhaps bringing Bollywood and Hollywood closer, at least in terms of shared problems.

      In summary, Netflix has built a business model of spending immense amounts on content, using that content to attract new subscribers, and then using those new subscribers as its pathway to market value. It is clear that investors have bought into the model, but the model is also one that burns through cash at alarming rates, with no smooth or near term escape hatch.

      The Valuation
      In keeping with the focus on subscriber numbers that is at the center of the Netflix story, I will value Netflix with the subscriber-based approach that I used to value Spotify a few weeks ago and Uber and Amazon Prime last year.

      Cost Breakdown
      The key to getting a subscriber-based valuation of Netflix is to first break its overall costs down into (a) costs for servicing existing subscribers, (b) the cost of acquiring new subscribers and (c) a corporate cost that cannot be directly related to either servicing existing subscribers or getting new ones. I started with the Netflix 2017 income statement:

      Since Netflix does not break its costs down into my preferred components I made subjective judgments in allocating these costs, treating G&A costs as expenses related to servicing existing subscribers and marketing costs as the costs of acquiring new subscribers. With content costs, I started first with the $2,146 million difference between the cash content cost and expensed content cost and treated it also as part of the cost of acquiring new subscribers. With the expensed content cost of $7,600 million, I assumed that only 20% of these costs are directly related to subscribers and treated that portion as part of the cost of servicing existing subscribers and that the remaining 80% would become part of the corporate cost, in conjunction with the investment in technology and development. One key difference between the Netflix and Spotify cost models is that most of the content costs are fixed corporate costs for Netflix but almost all content costsare variable costs for Spotify, since it pays for content based upon how its subscribers listen to it, rather than as a fixed fee.

      Value of an Existing Subscribers
      My decision to treat most of the content content costs as a corporate cost has predictable consequences. The costs associated with individual subscribers are only the G&A costs and 20% of content costs, and the number is small, relative to the revenues that Netflix generates per subscriber:
      Download spreadsheet

      A strength that Netflix has built, perhaps with its original content, is that it has reduced it's churn rate (the loss of existing customers), each year since 2015. In 2017, the annual renewal rate for a Netflix subscription was about 91%, and that number improved even more across the four quarters. In my subscriber-valuation, I have used a 92.5% renewal rate, for the life of a subscriber, assumed to be 15 years. I will assume that Netflix investments in original content will give it the pricing power to increase annual revenue per subscriber (G&A and the 20% of content costs), which was $113.16 in 2017, at 5% a year, while keeping the growth rate in annual expenses per subscriber at the inflation rate of 2%. I estimate after-tax operating income each year, using a global average tax rate of 25%, and discount it back at a 7.95% cost of capital (estimated for Netflix, based upon its business and geographic mix, and debt ratio) to derive a value of $508.89 subscriber and a total value of $59.8 billion for Netflix’s 117.6 million existing subscribers.

      Value of New Subscribers
      To value a new subscriber, I first estimated the total cost that Netflix spent on adding new subscribers by adding the total marketing costs of $1,278 million to the capitalized portion of the content costs of $2,142 million, and then divided this amount by the gross increase in the number of subscribers (30.84 million) during 2017, to obtain a cost of $111.01 for acquiring a new subscriber. I then net that number out from the value of an existing subscriber to arrive at a value of $397.88/new subscriber right now; I assume that this value will increase at the inflation rate over time.
      Download spreadsheet

      I assume that Netflix will continue to add new subscribers, adding 15% to its net subscriber rolls, each year for the first five years, and 10% a year for years 6 through 10, before settling into a steady state growth rate of 1% a year. Discounting the value added by new subscribers at a higher cost of capital of 8.5%, reflecting the greater uncertainty associated with new subscribers, yields a total value of $137.3 billion for new subscribers.

      The Corporate Drag
      The final piece of the puzzle is to bring in the corporate costs that we assumed could not be directly linked with subscriber count. In the case of Netflix, the  technology & development costs and 80% of the expensed content, that we put into this corporate cost category amounted to $6.13 billion in 2017 and the path that these costs follow in the future will determine the value that we attach to the company.
      Download spreadsheet

      I assume that technology & development costs will grow 5% a year, but it is on the content cost component that I struggled the most to estimate a growth rate. I decided that the accelerated spending that Netflix had in 2017 and continued to have in 2018 reflect Netflix’s attempt to acquire standing in the business, and that while it will continue to spend large amounts on content, the growth rate in this portion of the content costs will drop to 3% a year, for the next 10 years. Note that even with that low growth rate, Netflix will be consistently among the top five spenders in the content business, spending more than $100 billion on original content over the next ten years. Discounting back the after-tax corporate expenses back at the 7.95% cost of capital, yields a corporate cost drag of $111.3 billion.

      The Netflix Valuation: The One Number
      To value Netflix, I bring together the value of existing and new subscribers and net out the corporate cost drag. I also subtract out the $6.5 billion in debt that the company has outstanding and the value of equity options granted over time to its employees.
      The value per share of $172.82 that I estimate for Netflix is well below the stock price of $275, as of April 14, 2018. My value reflects the story that I am telling about Netflix, as a company that is able to grow at double digit rates for the next decade, with high value added with new users, while bringing its content costs under control. I am sure that your views on the company will diverge from mine, and you are welcome to use my Netflix subscriber valuation template to come to your own conclusions. 

      It is worth taking a pause, and considering the differences between Netflix and Spotify, both subscription-based business models, that draw their value from immense subscriber bases.
      1. By paying for its content, both licensed and original, and using that content to go after subscribers, Netflix has built a more levered business model, where subscribers, both new and existing, have higher marginal value than at Spotify, where content costs are tied to subscribers listening to music. 
      2. The Netflix model, which is increasingly built around original rather than licensed content, provides for a stronger competitive edge, which should show up in higher renewal rates and more pricing power, adding to the value per subscriber, both existing and new. 
      3. The Netflix model will deliver higher value from subscription growth than the Spotify model, but it comes with a greater downside, because a slackening of that growth will leave Netflix much deeper in the hole, with more negative cash flows, than it would Spotify. 
      Now that both companies are listed and traded, it will be interesting to see whether this plays out as much larger market reactions to subscription number surprises, both positive and negative, at Netflix than at Spotify.

      In my earlier post on Google, I noted that every company has a value driver, one number that more than any of the others determines value. In the case of Netflix, the key value driver, in my view, is content costs. My value per share is premised not just on high growth in subscribers and continued subscriber value, but also on content costs growing at a much lower rate (of 3%) in the future. To illustrate the sensitivity of value per share to this assumption, I varied the growth rate in content costs and calculated value per share:
      To illustrate the dangers to Netflix of letting content costs grow at high rates, note that the company’s equity value becomes negative (i.e., the company goes bankrupt), if content costs grow at high rates, relative to revenue growth, with double digit growth rates creating catastrophic effects. If Netflix is able to cap the costs at 2017 levels in perpetuity, the estimated value per share is approximately $216,  at the base case growth rate of 15%, and if it is able to reduce content costs in absolute terms over time, it is worth even more. In my view, investing in Netflix is less a bet on the company being able to deliver subscriber and/or revenue growth in the future and more one on the future path of content costs at the company.

      The Decision
      There is no doubt that Netflix has changed the way we watch television and the movies, and it is changing the movie/TV business in significant ways. By competing for talent in the content business, it is pushing up costs for its competitors and with its direct-to-streaming model, putting pressure on movie theaters and distribution. That said, the entertainment business remains a daunting one, because the talent is expensive and unpredictable, and egos run rampant. The history of newcomers who have come into this business with open wallets is that they leave with empty ones. For Netflix to escape this fate, it has to show discipline in controlling content costs, and until I see evidence that it is capable of this discipline, I will remain a subscriber, but not an investor in the company.

      YouTube Video

      Data Links
      1. Valuation of Netflix - April 2018



      The Facebook Feeding Frenzy: Time for a Pause!

      In my last post, I noted that the FANG stocks have been in the spotlight, as tech has taken a beating in the market, but it is Facebook that is at the center of the storm. It was the news story on Cambridge Analytica's misuse of Facebook user data,  in mid-March of 2018, that started the ball rolling and in the days since, not only have more unpleasant details emerged about Facebook's culpability, but the rest of the world seems to have decided to unfriend Facebook. More ominously, regulators and politicians have also turned their attention to the company and that attention will be heightened, with Zuckerberg testifying in front of Congress. That is a precipitous fall from grace for a company that only a short while ago epitomized the new economy.

      A Personal Odyssey
      My interest in Facebook dates back to the year before it went public, when it was already getting attention because of its giant user base and its high private company valuation. In the weeks leading up to its IPO, I valued Facebook at about $29/share, with a story built around it becoming a Google wannabe. If that sounded insulting, it was not meant to be, since having a revenue path and operating margins that mimicked the most successful tech companies in the decade prior is quite a feat.

      That initial public offering was among the most mismanaged in recent years and a combination of hubris and poor timing led to an offering day fiasco, where the investment bankers had to step in to support the priced. The first few months after the offering were tough ones for Facebook, with the stock dropping to $19 by September 2012, when I argued that it was time to befriend the company and buy its stock, one of the few times in my life when I have bought a stock at its absolute low.

      Much as I would like to tell you that I had the foresight to see Facebook's rise from 2012 through 2017 and that I held on to the stock, I did not, and I sold the stock just as it got to $50, concerned that the advertising business was not big enough to accommodate the players (Google, the social media companies and traditional advertising companies), elbowing for market share. I under estimated how much Google and Facebook would both expand the market and dominate it, but I have no regrets about selling too early. I did what I felt was right, given my assessment and investment philosophy, at the time.

      A Numbers Update
      To undersand how Facebook became the company that it is today, let's start with its most impressive numbers, which are related to its user base. At the start of 2018, Facebook had more than 2.1 billion users, about 30% of the world's population:

      While the user numbers have leveled off in North America, where Facebook already counts 72.5% of the population in its user base, the company continues to grow its user base in the rest of the world, with an added impetus coming from the scaling up of Instagram, Facebook's video arm. These user numbers, while staggering, are made even more so when you consider how much time Facebook users spend on its platforms:
      Collectively, users spent more than an hour a day on Facebook platforms, and that usage does not reflect the time spent on WhatsApp, also owned by Facebook, by its 1.5 billion users.

      If you are a value investor, it would easy to dismiss Facebook as another user-chasing tech company and deliver a cutting remark that you cannot pay dividends with users, but Facebook is an exception. It has managed to to convert its user base into revenues and more critically, operating profits.

      With its operating margin approaching 58%, if you capitalize its technology and content costs, Facebook outshines most of the other companies in the S&P 500, in both growth and profitability:

      What makes Facebook's rise even more impressive is that it has been able to deliver these results in a market, where it faces an equally voracious competitor in Google.

      In summary, Facebook has had perhaps the most productive opening act in history of any publicly listed company, if you define production in operating results. It promised the moon at the time of its IPO, and has delivered the sun. In my book on connecting stories to value, I pointed to Facebook as a company that seemed to find new ways, with each acquisition, announcement and earning report, to expand and broaden its story, first by conquering mobile and then going global. By the start of 2016, I had changed my story for Facebook from a Google Wannabe to one that would eclipse Google, with added potential from its user base. While the Facebook story has been one of business success, the company, its users and investors have been in denial about central elements in the story. Facebook's users have been trading information on themselves to the company in return for a social media site where they can interact with friends, family and acquaintances, and their complaints about lost privacy ring hollow. Facebook's strengths are built upon using the information that users provide about themselves to better target advertising and generate revenues, but Facebook and its investors have been unwilling to face up to the reality that the company's high margins reflect its use of third parties and outsiders to collect and manage data, a business practice that is profitable but that also creates the potential for data leakages. (Some of you seem to be reading into my words an implication that Facebook sells user data to third parties to generate revenues. It does not. It processes the data to make it information (its first competitive advantage), uses that information to better target advertising and generates revenues, as a consequence.)

      A Story Break, Twist or Change?
      If the Facebook story so far sounds like a fairy tale, there has to be a dark twist, and while Facebook's troubles are often traced back to the stories in mid-March 2018, when the current user scandal news cycle began, its problems have been simmering for much longer. Put on the defensive, after the 2016 US presidential elections, for being a purveyor of fake news, Facebook announced in January 2018, that it had changed its news feed to emphasize user interaction over passive consumption of public news feeds. That change, which led to a leveling off in user numbers and a loss of advertising revenues was not well received on Wall Street, with the stock price dropping almost 5%.

      If Facebook was trying to preempt its critics with this announcement, the Cambridge Analytica story has knocked them off stride. Specifically, a whistle blower at Cambridge Analytica claimed that the company has not only accessed detailed user data on 50 million Facebook users but had used that data to target voters in political campaigns. In the three weeks since, the story has worsened for Facebook both in terms of numbers (with accessed users increasing to 87 million) and culpability (with Facebook's sloppiness in protecting user data highlighted). As politicians, commentators and competitors have jumped in to exploit the breach, financial markets knocked off $81 billion from Facebook's market capitalization. It is unquestionable that Facebook is mired in a mess and that it deserves market punishment, but from an investing perspective, the question becomes whether the loss in value is merited or not. 

      The worst case scenario, and some have bought into this, is that the company will lose users, both in numbers and intensity, and that advertisers will pull out. If you add large fines and regulatory restrictions on data usage that may cripple Facebook's capacity to use that data in targeted advertising, you have the makings of a perfect storm, playing out as flat or declining revenues, big increases in operating costs and imploding value. In my view, and I may very well be wrong, I think the effects will be more benign:
      1. User loss, in numbers and intensity, will be muted: It is still early in this news cycle, and there may be more damaging revelations to come, but I don't believe that anything that has come out so far is  egregious enough to cause large numbers of users to flee. We live in cynical times and many users will probably agree with Mark Snyder, a Facebook user whose data had been accessed by Cambridge Analytica, who is quoted as saying in this New York Times article, "If you sign up for anything and it isn’t immediately obvious how they’re making money, they’re making money off of you.” There is some preliminary evidence that can be gleaned from surveys taken right after the stories broke, which indicate that only about 8% of Facebook users are considering leaving and 19% plan significant cutbacks in usage. If this represents the high water mark, the actual damage will be smaller. I will assume that Facebook's push towards more data protections and its larger base will slow growth in revenues down to about 20% a year, for the next 5 years, from the 51.53% growth rate over the last five years.
        Source: Raymond James, reported by Variety
      2. Advertisers will mostly stay on: While a few companies, like Mozilla, Pep Boys and Commerzbank, announced that they were pulling their ads from Facebook, there is little evidence that advertisers are abandoning Facebook in droves, since much of what attracted them to Facebook (its large and intense user base and targeting) still remains in place. Facebook, in an attempt to clean up the platform, may impose restrictions on advertisers that may drive some of them away. For instance, last week, Facebook announced that it would stop accepting political advertisements from anonymous entities and I would not be surprised to see more self-imposed restrictions on advertising. I will assume that there will be more defections in the weeks ahead, mostly from companies that don't feel that their Facebook advertising is effective right now, leading to a loss in revenues of $1.5 billion next year.
      3. Data restrictions are coming, and will be costly: There is no doubt that data restrictions are coming, with the question being about how restrictive they will be and what it will cost Facebook to implement them. Data privacy laws, modeled on the EU's format, will require the company to hire more people to oversee data collection and protection. I will assume that these actions will push up costs and reduce the pre-tax operating margin from 57%, after capitalizing technology and content costs, to 42% over the next 5 years. Pre-capitalization of technology and content, I am expecting the operating margin to drop from 49.7% (current) to about 37-38%,
      4. There will be fines: This is a wild card in this process, with the possibility that the Federal Trade Commission  may impose a fines on the company for violating an agreement reached in 2011, where Facebook agreed to protect user data from unauthorized access. While no one seems to have a clear idea of how much these fines will be, other than that they will be large, there are some who believe that the fines could be as high as a billion dollars. I will assume that the FTC will use Facebook to send a signal to other companies that collect data, by fining it $1 billion.
      As I see it, the scandal will lead to lost sales in the near term, slow revenue growth in the coming years and increase costs at the company, making the Facebook story a less attractive one. My estimates of how the story changes will play out in the numbers is shown below:
      In summary, the story that I have for Facebook is still an upbeat one, albeit one with lower growth and operating margins. The resulting value is shown below:
      Download spreadsheet
      The value per share that I obtain, with my story, is abut $181, and on April 3, the date of the valuation, the stock was trading at $155 a share. As always, I am sure that there are inputs where you will disagree with me, and if you do, you can download the spreadsheet and change the numbers that you disagree with. Some of you may be wondering why I have no margin of safety, but as I noted in this post on the topic from a while back, I believe that there are more effective ways of dealing with uncertainty that adopting an arbitrary margin of safety and sitting on the sidelines. In fact, my favored device is to face up to uncertainty frontally in a simulation, shown below:
      Simulation run with Crystal Ball, in Excel
      This graph reinforces my decision to invest in Facebook. While it is true that there is a 30% chance that the stock is still over valued, there is more upside than downside potential, given my inputs. The median value of $179 is close to my point estimate value, but that should be no surprise since my distributions were centered on my base case assumptions.

      Time to Buy?
      Every corporate scandal becomes a morality play, and the current one that revolves around Facebook is no exception. Facebook has been sloppy with user data, driven partly by greed (to keep costs down and profits up) and partly by arrogance (that its data protections were sufficient), and is and should be held accountable for its mistakes. That said, I don't see Facebook as a villain, and I don't think that the company should be used as a punching bag for our concerns about politics and society.  I am sure that when Mark Zuckerberg delivers his prepared testimony in a couple of hours, senators from both parties will lecture him on Facebook's sins, blissfully blind to their hypocrisy, since I am sure that many of them have had no qualms about using social media data to target their voters. I hear friends and acquaintances wax eloquent about invasion of privacy and how data is sacred, all too often on their favorite social media platforms, while revealing details about their personal lives that would make Kim Kardashian blush. I am an inactive Facebook user, having posted only once on its platform, but to those who would tar and feather the company for its perceived sins, I will paraphrase Shakespeare, and argue that the fault for our loss of privacy is not in our social media, but in how much we share online. I will invest in Facebook, with neither shame nor apology, because I think it remains a good business that I can buy at a reasonable price.

      YouTube Video


      Data Links

      1. Valuation of Facebook - April 2018



      User and Subscriber Businesses: The Good, the Bad and the Ugly!

      In a series of posts over the course of the last year, I argued that you can value users and subscribers at businesses, using first principles in valuation, and have used the approach to value Uber ridersAmazon Prime members and Spotify & Netflix subscribers. With each iteration, I have learned a few things about user value and ways of distinguishing between user bases that can create substantial value from user bases that not only are incapable of creating value but can actively destroy it. I was reminded of these principles this week, first as I wrote about Walmart's $16 billion bid for 77% of Flipkart, a deal at least partially motivated by shopper numbers, then again as I read a news story about MoviePass and the potential demise of its "too good to be true" model, and finally as I tripped over a LimeBike on my walk home. 

      User Based Value
      My attempt to build a user-based valuation model was triggered by a comment that I got on a valuation that I had done of Uber about a year ago on my blog. In that post, I approached Uber, as I would any other business, and valued it, based upon aggregated revenues, earnings and cash flows, discounted back at a company-wide cost of capital. I was taken to task for applying an old-economy valuation approach to a new-economy company and was told that that the companies of today derive their value from customers, users and subscribers. While my initial response was that you cannot pay dividends with users, I realized that there was a core truth to the critique and that companies are increasingly building their businesses around their members. 

      Consequently, I went back to valuation first principles, where the value of any asset is a function of its cashflows, growth and risks, and adapted that approach to valuing a user or subscriber:

      To get from the value of existing users to the value of an entire company, I incorporated the value effect of new users, bringing in the cost of acquiring a new user into the value:

      I applied closure by consider all corporate costs that are not directly related to users or subscribers in a corporate cost drag, a drag because it reduces the value of the business:
      Cumulating the value of existing and new users, and netting out the corporate cost drag yields the value of operating assets, i.e., the same value that you would derive by discounting the free cash flows to the entire business by its overall cost of capital. You would still need to clean up, by adding in cash, netting out debt and dealing with outstanding options, but that process is the same in both models.

      I would hasten to add that a user-based value model is not a panacea to any of the valuation challenges that we face with young, user-based companies. In fact, the difficulties with obtaining the raw data needed on user renewal rates and acquisition costs can be so daunting that any potential advantages that you obtain by looking at user-level value can be drowned out by noise. It is also worth emphasizing that its user-focus notwithstanding, this model is grounded in fundamentals, with value coming, as it always does, from cash flows, growth and risk. I am still learning about this model, but I have put down what I have learned over the last year, when valuing Uber, Amazon Prime and Netflix, into a paper that you can download, read and critique.

      Good, Bad and Indifferent User-based Models
      One of the motivations for my user-focused valuation was based upon casual empiricism. In my view, many venture capitalists and public investors are pricing user-based companies on user count, with only a few seriously trying to distinguish between good, indifferent and bad user-based models. One of the bonuses of using a user-based model is that it provides a framework for differentiating between great and mediocre user-based companies.

      Drivers of Value
      A standard critique that old-time value investors have of user-based companies is that they all lose money, but that is not true. There are user-based companies that make money, but it is also true that the user-based model is still in its infancy and that many user-based companies are young, and therefore lose money. That said, there are elements of the cost structure that you can look at, to make judgments on which user-based companies are most likely to grow out of their problems and which ones are just going to grow their problems.

      a. Cost Structure: Most young, user-based companies lose money but at the risk of sounding unbalanced, there are good ways to lose money and bad ones, from a value perspective. 
      1. Servicing Existing Users versus New User Acquisition: From a value perspective, it is far better for a company to be losing money, because it is spending money trying to acquire new users, than it is to be losing money, because it costs so much to service existing users. The latter signals a bad business model, at least for the moment, whereas the former offers a semblance of hope.
      2. Fixed versus Variable Costs: For mature companies with established business models, it is better to have a more flexible cost structure (with more variable costs and less fixed costs). With money-losing, high-growth companies, the reverse is true, since it is the fixed cost portion that yields economies of scale, as the company grows.
      b. Growth: Repeating a value nostrum, growth is not always value-creating and not all growth is created equal.
      1. Existing versus New Users: A user-based model, where you can grow cash flows from existing users is more valuable, other things remaining equal, than a user-based model that is dependent on adding new users for growth. The reason is simple. Since a company already has expended resources to get existing users, any added revenue it derives from them is more likely to flow directly to the bottom line. Adding new users is more expensive, partly because it costs money to acquire them, but also because new users may not be as active or lucrative as existing ones.
      2. Cost of New User Acquisition: This is a corollary of the first proposition, since the value of a new user is net of user acquisition costs. Consequently, user-based companies that are more cost-efficient in adding new users will be worth more than user-based companies that spend considerable amounts on promotion on marketing, to the same end.  
      This contrast is best illustrated by looking at Netflix and Spotify, both subscriber-based companies, but with very different models for paying for content. Netflix pays for content as a fixed cost, and derives economies of scale, when it adds fresh subscribers, whereas Spotify pays for content, based upon how much subscribers listen to songs, making it a variable and existing user based cost. As a result, Netflix derives much higher value from both existing and new subscribers:
      NetflixSpotify
      Number of Subscribers117.671
      Annual Revenue/Subscriber $         113.16  $         77.63 
      Subscriber Service Expenses (as %)18.90%79.24%
      CAGR in subscriber count223.93%369.86%

      Value per Existing Subscriber $         508.89  $       108.65 
      Cost of acquiring New Subscriber $         111.01  $         27.30 
      Value per New Subscriber $         397.88  $         81.35 
      Value of all Existing Subscribers $    59,845.86  $    7,714.28 
       + Value of all New Subscribers $  137,276.49  $  20,764.56 
       - Corporate Cost Drag $  111,251.70  $  13,139.75 
       =Value of Operating Assets $    85,870.65  $  15,339.10 

      c. Revenue Models: There are three user-based models, the first is the subscription-based model (that Netflix uses), the second is the advertising-based model (that Yelp uses) and the third is a transaction-based model (that Uber uses). There are companies that use hybrid versions, with Amazon Prime (membership fees and incremental sales) and Spotify (Subscription plus Advertising) being good examples. Each model comes with its pluses and minuses. 
      1. Subscription models tend to be stickier (making revenues more predictable) but they offer less upside potential (it is difficult to grow subscription fees at high rates).
      2. Advertising models scale up faster, since they require little in capital investment and adding new users is easier (since they free), but revenues are heavily driven by user intensity (how much time you can get users to stay in your ecosystem) and exclusive data (collected in the course of usage).
      3. Transaction models are the riskiest, since they require users to use your product or service, but they also offer the most upside, since your upside is less constrained. Amazon Prime's value, in my view, does not stem primarily from the subscription revenues of $99/year but from Amazon's capacity to sell Prime members more products and services.
      While no model dominates, picking the wrong revenue model can quickly handicap a business. For instance, using a subscription-based model for a transaction business, where usage varies widely across users, can result in self-selection, where the most intense users choose the subscription-based model to save money, and less intense users stay with a transaction-based model.

      Differentiating across User-based Models
      With the user-based framework in place, we can start distinguishing between user-based companies. Using existing user value and new customer acquisition costs as the dimensions, we can derive a matrix of companies that go from user-value stars to user-value dogs.

      While the combination of high user value with low user acquisition costs may sound like a pipe dream, it is what network benefits and big data, if they exist, promise to deliver. 
      • Network benefits refer to the possibility that as you grow bigger, it becomes easier for you to get even bigger, making it less costly to acquire new users. That is the promise of ride sharing, for instance, where as a company gets a larger share of a ride sharing market, both drivers and customers are more likely to switch to it, the former, because they get more customers and the latter, because they find rides more quickly.
      • Big data, in a value framework, offers user-based companies an advantage, since what you learn about your users can be used to either sell them more products or services (if you are a transaction-based company), charge them higher premiums (if you are subscription-based) or direct advertising more effectively (if advertising-based). 
      Many user-based companies aspire to have network benefits and to use data well, but only a few succeed.

      The Pricing Game
      As I look at user-based companies, some of which are being priced at billions of dollars, I am struck by how few of them are built to be long term businesses and how many of them are being priced on user numbers and buzz words. Using the framework from the last section, I would like to develop some common features that bad user-businesses seems to share in common and use one high profile examples, MoviePass , to make my case.

      Mediocre User-based Companies
      Given that so many young companies market themselves, based upon user and subscriber numbers, and that some of them can become valuable companies, are there signs that you can look for that separate the good from the mediocre companies? I think so, and here are a few red flags:
      1. All about users, all the time: If the entire sales pitch that a company makes to investors is about its user or subscriber numbers, rather than its operating results (revenues and operating profits/losses), it is a dangerous sign. While large user numbers are a positive, it requires a business model to convert these users into revenues and profits, and that business model will not develop spontaneously. Companies that do not work on developing viable business models go bankrupt with lots of users.
      2. Opacity about user data: It is ironic that companies that market themselves to investors, based upon user numbers, are often opaque about key dimensions on users, including renewal (churn) rates, user behavior and side costs related to users. The companies that are most opaque are often the ones that have user models that are not sustainable.
      3. Bad business models: If having no business model to convert users to operating results is a bad sign, it is an even worse sign when you have a business model that is designed to deliver losses, not only in its current form, but with no light at the end of the tunnel. That is usually the consequence of having losses that scale up as the company gets bigger, because there are economies of scale. 
      4. Loose talk about data: The fall back for many user based companies that cannot defend their business models is that they will find a way to use the data that they will collect from their users to make money in the future (from targeted advertising or additional products and services), without any serious attempt to explain why the data will give them an edge.
      5. And externalities: Many user based companies argue that their "innovative" twists on an existing business will both expand and alter the business, leading to benefits for other players in that business, who, in turn, will share their benefits with the user based companies.
      The bottom line is simple. It is easy to build user numbers, if you sell a product or service at way below cost, but if your objective is build a long-standing user-based companies, you need a pathway to profitability that is defined early and worked on continuously.

      MoviePass: Too Good to be True? 
      If you subscribe to MoviePass, for a monthly subscription of $10, you get to watch one theatrical movie, every day, for the entire month. Given that the average price of a theater ticket in the US is $9, this sounds like an insanely good deal, and for an avid movie goer, it is, and the service had two million subscribers in May 2018. MoviePass, though, pays the theaters for the tickets, creating a model that is more designed to drive it into bankruptcy than to deliver profits.
      MoviePass Economics
      When confronted by the insanity of the business model, Mitch Lowe, the CEO of MoviePass, argued that after an initial burst, where subscribers would see four or five movies a month, they would settle into watching a movie a month, allowing the service to break even. Since Mr. Lowe is a co-founder of Netflix and a former CEO of Redbox, I will concede that he knows a lot more about the movie business than I do, but this is an absurd rationale. If the only way that your service can become viable is if people don't use it very much, it  is not much of a service to begin with.  

      In its early days, MoviePass seemed to be trying to build a viable business model, and acquired some high profile venture capital investors, but it was eventually acquired by Helios and Matheson, a data analytics firm, in a  transaction in August 2017. It is Helios and Matheson, intent on giving both data and analysis a bad name, that instituted the $10 a month for a movie-a-day subscription. The subscription worked in delivering users but it, not surprisingly, came with large losses. As MoviePass has continued to burn cash (more than $20 million a month by April 2018), the share price of Helios and Matheson has collapsed, in a belated recognition of its non-viable business model.

      Adding to the sense that no one in this company has a grip on reality, Ted Farnsworth, the CEO of Helios and Matheson, argued that the service would continue and had acquired a $300 million line of credit. Since his backing for this line of credit was that he could issue the remaining authorized shares at the current market price, this indicates either extreme ignorance (potential equity issues don't comprise a line of credit) or unalloyed deception, neither of which is a quality that builds trust. Along the way, there have been other attempts to rationalize the model, including the possibility of using the data collected from subscribers to target advertising and the sharing of additional revenues generated by theaters and studios from more movie going. There is nothing exclusive about the data that will be collected from MoviePass subscribers and it is unlikely that theaters and small studios, already on the brink financially, will be willing to share their revenues. In short, this is a bad business model hurtling to a bad end, and the only question is why it took so long.

      The Bottom Line
      To build a good user-based business, you have to start with the common sense recognition that users are not the end game, but a means to an end. Unfortunately, as long as venture capitalists and investors reward companies with high pricing, based just upon user count, we will encourage the building of bad businesses with lots of users and no pathways to becoming successful businesses.

      YouTube Video


      Paper on User Based Value
      1. Going to Pieces: Valuing Users, Subscribers and Customers
      Blog Posts on User-based Value
      1. Valuing Uber Riders
      2. Valuing Amazon Prime Members
      3. Valuing Spotify Subscribers
      4. Valuing Netflix Subscribers



      Walmart's India (Flipkart) Gambit: Growth Rebirth or Costly Facelift?

      On May 9, 2018, Walmart confirmed officially what had been rumored for weeks, and announced that it would pay $16 billion to acquire a 77% stake in Flipkart, an Indian online retail firm, translating into a valuation of more than $21 billion for a firm founded just over ten years ago, with about $10,000 in capital. Investors are debating the what, why and what next on this transaction, with their reactions showing up in a drop in Walmart’s market capitalization of approximately $8 billion. For Indian tech start-ups, the deal looks like the Nirvana that many of them aspire to reach, and this will undoubtedly affirm their hopes that if they build an India presence, there will be large players with deep pockets who will buy them out.

      The Players
      The place to start, when assessing a merger or an acquisition, is by looking at the companies involved, both acquiring and target, before the deal. It not only provides a baseline for any assessment of benefits, but may provide clues to motives.

      a. Flipkart, an Amazon Wannabe?
      Of the two players in this deal, we know a lot less about Flipkart than we do about Walmart, because it is not publicly traded, and it provides only snippets of information about itself. That said, we can use that information to draw some conclusions about the company:
      1. It has grown quickly: Flipkart was founded in October 2007 by Sachin and Binny Bansal, both ex-Amazon employees and unrelated to each other, with about $6000 in seed capital. The revenues for the company increased from less than $1 million in 2008-09 to $75 million in 2011-12 and accelerated, with multiple acquisitions along the way, to reach $3 billion in 2016-2017. The revenue growth rate in 2016-17 was 29%, down from the 50% revenue growth recorded in the prior fiscal year. Flipkart’s revenues are shown, in Indian rupees, in the graph below:
      2. While losing lots of money and burning through cash: As the graph above, not surprisingly, show, Flipkart lost money in its early years, as growth was its priority. More troubling, though, is the fact that the company not only continues to lose money, but that its losses have scaled up with the revenues. In the 2016-17 fiscal year, for instance, the company reported an operating loss of $0.6 billion, giving it an operating margin of minus 40%. The continued losses have resulted in the company burning through much of the $7 billion it has raised in capital over its lifetime from investors. 
      3. And borrowing money to plug cash flow deficits: Perhaps unwilling to dilute their ownership stake by further seeking equity capital, the founders have borrowed substantial amounts. The costs of financing this debt jumped to $671 million in the 2016-17 fiscal year, pushing overall losses to $1.3 billion. Not only are the finance costs adding to the losses and the cash burn each year, but they put the company’s survival, as a stand-alone company, at risk.
      4. It has had issues with governance and transparency along the way: Flipkart has a complex holding structure, with a parent company in Singapore and multiple off shoots, some designed to get around India’s byzantine restrictions on foreign investment and retailing and some reflecting their multiple forays raising venture capital.
      While the defense that will be offered for the company is that it is still young, the scale of the losses and the dependence on borrowed money would suggest that as a stand-alone business, you would be hard pressed to come up with a justification for a high value for the company and would have serious concerns about survival. 

      b. Walmart, Aging Giant?
      Walmart has been publicly traded for decades and its operating results can be seen in much more detail. Its growth in the 1980s and 1990s from an Arkansas big-box store to a dominant US retailer is captured below:

      That operating history includes two decades of stellar growth towards the end of the twentieth century, where Walmart reshaped the retail business in the United States, and the years since, where growth has slowed down and margins have come under pressure. As Walmart stands now, here is what we see:
      1. Growth has slowed to a trickle: Walmart’s growth engine started sputtering more than a decade ago, partly because its revenue base is so overwhelmingly large ($500 billion in 2017) and partly because of saturation in its primary market, which is the United States. 
      2. And more of it is being acquired: As same store sales growth has leveled off, Walmart has been trying to acquire other companies, with Flipkart just being the most recent (and most expensive) example. 
      3. But its base business remains big box retailing: While acquiring online retailers like Jet.com and upscale labels like Bonobos represent a change from its original mission, the company still is built around its original models of low price/ high volume and box stores. The margins in that business have been shrinking, albeit gradually, over time.
      4. And its global footprint is modest: For much of the last few years, Walmart has seen more than 20% of its revenues come from outside the United States, but that number has not increased over the last few years and a significant portion of the foreign sales come from Mexico and Canada. 
      Looking at the data, it is difficult to see how you can come to any conclusion other than the one that Walmart is not just a mature company, but one that is perhaps on the verge of decline.

      Very few companies age gracefully, with many fighting decline by trying desperately to reinvent themselves, entering new markets and businesses, and trying to acquire growth. A few do succeed and find a new lease on life. If you are a Walmart shareholder, your returns on the company over the next decade will be determined in large part by how it works through the aging process and the Flipkart acquisition is one of the strongest signals that the company does not plan to go into decline, without a fight. That may make for a good movie theme, but it can be very expensive for stockholders.

      The Common Enemy
      Looking at Flipkart and Walmart, it is clear that they are very different companies, at opposite ends of the life cycle. Flipkart is a young company, still struggling with its basic business model, that has proven successful at delivering revenue growth but not profits. Walmart is an aging giant, still profitable but with little growth and margins under pressure. There is one element that they share in common and that is that they are both facing off against perhaps the most feared company in the world, Amazon. 
      a. Amazon versus Flipkart: Over the last few years, Amazon has aggressively pursued growth in India, conceding little to Flipkart, and shown a willingness to prioritize revenues (and market share) over profits:
      Source: Forrester (through Bloomberg Quint)
      While Flipkart remains the larger firm, Amazon India has continued to gain market share, almost catching up by April 2018, and more critically, it has contributed to Flipkart’s losses, by being willing to lose money itself. In a prior post, I called Amazon a Field of Dreams company, and argued that patience was built into its DNA and the end game, if Flipkart and Amazon India go head to head is foretold. Flipkart will fold, having run out of cash and capital.
      b. Amazon versus Walmart: If there is one company in the world that should know how Amazon operates, it has to be Walmart. Over the last twenty years, it has seen Amazon lay waste to the brick and mortar retail business in the United States and while the initial victims may have been department stores and specialty retailers, it is quite clear that Amazon is setting its sights on Walmart and Target, especially after its acquisition of Whole Foods. 

      It may seem like hyperbole, but a strong argument can be made that while some of Flipkart and Walmart’s problems can be traced to management decision, scaling issues and customer tastes, it is the fear of Amazon that fills their waking moments and drives their decision making.

      The Pricing of Flipkart
      Walmart is just the latest in a series of high profile investors that Flipkart has attracted over the years. Tiger Global has made multiple investments in the company, starting in 2013, and other international investors have been part of subsequent rounds. The chart below captures the history:
      Barring a period between July 2015 and late 2016, where the company was priced down by existing investors, the pricing has risen, with each new capital raise. In April 2017, the company raised $1.4 billion from Microsoft, Tencent and EBay, in an investment round that priced the company at $11 billion, and in August 2017, Softbank invested $2.5 billion in the company, pricing it at closer to $12.5 billion. Walmart’s investment, though, represents a significant jump in the pricing over the last year. 

      Note that, through this entire section, I have used the word “pricing” and not “valuation”, to describe these VC and private investments, and if you are wondering why, please read this post that I have on the difference between price and value, and why VCs play the pricing game. Why would these venture capitalists, many of whom are old hands at the game, push up the pricing for a company that has not only proved incapable of making money but where there is no light at the end of the tunnel? The answer is simple and cynical. The only justification needed in the pricing game is the expectation that someone will pay a higher price down the road, an expectation that is captured in the use of exit multiples in VC pricing models. 

      The Why?
      So, why did Walmart pay $16 billion for a 70% stake in Flipkart? And will it pay off for the company? There are four possible explanations for the Walmart move and each comes with troubling after thoughts. 
      1. The Pricing Game: No matter what one thinks of Flipkart’s business model and its valuation, it is true, at least after the Walmart offer, that the game has paid off for earlier entrants. By paying what it did, Walmart has made every investor who entered the pricing chain at Flipkart before it a “success”, vindicating the pricing game, at least for them. If the essence of that game is that you buy at a low price and sell at a higher price, the payoff to playing the pricing game is easiest seen by looking at the Softbank investment made just nine months ago, which has almost doubled in pricing, largely as a consequence of the Walmart deal. In fact, many of the private equity and venture capital firms that became investors in earlier years will be selling their stakes to Walmart, ringing up huge capital gains and moving right along. Is it possible that Walmart is playing the pricing game as well, intending to sell Flipkart to someone else down the road at a higher price?
      My assessment: Since the company’s stake is overwhelming and it has operating motives, it is difficult to see how Walmart plays the pricing game, or at least plays it to win. There is some talk of investors forcing Walmart to take Flipkart public in a few years, and it is possible that if Walmart is able to bolster Flipkart and make it successful, this exit ramp could open up, but it seems like wishful thinking to me.


      2. The Big Market Entrée (Real Options): The Indian retail market is a big one, but for decades it has also proved to be a frustrating one for companies that have tried to enter it for decades. One possible explanation for Walmart’s investment is that they are buying a (very expensive) option to enter a large and potentially lucrative market. The options argument would imply that Walmart can pay a premium over an assessed value for Flipkart, with that premium reflecting the uncertainty and size of the Indian retail market.
      My assessment: The size of the Indian retail market, its potential growth and uncertainty about that growth create optionality, but given that Walmart remains a brick and mortar store primarily and that there is multiple paths that can be taken to be in that market, it is not clear that buying Flipkart is a valuable option.

      3. Synergy: As with every merger, I am sure that the synergy word will be tossed around, often with wild abandon and generally with nothing to back it up. If the essence of synergy is that a merger will allow the combined entity to take actions (increase growth, lower costs etc.) that the individual entities could not have taken on their own, you would need to think of how acquiring Flipkart will allow Walmart to generate more revenues at its Indian retail stores and conversely, how allowing itself to be acquired by Walmart will make Flipkart grow faster and turn to profitability sooner.
      My assessment: Walmart is not a large enough presence in India yet to benefit substantially from the Flipkart acquisition and while Walmart did announce that it would be opening 50 new stores in India, right after the Flipkart deal, I don’t see how owning Flipkart will increase traffic substantially at its brick and mortar stores. At the same time, Walmart has little to offer Flipkart to make it more competitive against Amazon, other than capital to keep it going. In summary, if there is synergy, you have to strain to see it, and it will not be substantial enough or come soon enough to justify the price paid for Flipkart.


      4. Defensive Maneuver:Earlier, I noted that both Flipkart and Walmart share a common adversary, Amazon, a competitor masterful at playing the long game. I argued that there is little chance that Flipkart, standing alone, can survive this fight, as capital dries up and existing investors look for exits and that Walmart’s slide into decline in global retailing seems inexorable, as Amazon continues its rise. Given that the Chinese retail market will prove difficult to penetrate, the Indian retail market may be where Walmart makes its stand. Put differently, Walmart’s justification for investing in Flipkart is not they expect to generate a reasonable return on their $16 billion investment but that if they do not make this acquisition, Amazon will be unchecked and that their decline will be more precipitous.
      My assessment: Of the four reasons, this, in my view, is the one that best explains the deal. Defensive mergers, though, are a sign of weakness, not strength, and point to a business model under stress. If you are a Walmart shareholder, this is a negative signal and it does not surprise me that Walmart shares have declined in the aftermath. Staying with the life cycle analogy, Walmart is an aging, once-beautiful actress that has paid $16 billion for a very expensive face lift, and like all face lifts, it is only a matter of time before gravity works its magic again.


      In summary, I think that the odds are against Walmart on this deal, given what it paid for Flipkart. If the rumors are true that Amazon was interested in buying Flipkart for close to $22 billion, I think that Walmart would have been better served letting Amazon win this battle and fight the local anti-trust enforcers, while playing to its strengths in brick and mortar retailing. I have a sneaking suspicion that Amazon had no intent of ever buying Flipkart and that it has succeeded in goading Walmart into paying way more than it should have to enter the Indian online retail space, where it can expect to lose money for the foreseeable future. Sometimes, you win bidding wars by losing them!

      What next?
      In the long term, this deal may slow the decline at Walmart, but at a price so high, that I don’t see how Walmart’s shareholders benefit from it. I have attached my valuation of Walmart and with my story of continued slow growth and stagnant margins for the company, the value that I obtain for the company is about $63, about 25% below its stock price of $83.64 on May 18, 2018.
      Download spreadsheet
      In the short term, I expect this acquisition to a accelerate the already frenetic competition in the Indian retail market, with Flipkart, now backed by Walmart cash, and Amazon India continuing to cut prices and offering supplementary services. That will mean even bigger losses at both firms, and smaller online retailers will fall to the wayside. The winners, though, will be Indian retail customers who, in the words of the Godfather, will be made offers that they cannot refuse! 

      For start-ups all over India, though, I am afraid that this deal, which rewards the founders of Flipkart and its VC investors for building a money-losing, cash-burning machine, will feed bad behavior. Young companies will go for growth, and still more growth, paying little attention to pathways to profitability or building viable businesses, hoping to be Flipkarted. Venture capitalists will play more pricing games, paying prices for these money losers that have no basis in fundamentals, but justifying them by arguing that they will be Walmarted. In the meantime, if you are an investor who cares about value, I would suggest that you buy some popcorn, and enjoy the entertainment. It will be fun, while it lasts!

      YouTube Video


      Data Links
      1. Walmart Valuation - May 2018



      Twists and Turns in the Tesla Story : A Boring, Boneheaded Update!

      There are lots of complaints that you can have about Tesla, but being boring is not one of them. It helps to have a CEO who seems to find new ways to make himself newsworthy, in good and bad ways. In fact, if Tesla were a reality show, the twists and turns in its fate would give it sky-high ratings and put the Kardashians to shame. Consequently, it should comes as no surprise that there is no other company where investors disagree more about the future than Tesla, with bulls finding new reasons for pushing it price up and short sellers picking the stock as their favorite, albeit elusive, target

      Tracing my Tesla Past
      I am often tabbed as a Tesla bear, and while I have never found it to be an attractive investment, I have admired the company, and by extension, Elon Musk, for shaking up the auto business. In my first valuation of Tesla in September 2013, I valued it as a luxury car company that would require large cash infusions to get to steady state. Factoring in the resulting negative cash flows and failure risk, the value per share that I obtained was well below the market price then. In the years since, I have revisited the company many times, and what I have learned about the stock has led me to to call it the ultimate story stock, which is how I described it in a post in 2016, explaining both its price volatility and its capacity to weather bad news. I also argued in that post that investors in Tesla were investing in Elon Musk, not the company, with the company reflecting his strengths, a surplus of vision and out-of-the-box thinking, and his weaknesses, which include an unwillingness to pay attention to operating details and financial first principles in running the company.

      While Tesla's consistent failure to deliver on production targets over its lifetime is well documented, its failure to heed financial first principles may be even more damaging to it in the long term, as evidenced in at least two major decisions that the company has made in the last two years.
      1. The acquisition of Solar City: In acquiring Solar City, a company where Musk was a lead stockholder and his cousin was CEO, Tesla had to not only overcome the perception of conflicts of interest, but it acquired a company with negative cash flows in a rapidly commoditizing business, not a great fit for a company that had its own cash flow problems.
      2. The turn to debt: Tesla's decision to borrow more than $5 billion in September 2017 to fund its capital needs, was almost incomprehensible, given Tesla's standing at the time. As I noted in a post at that time, there was no good reason that could be offered for that borrowing, since none of the usual arguments for debt applied.
      • Tesla gets no tax benefits from debt: When a company is losing money, as Tesla was in 2017, there are no tax benefits to borrowing money, and to the argument that they might make money in the future, the response is that it then best to wait until then to borrow money. Borrowing money in anticipation of future profits is not just stupid, but it is dangerous.
      • Tesla has easy access to equity capital: It is true that Tesla needed capital to build up its production capacity, especially given its promise to deliver hundreds of thousands of Tesla 3s in 2018, but it is also true that the best way to raise this capital for a company with negative earnings and cash flows and significant growth potential is to use equity, not debt. To the counter that this will cause dilution, it is better to have a diluted share in a much valuable company than a concentrated share of a defaulted entity.
      • Musk's control of Tesla is absolute: There is the possibility that the debt issue was motivated by Elon Musk's desire to keep control of Tesla, but given his exalted status with shareholders and a rubber stamp board of directors, I see very little threat to his absolute control from issuing more shares in the company.
      In sum, the Solar City acquisition was ill-advised in 2016, and there were no good reasons for the Tesla debt issue in September 2017, suggesting either that the company does not have a functioning CFO in Deepak Ahuja or that Elon Musk is taking on that role as well.

      Tesla: News and Data Updates
      As I said at the start of this post, the Tesla story is never a dull one and the last few months has brought that lesson home. Not only have their been multiple news stories about the company, but Elon Musk has outdone himself as a newsmaker:
      1. Financial filings: There have been three quarterly filings since my last valuation of Tesla and the company has only made the hole it is in, as a result of its operating losses, worse by adding debt to the mix. The chart below captures the trend lines in revenues, operating income and net income for the company on a quarter-by-quarter basis:
        Looking at the last three quarterly reports delivered since my last valuation of Tesla, there is little that would lead me to radically reassess what I think about the company. The good news is that revenues continue to grow but the bad news is that losses are growing proportionately, since there is no improvement in margins. Backing up the point made in the last section about the debt issue, Tesla's borrowing has made the hole that the company is in much deeper.
      2. Earnings Call: Earnings calls are normally staid affairs, where top managers stick to the script and analysts dance with them, asking questions about operations and seeking guidance on future growth. The Tesla earnings call after the most recent earnings report certainly did not fit this script, since Elon Musk, a few minutes into the call, blew up at at Toni Sacconaghi, a Sanford Bernstein analyst, calling his question about future capital needs "boring and boneheaded". He then proceeded to stop taking questions from analysts entirely and answered only questions posed by investors gathered by a recent YouTube start-up. While the market reaction to the bizarre earnings call was negative, with the stock dropping 5.5%, the stock, as it has so many times before, recovered in the weeks after and climbed to close to all-time highs.
      3. Other News: In the weeks after the earnings call, Musk has added to the news stories with more announcements, many of them taking the form of tweets. First, he announced that given Tesla's financial constraints, the company would focus. at least for the next few months, on turning out the higher priced version of the Tesla 3, priced at $75,000 rather than the $35,000 base price that he had announced as part of the original rollout. His reasons for doing so, i.e., that shipping the lower cost model would cause Tesla to "lose money and die" suggest that the lower priced version may not be viable in the long term. Second, he also announced that Tesla would lay off 9% of its employees, mostly from the Solar City portion of the company, explaining that the company needed to move towards sustained profitability. 
      The need to become "profitable" is one of two constraints that Musk has added to the company's objective, with the other being that the company will be "cash flow positive" by the third quarter. In fact, Musk has been categorical that Tesla will not need to raise capital to cover its investment needs in the near future, in response to stories in the press that Tesla would need to raise between billions to cover its growth plans. In fact, much of Tesla's focus seems to be on delivering one part of a long-standing promise, which is manufacturing 5000 cars from its assembly lines each week, a meager number for most auto makers but driving decision making at Tesla. It is in pursuit of this goal that Tesla has augmented its Fremont plant with additional tented assembly lines, Musk has been "sleeping on the factory floor" and at least partly pulled back on its plan to replace workers with robots.

      Tesla's Value Drivers
      No matter what your story is for Tesla, the value of Tesla is determined by four big drivers and to help in construction your story, it is worth looking at background:
      1. Revenue Growth: In the trailing twelve months, ending March 2018, Tesla had revenues of about $12.5 billion and to justify the market capitalization at which the company trades at currently, these revenues have to grow significantly. To get perspective on how large revenues can become, I looked at the twenty largest auto companies in the world, ranked based upon trailing revenues:
        Note that most of the companies on this list are mass market auto companies, with Daimler (arguably) and BMW being the only exceptions. Put differently, the question of whether Tesla will be able to deliver on a $35,000 Tesla 3, now or in the future, becomes central to estimating revenue growth.
      2. Operating Margin: No matter how you slice it, Tesla is losing money, and it happens to operate in a sector where profit margins have been under pressure for a while, driven partly by competition and partly by changes in the business itself. In the chart below, I have a distribution of operating margins for global auto companies in June 2018:
        Global Auto Data
        Note that the median pre-tax operating  margin for auto companies is only 4.81%, with double digit operating margins putting you at the 80th percentile of all auto companies. It is also worth noting that among the ten largest auto companies, there is not a single one that generates an operating margin higher than 10%; BMW has the highest margin, at 9.89%.
      3. Reinvestment: Scaling up revenues will require significant reinvestment, especially in the auto business. One simple measure of this reinvestment is the sales to invested capital ratio, measuring how much revenue a dollar in invested capital generates. Looking at this measure across the global auto business, here is what I see:
        Note that the global auto business is capital intensive, with a dollar in capital invested generating only $1.29 in revenue at the median firm, and that Tesla, over its history, has been even more capital intensive, generating less revenue per dollar invested than the typical auto firm, with capital intensity increasing after the Solar City acquisition. Tesla's counter to this has  been that by bringing in technology into assembly lines, they will become more efficient than other auto companies, but that argument has lost some of its luster after the last few months, with Musk openly admitting that the robots that Tesla had hoped to put on the factory floor were not doing their jobs. 
      4. Risk: There are two dimensions through which risk affects Tesla's value. The first is the cost of capital, which reflects the operating risk at the company. As an auto company, Tesla is exposed to economic cycles and its cost of capital will reflect that risk:
        Global Auto Data
        The second is the risk of failure and distress, and while being a small, money-losing company is one reason for exposure, Tesla has magnified its risk by borrowing billions of dollars. 
      Possible, Plausible and Probable Tesla Stories
      I have long argued that every valuation tells a story and that one way to check your valuation is to check to pass your story through the 3P test: Is it possible? Is it plausible? Is it probable? If this sounds like a play on words, note that each test sets a higher standard than the previous one. There are lots of possible stories, a subset of plausible stories and an even smaller set of probable stories. 

      Tesla is a stock where there are widely divergent stories, with bullish investors telling big stories with happy endings, that deliver large values for the company, and bearish investors pushing much smaller stories, some with bad endings. In this section, I will start by offering some solace for Tesla bulls by looking at a plausible story that delivers a value greater than the current stock price, then argue that Elon Musk's story for the company, or at least the version that he is telling right now,  is an impossible story and close with my (still upbeat) story for the stock and resulting value.

      Getting to $400/share: A Plausible Story?
      Is it plausible that Tesla, notwithstanding all of the troubles weighing it down, is under valued, at its current stock price of $340/share? Yes, but only it can put together the following results:
      1. Increase revenues ten-fold over the next decade: Tesla's current revenues of $12.5 billion will have to increase to $120 billion or more in the next ten years, giving it revenues close to those of BMW today. Assuming an average car price of $60,000, that would translate into 2 million cars sold in year 10, illustrating why the focus on whether Tesla can hit its target of 5,000 cars a week is missing the big picture.
      2. Improve operating margins to match the most profitable auto companies: While Tesla scales up its revenues, it will not only have to become profitable (a minimal requirement) but much more so than the typical auto company. In fact, its pre-tax operating margin will climb to 12%, well above the median auto margin of 4.81% or BMW's 9.89%, powered by brand name and pricing power.
      3. Invest more efficiently than the sector: To accomplish its objectives of increasing revenues and ramping up profitability, Tesla will have to reinvest and reinvest efficiently, delivering about $2.25 in revenues for every dollar of capital invested, much higher than than the typical auto firm. To provide perspective, Tesla in year 10 will have to deliver BMW-like revenues ($120 billion) with about a third of BMW's invested capital; with the estimated sales to capital ratio, Tesla's invested capital in year 10 will be $64 billion, whereas BMW's invested capital in 2018 was $185 billion).
      4. Navigate its way through debt to safety: Finally, as it moves towards becoming a much larger, more profitable firm, Tesla will also have to meet its commitments on current debt and not add to the mix, at least for the near term. In terms of operating risk, Tesla will have to face a cost of capital of 8.29%, in line with the typical auto firm.
      Download spreadsheet
      With these assumptions in place, the value that I get per share is $412, but as you can see from the assumptions, it would be the equivalent of a Royal Flush in poker. Note also that in this optimistic story, Tesla will have to have to raise $14 billion in fresh capital over the next few years and will not become operating cash flow positive until 2025. I am sure that there are people who will be unfazed by this story, especially if they are true believers in Elon Musk, but I am not one of them.

      The Musk Story for Tesla: A Fairy Tale?
      With a story stock, it is imperative that you have a CEO who not only is able to get the market to buy into a big story, but one who stays focused and disciplined. To me, there is no better example of how to do this well than Amazon, where Jeff Bezos has been consistent in telling the same story for the company, since its inception in 1997, and delivering on that story. Elon Musk is a gifted story teller, but as the last few months have shown, focus and discipline are not his strong points.

      If you are a Tesla investor, your primary concern should be that Musk, with his numerous and often conflicting claims about the company, has muddled the Tesla story and perhaps put the company at risk. If Musk is to be believed, and the company will turn the corner on profitability soon and will not need to go back to capital markets in the near future, while also scaling up production and revenues. While that would be wonderful, from a value perspective, it is fantasy. Put bluntly, there is no chance that Tesla can deliver what it needs to, in terms of scaling up revenues and improving profitability, to justify its market capitalization, without raising new equity along the way. Either Musk knows this, and really does not mean what he says, in which case he is being deceptive, or he does not, in which case he is delusional. Neither is a good character quality in a CEO, especially one at a young company that needs investors on its side.

      The fact that Tesla's stock price has remained at elevated levels, and even risen, may lead some to conclude that Musk's behavior has no consequences, but I believe it not only will, but it already has  hurt the company. For instance, I think that Tesla has got a bum's rap for some of the accidents that its cars have been in, either from malfunctioning auto-pilots or combustible cars. However, Tesla's hand is weakened by Elon Musk not only acting as the spokesperson for the company but by his responses, which are a mix of arrogance and victimhood (blaming the media, short sellers and analysts) that sap whatever sympathy bystanders may have for the company.

      My Tesla Story in June 2018
      My story for Tesla is still an optimistic one, but it is much less so than the Royal Flush story that delivered a value in excess of $400. I do think that Tesla will be able to grow revenues substantially over the next decade and improve margins to rank among the more profitable auto companies. I also think that Elon Musk will back track on his promise of not having to raise fresh capital and that Tesla will invest billions into new plant and equipment, and do so more efficiently than other auto companies, partly because it is not saddled with legacy investments. On the risk front, I am comfortable with assuming that operating risk will stabilize over time, but I do think that the debt burden will pose a danger to survival, at least for the next year or two. Pulling these assumptions together, I revalued the firm at about $186/share.
      Download spreadsheet
      In this story, Tesla's capital needs will be even higher than under the Royal Flush story, with negative cash flows for the next eight years, and $22 billion in new capital over that period. That may strike some as pessimistic, but notwithstanding all the talk about robots and technology, this remains a capital intensive business. It is entirely possible that over the next few weeks, Tesla might be able to get its production up to 5000 cars a week, using tents and spare parts, but that is not a long term solution. There is no tent big enough to produce 30,000 cars a week, which would be Tesla's target in my story, in year 10. 

      Bottom Line
      There is no denying the fact that Elon Musk has been central to the Tesla story and that his vision and charisma have been largely responsible for pushing the stock price to its current levels. That said, we are at a point in Tesla's history where I think that the question can be raised as to whether the negatives that Musk brings to the job are starting to catch up with, and perhaps overwhelm the positives. Picking fights with equity research analysts and short sellers may get the blood flowing for Tesla bulls, but they are distractions from what Tesla has to do right now. Promising the market that the company will turn the corner on profitability and be cash flow positive soon may signal Musk's faith in his own story, but they do more harm than good for the company's long term value. I know that it is inconceivable for many investors to think of Tesla without Elon Musk at its helm, but this is a company in clear need of checks and balances, either from a strong management team or a powerful board of directors. Unfortunately, neither exists at the company now, and if you are bullish on Tesla, that should scare you.

      YouTube Video


      Spreadsheets
      1. Auto companies data
      2. Tesla - Royal Flush Valuation (June 2018)
      3. Tesla - My Valuation (June 2018)
      Past posts on Tesla
      1. Keystone Kop Valuations: Lazard, Evercore and the TSLA/SCTY deal
      2. Tesla: It's a story stock, but what's the story?
      3. A Tesla  2017 Update: A Disruptive Force and a Debt Puzzle



      Share Count Confusion: Dilution, Employee Options and Multiple Share Classes!

      In my last post, just about four weeks ago, I valued Tesla, and as with all of my Tesla valuations, I got feedback, much of it heated. My valuation of Tesla was $186, in what I termed my base case, and there were many who disputed that value, from both directions. There were some who felt that I was being too pessimistic in my assessments of Tesla's growth potential, but there were many more who argued that I was being too optimistic. In either case, I have no desire to convert you to my point of view, since the essence of valuation is disagreement. In the context of some of these critiques, there was discussion of how my valuation incorporated (or did not incorporate) the expected dilution from future share issuances and what share count to use in computing value per share. Since these are broader issues that recur across companies, I decided to dedicate a post entirely to these questions.

      Share Count and Value Per Share
      There was a time, not so long ago, when getting from the value of equity for a company to value per share was a trivial exercise, involving dividing the aggregate value by the number of shares outstanding.
      Value per share = Aggregate Value of Equity/ Number of Shares outstanding
      This computation can become problematic when you have one or more of the following phenomena:
      1. Expected Dilution: As young companies and start-ups get listed on public market places, investors are increasingly being called upon to value companies that will need to access capital markets in future years, to cover reinvestment and operating needs. To the extent that some or all of this new capital will come from new share issuances, the share count at these companies can be expected to climb over time. The question for analysts then becomes whether, and if yes, how, to adjust the value per share today for these additional shares.
      2. Share based compensation: When employees and managers are compensated with shares or options, there are three issues that affect valuation. The first is whether the expense associated with stock based compensation should be added back to arrive at cash flows, since it is a non-cash expense. The second is how to adjust the value per share today for the restricted shares and options that have already been granted to managers. Third, if a company is expected to continue with its policy of using stock based compensation, you have to decide how to adjust the value per share today for future grants of options or shares.
      3. Shares with different rights (voting and dividend): When companies issue shares with different voting rights or dividends, they are in effect creating shares that can have different per-share values. If a company has voting and non-voting shares, and you believe that voting shares have more value than non-voting shares, you cannot divide the aggregate value of equity by the number of shares outstanding to get to value per share.
      Note that while none of these developments are new, analysts in public markets dealt with them infrequently a few decades ago, and could, in fact, get away with using short cuts or ignoring them. Today, they have become more pervasive, and the old evasions no longer will stand you in good stead.

      Expected Dilution
      The Change: An investor or analyst dealing with publicly traded companies in the 1980s generally valued more mature companies, since going public was considered an option only for those companies that had reached a stage in their life cycle, where profits were positive (or close) and continued access to capital markets was not a prerequisite for survival. Young companies and start-ups tended to be funded by venture capitalists, who priced these companies, rather than valued them. In the 1990s, with the dot com boom, we saw the change in the public listing paradigm, with many young companies listing themselves on public markets, based upon promise and potential, rather than profits or established business models. Even though the dot com bubble is a distant memory, that pattern of listing early has continued, and there are far more young companies listed in markets today. An investor who avoids these companies just because they do not fit old metrics or models is likely to find large segments of the market to be out of his or her reach.

      The Consequence: If you are valuing a young company with growth potential, you will generally find yourself facing two realities. The first is that many young companies lose money, as they focus their attention on building businesses and acquiring clientele. The second is that growth requires reinvestment, in plant and equipment, if you are a manufacturing company, or in technology and R&D, if you are a technology company. As a consequence, in a discounted cash flow valuation, you can expect to see negative expected cash flows, at least for the first few years of your forecast period. To survive these years and make it to positive earnings and cash flows, the company will have to raise fresh capital, and given its lack of earnings, that capital will generally take the form of new equity, i.e., expected dilution, which, in turn, will affect value per share.

      The Right Response: If you are doing a discounted cash flow valuation, the right response to the expected dilution is to do nothing. That may sound too good to be true, but it is true, and here is why. The aggregate value of equity that you compute today includes the present value of expected cash flows, including the negative cash flows in the up front years. The latter will reduce the present value (value of operating assets), and that reduction captures the dilution effect. You can divide the value of equity by the number of share outstanding today, and you will have already incorporated dilution. 

      I know that it sounds like a reach, but let me use my base case Tesla valuation to illustrate. In the table below, I have my expected cashflows for the next 10 years, with the terminal value in year 10.

      Download Tesla Valuation and Dilution Spreadsheet 
      The present value of the expected cash flows across all 10 years is $41,333 million, and netting out debt and adding back cash, yields an equity value of $33,124 million; the value per share is $189.23. However, this value includes the present value of expected cash flows from years 1 through 8, which are negative in my forecast,s and have a present value of $16,157 million. If these cash flows had not been considered, the value of the operating assets would have been $57,490 million and the value of equity would have been $48,282 million, a value per share of $284.41. In effect, we have applied a 33.46% discount to value, for future dilution. 

      Implicitly, I am assuming that the firm will fund 88.06% of its capital needs with equity, consistent with the debt ratio that I assumed in the DCF, and that the shares will be issued at the intrinsic value per share (estimated in the valuation), with that value per share increasing over time at the cost of equity. That may strike some as unrealistic, but it is the choice that is most consistent with an intrinsic valuation. If Tesla is able to issue shares at a higher price (than its intrinsic value), we will have under estimated the value per share, and if it has to issue shares at a price lower than its intrinsic value, we will have over estimated value. There is one final reality check. While we have implicitly assumed that Tesla will have access to capital markets and be able to raise capital, there is a chance that capital markets could shut down or become inaccessible to the firm. That risk is not in the discounted cash flow valuation and has to be brought in explicitly in the form of a chance of failure. In my base case valuation, it is one of the reasons that I attached a chance of failure (albeit a small one of 5%) to the company.

      A Viable Alternative: There is an alternative approach, where you forecast the number of shares that will be issued in future years to cover the negative cashflows, and count them as shares outstanding today. If you use this approach, you should set the cash flows for the negative  cash flow years to be zero. The peril in this approach is that there is a circularity that can cause your valuations to become unstable, since you will need to forecast a price per share in future years to get an estimate of value per share today. To illustrate this process, assume that you believe that the issuance price for Tesla for the new shares will be $200, with a price appreciation of 9% a year for the next 8 years. The table below computes the new shares that will need to be issued each year, assuming that 88.06% of capital comes from equity, and the dilution that will result as a consequence:
      Download dilution spreadsheet
      Note that, with the assumptions about the issuance price of $200, Tesla will issue 69.35 million shares over the next eight years. Adding that to the current share count of 169.76 million shares yields total shares outstanding of 236.85 million shares. If you set the cash flows in years 1-8 to zero and compute the value of equity, you arrive at a value of equity of $48,282 million, which can be divided by the 239.11 million shares to arrive at a value per share of $201.92. This is slightly higher than the value that I obtained in the cash flow approach, but it is partly because I have assumed an issuance price that is higher than the intrinsic value.

      But Never Do This: Reviewing the two approaches, you can either incorporate the present value of the negative cash flows into the value of operating assets today and use the current share count, in estimating value per share, or you can try to forecast expected future share issuances and divide the present value of only positive cash flows by the enhanced share count to get to value per share. You cannot do both, because you are then reducing value per share twice for the same phenomenon, once by discounting the negative cash flows and including them in value and then again by increasing the share count for the shares issued to cover those negative cash flows.

      Share Based Compensation (SBC)
      The Cause: Over history, businesses have used equity to compensate employees, either to align incentives or because they lack the cash to pay competitive wages. That said, the use of share based compensation exploded in the 1990s due to two reasons. The first was an ill-conceived attempt by the US Congress to put a cap on management compensation, while not counting options granted as part of that compensation. Not surprisingly, many firms shifted to using options in compensation packages. The second was the dot com boom, where you had hundreds of young companies that had sky high valuations but no earnings or cash flows; these companies used options to attract and keep employees. Aiding and abetting these firm, in this process were the accountants, who chose not to treat these option grants as expensed at the time they were granted, and thus allowed companies to report much higher income than they were truly earning.

      The Consequence: As companies shifted to share based compensation, there were two side effects that analysts had to deal with, when valuing them. The first was the drag on per-share value created by past option and share grants to employees, with options, in particular, creating trouble, since they could create dilution, if share prices went up, but could be worthless, if share prices dropped. The second was the question of how to factor in expected option and share grants in the future, since the value of these grants would be affected by expected future share prices. As with the dilution question, analysts faced a circular reasoning problem, where to value a share today, you had to make forecasts of the value per share in future years.

      The Right Response: To deal with share based compensation correctly, you have to break it down into two parts:
      1. Past option and share grants: If you own shares in a company, the shares and options granted by the firm in prior years to employees represent claims on the equity, that reduces your value per share. The shares issued in the past are simple to deal with, since adding them to the share count will reduce the value per share today. The fact that employees have to vest (which requires staying with the firm for a specified time period) and that the shares have restrictions on trading can make them less valuable than unrestricted shares, but that is a relatively small problem. The options that have been granted in the past are a bigger challenge, since they represent potential dilution, but only if the share price rises above the exercise price. Option pricing models are designed to capture the probabilities of  this happening and can be used to value options, no matter how in or out of the money the options are. In an intrinsic valuation, you should value these options first (using an option pricing model) and net the value out of the estimated value of equity, before dividing by the existing share count :
      • SBC Adjusted Value per share = (DCF Value of Equity - Value of Employee Options)/ Share count today including restricted shares
      Note that the shares that will be created if the options get exercised should not be included in share count, in this approach, since that would be double counting.
      2. Expected future grants: To the extent that a company is expected to continue to compensate its employees with options or restricted shares in future years, the most logical way to deal with these grants is to treat them as expenses in future years, and reduce expected income and cash flows. Rather than grapple with expected future share prices, you should estimate the expenses (associated with SBC) as a percent of revenues, and use that forecast as the basis for expenses in the future. Until accounting came to its senses in 2004 and required companies to expense share based  compensation at the time of grant, this was an onerous exercise for analysts, since it required estimating the value of option and share grants in past years to get historical numbers on the value of SBC grants. With the prevalent accounting rules in both GAAP and IFRS, the earnings that you see for companies should already be adjusted for SBC expenses and reported income should therefore give you a fair basis for forecasting. (The operating and net margins that I report by sector, on my website, are margins after stock based compensation expenses). At first sight, it may seem like double counting to lower future earnings because you expect option and share grants in the future, and then again lower the value of equity that you obtain by the value of options that are already outstanding. It is not, since we are dealing with two separate issues. A company that has had a history of stock based compensation, but has decided to suspend using SBC in the future, will be affected by only the second adjustment, whereas a company that has never used share based compensation in the past but plans to use it in the future, will be affected only by the former. A company that has share based compensation in its past and expects to use it in the future will be affected by both adjustments.

      Tesla uses stock based compensation, and its most recent annual and quarterly statements provide a measure of the magnitude.
      Tesla 10K for 2017 and Tesla 10Q, First Quarter 2018
      The compensation can take the form of restricted stock or options, and the annual filing provides the cumulative effect of this share based activity. At the end of 2017, according to Tesla's 10K, the company had 10.88 million options outstanding, with a weighted average exercise price of $105.56 and a weighted average maturity of 5.30 years and 4.69 million restricted shares. The restricted shares are already included in the share count of 169.76 million shares, but the options need to be accounted for. We value the options, using a modified version of the Black-Scholes model, to arrive at a value of $2,927 million. Netting this value out of the value of equity that we obtained from the cash flows allows us to get to a corrected value per share:
      Download Tesla valuation
      The value per share, after adjusting for options, is $171.99. There is an elephant in the room in the form of a gigantic grant of 20.26 million shares to Elon Musk, with the issuance contingent on meeting operating milestones (revenues and adjusted EBITDA) and market milestones (market capitalization). The complexity of the vesting schedule on this grant makes it difficult to value using option pricing models, but the effect of this looming grant is to lower value per share today and here is why. If Tesla succeeds in growing revenues and turning to profitability, these option grants will vest, creating large expenses in the year in which that occurs and putting downward pressure on margins. In making my forecasts of future margins for Tesla, I have been more conservative at least in the early years, simply for this reason.

      A Sloppy Alternative: There is an alternative approach to deal with options outstanding from past grants. They value options at their exercise value, i.e., the difference between the stock price and strike price today, and ignore out of the money options. This is called the treasury stock approach and the value of equity per share in this approach can be written as follows:
      Treasury Stock Value per share = (DCF value of equity + Exercise Price * # Options outstanding) / (Share Count today + Options Outstanding)
      By ignoring the time premium on options, this approach will over value shares today and by ignoring out of the money options, you exacerbate the problem. In the case of Tesla, using the exercise stock approach would yield the following value per share:
      Treasury Stock Value per share (Tesla) = ($32,124 + $105.56 * 10.88) / (169.76 + 10.88) = $184.19
      The analysts who use this approach often justify it by arguing that option pricing models can yield noisy estimates, but even the worst option pricing model will outperform one that assumes that options trade at exercise value.

      And Nonsensical Practices: There are two woefully bad practices, when it comes to stock based compensation, that should be avoided. The first is to just adjust the share count for options  outstanding and make no other changes. In this "fully diluted" approach, you are counting in the dilution that will arise from option exercise but ignoring the cash that will come into the firm from the exercise.

      • Fully Diluted Value per share =  DCF value of equity / (Share Count today + Options Outstanding)
      With Tesla, for instance, this approach would yield the following:

      • Fully Diluted Value per share (Tesla) = $32,124/ (169.76 + 10.88) = $177.83
      This approach will yield too low a value per share, and especially so if you count out of the money options as well in the denominator. The second and even more indefensible practice is to add back share based compensation to earnings to get to adjusted earnings. The rationale that is offered for doing so is that share based compensation is a non-cash expense, a dangerous bending of logic, since it allows companies to use in-kind payments (shares, services) to evade the cash flow test. Using this logic, Tesla would add back the $141.6 million they had in share-based compensation expenses to their income in the first quarter of 2018 and report lower losses. Carried into future forecasts, this will inflate future earnings and cash flows, pushing up estimated value. Since these two bad practices push value away from fair value in different directions, the only logic for their continued use is that, in combination, the mistakes will magically offset each other. Good luck with that!

      Shares with different rights
      The Cause: Founders and families who take their companies public have always wanted to have their cake and eat it too, and one way in which they have been able to do so is by creating different share classes, usually built around voting rights. The founder/family hold on to the higher voting right shares and thus maintain control of the company, while selling off large shares of equity to the public, and cashing out. In the United States, shares with different voting rights were rare for much of the last century, primarily because the New York Stock Exchange, which was the preferred listing place for companies, did not allow them. Again, the tech boom of the 1990s changed the game, by making the NASDAQ, which had no restrictions on shares with different voting rights, an alternative destination, especially for large technology companies. The floodgates on shares with different voting rights opened up with the Google listing in 2004, and the Google model, with shares with different voting rights, has become the default model for many of the tech companies that have gone public in the last decade.

      The Consequence: When you have different classes of shares, with different voting rights, you have two effects on value. The first is a corporate governance effect, since changing management becomes much more difficult, and that can affect how you value and view badly managed firms. The second is a unit problem, since a voting right share and a non-voting right share represent different equity claims and cannot be treated as having the same value. Thus, you can no longer divide the aggregate value of equity by the total number of shares outstanding.

      The Right Response: When valuing firms with different voting rights, you have to deal with it in two steps. When valuing the firm, you have to incorporate the fact that changing management is going to be more difficult to do in your estimates. Thus, if you firm borrows no money (even though it can lower its cost of capital by moving to an optimal or target debt ratio fo 40%), you should leave the debt ratio at zero rather than change it. This will lower the value that you estimate for the operating assets and equity in the firm. Once you have the value of equity, you will have to make a judgment on how much of a premium you would expect the voting shares to trade at, relative to non-voting shares, in one of two ways. In the first, you can look at studies of voting shares in publicly traded companies in the US and Europe, which find a premium of between 5-10% for voting shares, and use that premium as your base number. In the second, you can use an approach that uses intrinsic valuation models to estimate the premium, which I describe in my paper on valuing control. Once you have the estimate, you can use algebra to complete your estimate of value per share. 
      Value per non-voting share = Aggregate Value of Equity/ (# Non-Voting Shares + (1+ Voting Share Premium) # Voting Shares)
      For example, if the value of equity is $210 million, there are 50 million non-voting shares and 50 million voting shares and the voting share premium is 10%, your value per non-voting share will be:
      Value per non-voting share = 210/ (50+ 1.1*50) = $2.00/share
      Value per voting share = $2.00 (1.10) = $2.20/share

      The Bottom Line
      I know that some of you will view this post as nit-picking, but you will be surprised at how much of an effect on value you can have by not being careful about share count. Those of you who use multiples (PE, EV/EBITDA) may be secretly happy that you don't have to deal with the issues of share count, since you don't do discounted cash flow valuations. Unfortunately, that is not true. Dilution, share based compensation and shares with different rights are just as much an issue when you compare multiples across companies, and ignoring them or using short cuts (like full dilution) will only skew your comparisons and lead to mis-pricing stocks. I would suggest four general rules:
      1. Aggregate versus Per-share numbers: Given how dilution and options can play havoc with share count, it is better to use aggregate than to use per share numbers, in valuation and in pricing. Thus, to obtain PE, divide the market capitalization of the company by its total net income, rather than price per share by earnings per share.
      2. When SBC is rampant, control for differences: If the use of restricted stockand options vary widely across sector, you need to control for those differences when comparing pricing in the sector. If you do not, companies that have large option overhangs will look cheap, relative to those that do not.
      3. Don't use SBC adjusted earnings: Adjusting earnings and EBITDA, by adding back stock based compensation, is an abomination, used by desperate companies and analysts to show you that they are making money, when they are not even close. Don't fall for the sleight of hand.
      4. With forward multiples, check on and control for dilution: Analysts, when valuing young companies, often divide today’s market capitalization or enterprise value by expected revenues or EBITDA in the future. The dilution that will be needed to get to future EBITDA has to be brought into the equation.
      YouTube Video


      Spreadsheets
      1. Tesla Valuation (June 2018)
      2. Tesla Dilution 
      Blog Posts on Tesla
      1. A Tesla  2017 Update: A Disruptive Force and a Debt Puzzle
      2. Twists and Turns in the Tesla Story: A Boring, Boneheaded Update!



      Deja Vu In Turkey: Currency Crisis and Corporate Insanity!

      This has been a year of rolling crises, some originating in developed markets and some in emerging markets, and the market has been remarkably resilient through all of them. It is now Turkey's turn to be in the limelight, though not in a way it hoped to be, as the Turkish Lira enters what seems like a death spiral, that threatens to spill over into other emerging markets. There is plenty that can be said about the macro origins of this crisis, with Turkey's leaders and central bank bearing a lion's share of the blame, but that is not going to be the focus of this post. Instead, I would like to examine how Turkish business practices, and the willful ignorance of basic financial first principles, are making the effects of this crisis worse, and perhaps even catastrophic. 

      The Turkish Crisis: So far!
      The Turkish problem became a full fledged crisis towards the end of last week, but this is a crisis that has been brewing for months, if not years. It has its roots in both Turkish politics and dysfunctional practices on the part of Turkish regulators, banks and businesses, and has been aided and abetted by investors who have been too willing to look the other way. The most visible symbol of this crisis has been the collapse of the Turkish Lira, which has been losing value, relative to other currencies, for a while, capped off by a drop of almost 15% last Friday (August 10):
      Yahoo! Finance
      While it is undoubtedly true that the weaker Lira will lead to more problems, currency collapses are symptoms of fundamental problems and for Turkey, those problems are two fold. One is a surge in inflation in the Turkish economy, which can be seen in graph below:

      While it easy to blame the Turkish central bank for dereliction of duty, it has been handicapped by Turkey's political leadership, which seems intent on making its own central bank toothless. Rather than allow the central bank to use the classic counter to a currency collapse of raising central bank-set interest rates, the government has put pressure on the bank to lower rates, with predictable (and disastrous) consequences.

      Corporate Finance: First Principles
      I teach both corporate finance and valuation, and while both are built on the same first principles, corporate finance is both wider and deeper than valuation since it looks at businesses from the inside out. i.e., how decisions made a firm's founders/managers play out in value. In my introductory corporate finance class, I list out the three common sense principles that govern all businesses and how they drive value:
      The financing principle operates at the nexus of investing and dividend principles and choices you make on financing can affect both investment and dividend policy. It is true that when most analysts look at the financing principle, they zero in on the financing mix part, looking at the right mix of debt and equity for a firm. I have posted on that question many times, including the start of this year as part of my examination of global debt ratios, and have used the tools to assess whether a company should borrow money or use equity (See my posts on Tesla and Valeant). There is another part to the financing principle, though, that is often ignored, and it is that the right debt for a company should mirror its asset characteristics. Put simply, long term projects should be funded with long term debt, convertible debt is a better choice than fixed rate debt for growth companies and assets with cash flows in dollars (euros) should be funded with dollar (euro) debt. The intuition behind matching does not require elaborate mathematical reasoning but is built on common sense. When you mismatch debt (in terms of maturity, type or currency) with assets, you increase your likelihood of default, and holding debt ratios constant, your cost of debt and capital.
      In effect, your perfect debt will provide you with all of the tax benefits of debt while behaving like equity, with cash flows that adapt to your cash flows from operations.

      There are two ways that you can match debt up to assets. The first is to issue debt that is reflective of your projects and assets and the second is to use derivatives and swaps to fix the mismatch. Thus, a company that gets its cash flows in rupees, but has dollar debt, can use currency futures and options to protect itself, at least partially, against currency movements. While access to derivatives and swap markets has increased over time, a company that knows its long term project characteristics should issue debt that matches that long term exposure, and then use derivatives & swaps to protect itself against short term variations in exposure.

      Turkey: A Debt Mismatch Outlier?
      The argument for matching debt structure (maturity, currency, convertibility) to asset characteristics is not rocket-science but corporations around the world seem to revel in mismatching debt and assets, using short term debt to fund long term assets (or vice versa) and sometimes debt in one currency to fund projects that generate cashflows in another. In numerous studies, done over the decades, looking across countries, Turkish companies rank among the very worst, when it comes to mismatching currencies on debt, using foreign currency debt (Euros and dollars primarily) to fund domestic investments. 

      Lest I be accused of using foreign data services that are biased against Turkey, I decided to stick with the data provided by the Turkish Central Bank on the currency breakdown of borrowings by Turkish firms. In the chart below, I trace the foreign exchange (FX) assets and liabilities, for non-financial Turkish companies, from 2008 and 2018:
      Central Bank of Turkey
      The numbers are staggeringly out of sync with  Turkish non-financial service companies owing $217 billion more in foreign currency terms than they own on foreign currency assets, and this imbalance (between foreign exchange assets and liabilities) has widened over time, tripling since 2008.

      I am sure that there will be some in the Turkish business establishment who will blame the mismatching on external forces, with banks in other European countries playing the role of villains, but the numbers tell a different story. Much of the FX debt has come from Turkish banks, not German or French banks, as can be seen in the chart below:
      Central Bank of Turkey
      In 2018, 59% of all FX liabilities at Turkish non-financial service firms came from Turkish banks and financial service firms, up from 39% in 2008. The mismatch is not just on currencies, though. Looking at the breakdown, by maturity, of FX assets and liabilities for Turkish non-financial service firms, here is what we see:
      Central Bank of Turkey
      In May 2018, while about 80% of FX assets are Turkish non-financial firms are short term, only 27% of the FX debt is short term, a large temporal imbalance.

      It is possible that the Turkish government may be able to put pressure on domestic banks to prevent them from forcing debt payments, in the face of the collapse of the lira, but looking at when the debt owed foreign borrowers comes due (for both Turkish financial and non-financial firms), here is what we see.
      Central Bank of Turkey
      From a default risk perspective, though, the debt maturity schedule carries a message. About 50% of debt owed by Turkish banks and 40% of the debt owed by Turkish non-financial service companies will be coming due by 2020, and if the precipitous drop in the Lira is not reversed, there is a whole lot of pain in store for these firms.

      Rationalizing the Mismatch: The Good, The Dangerous and the Deadly
      Turkish firms clearly have a debt mismatch problem, and the institutions (government, bank regulators, banks) that should have been keeping the problem in check seem to have played an active role in making it worse. Worse, this is not the first time that Turkish firms and banks will be working through a debt mismatch crisis. It has happened before, in 1994, 2001 and 2008, just looking at recent decades. If insanity is doing the same thing over and over, expecting a different outcome, there is a good case to be made that Turkish institutions, from top to bottom, are insane, at least when it comes to dealing with currency in financing. So, why do Turkish companies seem willing to repeat this mistake over and over again? In fact, since this mismatching seems to occur in many emerging markets, though to a lesser scale, why do companies go for currency mismatches? Having heard the rationalizations from dozens of CFOs on every continent, I would classify the reasons on a spectrum from acceptable to absurd.

      Acceptable Reasons
      There are three scenarios where a company may choose to mismatch debt, borrowing in a currency other than the one in which it gets its cash flows.
      1. The mismatched debt is subsidized: If the mismatched debt is being offered to you (the borrower) at rates that are well below what you should be paying, given your default risk, you should accept that mismatched debt. That is sometimes the case when companies get funding from organizations like the IFC that offer the subsidies in the interests of meeting other objectives (such as increasing investment in under developed countries). It can also happen when lenders and bondholders become overly optimistic about an emerging market's prospects, and lend money on the assumption that high growth will continue without hiccups.
      2. Domestic debt markets are moribund: There are emerging markets where the only option for borrowing money is local banks, and during periods of uncertainty or crisis, these banks can pull back from lending. If you are a company in one of these markets and have the option of borrowing elsewhere in the world to fund what you believe are good investments, you may push forward with your borrowing, even though it is currency mismatched.
      3. Domestic debt markets are too rigid: As you can see from the debt design section, the perfect debt for your firm will often require tweaks that include not only conversion and floating rate options, but more unusual tweaks (such as commodity-linked interest rates). If domestic debt markets are unwilling or unable to offer these customized debt offerings, a company that can access bond markets overseas may do so, even if it means borrowing in a mismatched currency.
      In all three cases, though, once the money has been borrowed, the company that has mismatched its debt should turn to the derivatives and swap markets to reduce or eliminate this mismatch.

      Dangerous Reasons
      There are two reasons that are offered by some companies that mismatch debt that may make sense, on the surface, but are inherently dangerous:

      1. Speculate on currency: Mismatching currencies, when you borrow money, can be a profitable exercise, if the currency moves in the right direction. A Turkish company that borrows in US dollars, a lower-inflation currency with lower interest rates, to fund projects that deliver cashflows in Turkish Lira, a higher-inflation currency, will book profits if the Lira strengthens against the US dollar. Since emerging market currencies can go through extended periods of deviation from purchasing power parity, i.e., the higher inflation emerging market currency strengthens (rather than weakening) against the lower inflation developed market currency, mismatching currencies can be profitable for extended periods. There will be a moment of reckoning, in the longer term, though, when exchange rates will correct, and unless the company can see this moment coming and correct its mismatch, it will not only lose all of the easy profits from prior periods, but find its survival threatened. Currency forecasting is a pointless exercise, even when practiced by professional currency traders, and I think that companies should steer away from the practice.
      2. Everyone does it: I have argued that many corporate finance practices are driven by inertia and me-tooism rather than good sense, and in many countries where currency mismatches are common, the standard defense is that everyone does it. Many of these companies argue that the government cannot let the entire corporate sector slide into default and will step in to bail them out, and true to form, governments deliver those bailouts. In effect, the taxpayers become the backstop for bad corporate behavior.
      Bad Reasons
      I am surprised by some of the arguments that I have heard for mismatching debt, since they suggest fundamental gaps in basic financial and economic knowledge.

      1. The mismatched debt has a lower interest rate:  I have heard CFOs of companies in emerging markets, where domestic debt carries high interest rates, argue that it is cheaper to borrow in US dollars or Euros, because interest rates are lower on loans denominated in those currencies. After all, it is cheaper to borrow at 5% than at 15%, right? Not necessarily, if the 5% rate is on a US dollar debt and the 15% debt is in Turkish Lira, and here is why. If the expected inflation rate in US dollars is 2% and in Turkish Lira is 14%, it is the Turkish Lira debt that is cheaper.
      2. Risk/Reward: There are some companies that fall back on the proposition that mismatching debt is like any other financial choice, a trade off between higher risk and higher reward. In other words, their belief is that they will earn higher profits, on average and over time, with mismatched debt than with matched debt, but with more variability in those profits. This argument stems from the misplaced belief that markets reward all risk taking, when the truth is that senseless risk taking just delivers more risk, with no reward, and mismatching debt is senseless.
      The Fix
      It is too late for Turkish companies to fix their debt problem for this crisis, but given that this crisis too shall pass, albeit after substantial damage has been done, there are actions that we can take to keep it from repeating, though it will require everyone involved to change their ways:
      • Governments should stop enabling debt mismatching, by not stepping in repeatedly to save corporates that have mismatched debt. That will increase the short term pain of the next crisis, but reduce the likelihood of repeating that crisis. 
      • Bank Regulators should measure how much the banks that they regulate have lent out to corporates, in mismatched debt, and require them to set aside more capital to cover the inevitable losses. That, in turn, will reduce the profitability of lending out money to companies that mismatch.
      • Banks have to incorporate whether the debt being taken by a business is mismatched in deciding how much to lend and on what terms. The interest rates on mismatched debt should be higher than on matched debt.
      • Companies and businesses have to consider what currency a loan or bond is in, when evaluating interest rates, and in their own best interests, try to match up debt to assets, either directly (in debt design) or using derivatives.
      • Investors in companies should start breaking down the profitability of firms with mismatched debt, especially in good periods, into profits from debt mismatch and profits from operations, and ignore or at least discount the former, when pricing these companies.
      I don't think any of these changes will happen overnight but unless we change our behavior, we are designed to replay this crisis in other emerging markets repeatedly. 

      YouTube Video


      Data

      1. FX Assets & Liabilities of Turkish non-financial corporations (from Turkish Central Bank)
      2. Loans from Abroad to Turkish Private Sector

      Papers

      1. Financing Innovations and Capital Structure Choices



      The Privatization of Tesla: Stray Tweet or Game Changing News

      After my last two posts in Tesla, I was planning to take a break from the company, since I had said everything that I had to say about the company. In short, I argued that Tesla, notwithstanding its growth potential, was over valued and that to deliver on this potential, it would need to raise significant amounts of capital in the next few years. In an even earlier post, I described Tesla as the ultimate story stock, both blessed and cursed by having Elon Musk as a CEO, a visionary with a self destructive streak.  Even by Musk's own standards, his tweet on August 7 that Tesla would be going private, adding both a price ($420) and a postscript (that funding had been secured), was a blockbuster, pushung the stock price up more than 10% for the day. The questions that have followed have been wide ranging, from whether Tesla is a good candidate for  "going private" to the mechanics of how it will do so (about funding and structure) to the legality of conveying a market-moving news story in a tweet. 

      1. Public to Private - The Why
      When we talk about transitions between private and public market places, we generally tend to focus on private companies going public. That is because it is natural and common for a small, privately owned business, as it grows larger, to move to public markets, with an initial public offering. That said, there are publicly traded companies that seem to move in reverse and go back to being privately run businesses, as Tesla may be proposing to do. 

      The Trade Off
      To understand both transitions, the more-common private to public and the less-frequent public to private, let us consider the trade off between being a private business and a publicly traded company, from the perspective of the business:
      Private versus Public: Business Perspective

      The simple summary is that as a private company's need to access capital increases, it will accept more information disclosure and a more outsider-driven corporate governance structure, and make the transition to being a public company.  In recent years, the market for private equity has broadened and become deeper, allowing companies to stay private for far longer; Uber, for instance, is worth tens of billions of dollars and is still a private company. To fully understand the transitions, though,  we also have to look at the choice from the perspective of investors:
      Private versus Public: Investor Perspective
      In the classic structure of going public, private firms raise money from venture capitalists who accept less liquidity, but structure their equity investments to often get more protection and a bigger say in how the company is run. It is the desire for liquidity that makes venture capitalists push private companies to go public, so that they can cash out their investments. To be able to negotiate better disclosure and control, private company investors have to be investing larger amounts, and it is one reason that regulatory authorities have been wary of allowing small investors to invest in private companies, since they may end up with the worst of all worlds: illiquid investments in businesses, where they have no say in how the company is run, and no information about how well or badly it is doing.

      The Public to Private Transition
      With this trade off in mind, why would a public company choose to go back to being a private business? This transition makes sense if a company feels that the easier access to capital and a continuously set market price (which delivers liquidity), two features of public markets, no longer provide it with sufficient benefits, and/or the costs of disclosure and outsider intervention (from activist investors), that also come with being a public company, increase. In short, it has to be a company:
      • that does not need access to large amounts of new capital to continue operating,
      • where the market is under pricing the company, relative to its intrinsic value ,
      • that feels the actions that it needs to take in its best long term interests will either create public backlash (layoffs and plant closures) or adverse market reactions (because of the effect that they will have on metrics that investors are focused upon).
      It should come as no surprise that most companies that have gone through the public-to-private transition have been aging companies (no growth, no capital needed), trading at prices that are below their peer group (lower multiples of earnings or cash flows) and that need to shrink or slim down to keep operating.

      The Tesla Case
      As I look at the list of criteria for a good buyout company, I see nothing that would bring Tesla onto my radar as a potential candidate:
      1. It is a growing company and it needs new capital to not only deliver on its growth promise but to survive for the next few years. If you are more optimistic than I am about Tesla, you may disagree with how much cash the company will have to raise to keep going, but I challenge even the most hardened optimist to tell me how the company will be able to increase production to a million cars or more without investing mind blowing amounts in new capacity.
      2. If markets are punishing Tesla by under pricing the company, they are doing so in a very strange manner, giving it a higher market capitalization than much larger, more profitable automobile companies, ignoring large losses and generally tolerant of Elon Musk's errant behavior. In fact, if the critique of markets is that they are short term and focused on profits, Tesla would be the perfect counter example.
      3. It is true that there was substantial drama and market volatility around the 5000 cars/week production target, and there may be some in the company who have the drawn the lesson that since there will be more production targets to come in the future, the company needs to operate out of market scrutiny. That would be the wrong lesson, since almost all of the drama in this episode, from setting the target (5000 cars/week) to the constant tweets about whether the targets would be met, was generated by Elon Musk, not the market. In fact, a cynic would argue that by focusing the market's attention on this short term target, Tesla has been able to avoid answering much bigger questions about its operations.
      There are, of course, the short sellers in Tesla and Musk's frustration with them was clearly a driver of his "going private" tweet. His argument, which many of his supporters buy into, is that short sellers in public markets make money from seeing stock prices go down, and that some of them may do real damage to companies, because of this incentive. I will not dismiss this complaint, but I will come back to it later in this post, since I do think it is playing an outsized role in this process.

      Public to Private - The Funding
      When you decide to take a publicly traded company into the privately owned space, you have to replace the public capital (public equity and debt) with new capital that can be either private equity or new debt. 

      The key questions then become what mix of debt and equity to use, how to raise the private equity needed to get the deal done and what the ultimate end game is in the transaction. Specifically, you may take a company private, because you want to control its destiny fully, and keep tit a private business in perpetuity. More often, though, the end game is to make the changes that you think will make the company more attractive to investors, and either take it back public or sell it to another public company.

      The Analysis
      If the company in question fits the buyout mold, i.e., it is an aging company with a lower market capitalization, relative to earnings and cash flows, than its peers, the going private transaction can be funded with a high proportion of debt, explaining why so many buyouts have leverage attached to them, making them leveraged buyouts. 

      Given that the equity investors in the transactions have to give up public market governance tools, it should come as no surprise that in many of these deals, the private equity comes from a single firm, like KKR or Blackstone, with top managers holding some of the private equity, to align interests, after the deal goes through. Success in these deals comes from taking the reconfigured company public again, at a much higher value, leaving equity investors with outsized gains.

      The Tesla Case
      Tesla is a money-losing company, burning through significant amounts of cash. Not only is the company in no position to borrow more, I have argued before that it should not even carry the debt that it does. If this deal is to make sense, it has to be predominantly equity funded, but that does create some challenges. 
      1. The No-pain solution: Musk, in his Tuesday tweets, seems to offer a solution, which, if feasible, would be relatively painless. In his set up, existing shareholders will be allowed to exchange their shares in Tesla, the public company, for shares in Tesla, the private business, and those shareholders who are unwilling to take this offer will sell their shares back to the company at $420/share. In the extreme case, where every existing shareholder takes this offer and if existing debt holders are willing to continue to lend to the new private enterprise, Tesla will need no new funding:

      This would be magical, if you can pull it off, but there are two significant impediments. The first is that the deal may not pass legal muster, since the SEC restricts private companies to having less than 2000 shareholders, and Tesla has far more than that number. It is true that you might be able to create a fund that has individual shareholders, which then holds equity in the private company, like Uber has, but that fund is restricted to very wealthy, big investors, and the SEC may be unwilling to go along with a structure where there are thousands of small stockholders in the fund. The second is that even if Tesla manages to get regulatory approval for this unconventional set up, many shareholders may choose to cash out at $420, if the company goes private, even if they think that the shares are worth more, because they value liquidity.
      2. A Deep-pocketed Outsider: The announcement that the Saudi Sovereign fund had invested $2 billion in Tesla shares came just before Musk's "going private" tweet, setting up a second possibility, which is the a large private equity investor (or several) would step in to fund the deal. Here, Tesla's large market capitalization and cash burning status work against it, reducing the number of potential players in the game. At the limit, if all existing shareholders, other than Musk, cash out at $420/share, you would need about $55-$60 billion in funding. No sovereign fund or passive investment vehicle can afford to have that much money tied up in one company, and especially one that is illiquid and will need more capital infusions in the future. Even the biggest private equity and venture capital investors, generally more willing to hold concentrated positions, will be hard pressed to put this much capital, for the same reasons. In fact, the only name that you can come up with that has even the possibility of pulling this off is Softbank, for three reasons:
      • They may be big enough to make the investment. As a publicly traded company with a market capitalization of $103 billion, making a $55-60 billion additional investment in Tesla would be a reach, but Softbank is capable of drawing other investors of its ilk into the funding.
      • They have and are invested in young, growth companies: Unlike traditional PE investors whose focus has been on doing leveraged deals of cash-rich companies, Softbank has invested successfully in growth companies, many of whom continue to burn through cash.
      • They have a history with Tesla: There were rumors last year that Tesla and Softbank had talked about taking the company private, but control disagreements caused negotiations to break down.
      That said, I am not sure that Elon Musk and Masayoshi Son (Softbank's CEO) can co-exist in the same company. Both value control, and both are unpredictable, and I have to confess that watching the two tango would make for great entertainment.
      3. A Corporate Investor:  There is one final possibility that I considered and it is that a corporation with deep pockets would provide the money needed to take Tesla private. Given how much money is needed, the list of potential buyers is small and perhaps restricted to the large tech companies - Apple and Google. While they have the cash and perhaps may even have the interest, Musk's follow up that he would continue to run the company and hold on to his ownership stake strikes me as a poison pill that no corporation will want to swallow.

      It is at this point that the "secured funding" claim that Musk made in his initial tweet comes into question. If the statement is true, he has either found an inept bank that will lend tens of billions to a money losing company with an undisciplined CEO, or a private equity investor who is willing to make the largest PE investment in history, while allowing Musk to continue running the company, with no checks and balances. If the statement is false, we will be seeing lawyers debating the meaning of the words "secured" and "funding" for a while.

      Occam's Razor: A simpler explanation
      This entire post has been premised on the notion that Elon Musk had done his homework and that he intended to send a serious signal to markets about a future buyout. Given Musk's history of impetuous and personal tweets, that premise might be completely wrong, in which case the explanation for this episode may be far simpler and rooted in the war with short sellers that Musk has been fighting for a while.  Musk is convinced, rightly or wrongly, that short sellers in Tesla are conspiring to bring not just the stock price, but the entire company, down. While there are short sellers in every publicly traded company, including the most successful in market capitalization (Apple, Facebook, Google, Amazon), Tesla is an outlier in terms of the short selling on two fronts:
      • It has a CEO who is obsessed with short selling and spends a disproportionate amount of his time and attention on bringing them down. So, it is true that short sellers are a distraction to the company, but only because Elon Musk has made it so. 
      • On the other side, many of the short sellers in Tesla seem to be just as obsessed with Musk and  are convinced that he is a scam artist. I have a sneaking feeling that for many of them, winning will mean not just making money on their Tesla positions, but seeing the company cease to exist (and taking Musk down with it). On my Tesla valuation from a few weeks ago, it is telling that the most heated responses that I got were not from Tesla bulls, accusing me of being too pessimistic, but from Tesla short sellers, arguing that I was being over valuing the company, even though my assessed value per share was half the prevailing price.
      Investing is a difficult game, to begin with, but it becomes doubly so, when it becomes personal. Just as it is dangerous to fall in love with a company that you have invested in, it is just as dangerous to bet against a company because you hate its management and want it to fail. I think both sides of the Tesla short selling game are so infected with personal bias that they may do or say things that are not in their best long term investing interests. That is why I hope, for Tesla's sake, that Musk's personal dislike of short sellers did not lead him to tweet out that Tesla would go private. with both the price ($420) and the "secured funding" being spur of the moment inventions. In his zeal to make short sellers pay, he may have handed them the weapon they need to bring him down. I know that Tesla's board has backed Musk, saying that he had opened a discussion about going private with the board, but since no mention is made of a price or funding, and given how ineffective and craven this board has been over the last few years, I cannot attach much weight to this backing.

      Bottom Line
      There are publicly traded companies where going private is not only an option, but a value-increasing one, but Tesla is not one of them. As with so much else that the company has done over its history, from its acquisition of Solar City to borrowing billions of dollars to this talk of going private, it is not the action per se that is inexplicable, it is that Tesla is not the company that should be taking the action. The drama will undoubtedly continue, and in a world where we get much our entertainment from reality shows, the Elon Musk show is on top of my list of must-watch shows.

      YouTube Video

      Blog Posts on Tesla
      Paper on Going Private



      Country Risk: A Midyear Update for 2018

      While political and trade wars are brewing around the world, centered on globalization, the enduring truth is that the globalization genie is out of the bottle, and no political force can put it back. Encouraged to spread their bets around the world, investors have shed some of the home bias in their investing and added foreign equities to their portfolios. Even those that have stayed invested with companies in their own markets are finding that those companies derive large chunks of their revenues from foreign markets. In short, there is no place to hide from assessing global risk and analysts who bury their head in the sand are missing large parts of the big picture. In this post, I revisit the assessments of country risk that I have made every year for the last 25 years and reiterate how to use those assessments when valuing companies or analyzing projects. The full version of this post is a paper that you can download and read, but I have to warn you that I am verbose and it is more than a hundred pages long.

      The Fundamentals of Country Risk
      So, what makes investing or operating in one country more or less risky than another? Most business people point to three factors. The first is the prevalence of corruption in a country, with the corrosive influences it has on business practices and financial reports. The second is the increased exposure to violence from war or terrorism in some parts of the world, creating not just additional operating costs (for insurance and protection) but also the real possibility of a complete loss of the business. The third is the legal system for enforcing property rights, since a share in even the most valuable business in the world is worth little or nothing, if property rights are ignored or violated on a whim. In this section, we will look at the state of the world on these three dimensions.

      I. Corruption
      Why we care: Operating in an environment where corruption and bribery are accepted as common practice has two consequences for value. 
      1. It is a hidden tax: You can view the cost of corruption as a hidden tax, paid not directly to the government but to its functionaries to get business done. As a consequence, the effective tax rate that a company pays in a corrupt economy will be much higher than the statutory tax rate. Since it is not legal for companies to pay bribes in much of the developed world, it is not explicitly reported as such in the financial statements but it is a drain on income, nevertheless.
      2. It can be a competitive advantage or disadvantage: In many corrupt economies, there are companies that are not only more willing but are also more efficient at playing the corruption game, giving them a leg up on businesses that face moral or legal restrictions on playing the game.
      Global differences: While businesses are quick to attach labels to entire regions of the world, there are entities that try to measure corruption in different parts of the world, using more objective measures. Transparency International, for instance, has a corruption index that it has developed and updates every year, with lower scores indicating more corruption and higher scores less. The mid-2018 picture on how different countries measure up is below:
      For heat map and for raw data
      While I am sure that there are some who will look at this chart and attribute the differences to culture, I think that it can be better explained by a combination of poverty and abysmal political governance.

      II. Violence
      Why we care: At the risk of stating the obvious, operating a business is much more difficult, in the midst of violence and war than in safety. There are two consequences. The first is that protecting the business and its employees against the violence is expensive, with more security built into even the everyday practices. To the extent that this protection is not complete, there is the added cost of the destruction wrought by violence. The second is that in extreme cases, the violence can cause a business to fail. It is true that you can insure against some of these events, but that insurance is never complete and its cost will be high and reduce profit margins.

      Global Differences: The news headlines, especially about war and terrorism, give us clues about the parts of the world where violence is most common. To measure exposure to violence, though, it is useful to see indices like the Global Peace Index developed by the Institute for Peace and Economics, with low scores indicating the most and high scores the least violence.
      For heat map and for raw data
      There are some surprises on this score. While some parts of the developed world, like Europe, Canada and Australia are peaceful, the United States, China and the United Kingdom don't score as well.

      III. Private Property Rights and Legal System
      Why we care: In valuation, we value a business or a share in it, on the assumption that that you are entitled, as the owner, to a share of its assets and cash flows. That is true, though, only if private property rights are respected and are backed up a legal system in a timely fashion. As property rights weaken, the claim on the cash flows and assets also weakens, reducing the assessed value, and in extreme circumstances, such as nationalization with no compensation, the value can converge on zero.
      Global Differences: A group of non-government organizations has created an international property rights index, measuring the protection provided for property rights in different countries. In their 2018 update, they measured property rights on three dimensions, legal, physical property and intellectual property, to come up with a composite measure of property rights, by country. The state of the world, on this measure, is in the picture below:
      For heat map and for raw data
      In 2018, property rights were most strongly protected in Oceania (Australia and New Zealand) and North America and were weakest in Africa, Russia and South America.

      IV. Overall Risk Scores
      As you look at the global differences on corruption, violence and property rights, you can see that there are correlations across the measures. Regionally, Africa performs worst on all three measures, but there are individual countries that perform better on one measure and worse on others. Consequently, a composite country risk score that brings together all of these exposures into one number would be useful and there are many services, ranging from public entities like the World Bank to private consultants, that try to measure that score. We will focus on Political Risk Services, a private service, and the picture below captures their measures of composite country risk, by country in July 2018:
      For heat map and for raw data
      There are few surprises here. Eight of the ten riskiest countries in the world, at least according to this measure, are in Africa with Venezuela and Syria rounding out the list. A preponderance of the safest countries in the world are in Northern Europe, though Taiwan and Singapore also make the list. The problem with country risk scores is that there is not only no standardization across services, but it is also difficult to convert these scores into numbers that can be used in financial analysis, either as cash flow or discount rate adjusters.

      Default Risk
      There is one dimension of country risk where measurements have not only existed for decades but are also more in tune with financial analysis and that is sovereign default risk. Put simply, there is a much higher that some countries will default than others, and default risk measures try to capture that likelihood. 

      I. Sovereign Ratings
      Ratings agencies have rated corporate bonds for default risk, using a letter grade system that goes back almost a century. In the last three decades these agencies have turned their attention to sovereign debt, using the same rating system. Between Moody’s and S&P, there were 141 countries that had sovereign ratings, and the picture below captures the differences across countries:
      For heat map and for raw data
      While North America and Europe represent the greenest (and safest) parts of the world, you do see shades of green in some unexpected parts of the world. In Latin America, historically a hotbed of sovereign default, Chile and Colombia are now highly rated. The patch of green in the Middle East includes Saudi Arabia, indicating perhaps the biggest weakness of this country risk measure, which is its focus on the capacity of a country to meet its debt obligations. As an oil power with a small population and little debt, Saudi Arabia has low default risk, but it is exposed to significant political risk. While ratings agencies have been maligned as incompetent and biased, I think that their biggest weakness is that they are too slow to update ratings to reflect changes on the ground. In the last decade, it took almost two years after Greece drifted into trouble before ratings agencies woke up and lower the company’s rating. 

      II. Default Spreads
      To those who are skeptical about ratings agencies, there is a market alternative, which is to look at what investors are demanding as a spread for buying bonds issued by a risky sovereign. That spread can be computed only if the sovereign in question issues bonds in a currency (like the US dollar or Euro) where there is a default free rate (the US treasury bond rate or German Euro bond rate) for comparison. Since there only a few countries where this is the case, it is provident that the sovereign CDS market has expanded over the last decade. This market, where you can buy insurance, on an annual basis, against default risk, has expanded over the last few years and there are now about 80 countries where you can observe the traded spreads. The picture below captures global differences in sovereign CDS spreads:
      For heat map and for raw data

      The sovereign CDS spreads are highly correlated with the ratings, but they also tend to be both more reflective of events on the ground and more timely.

      Equity Risk Premiums
      If you are lending money to a business, or buying bonds, it is default risk that you are focused on, but if you own a business, your exposure to risk is far broader, since your claims are residual. This is equity risk, and if there are variations in default risk across countries, it stands to reason that equity risk should also vary across countries, leading investors and business owners to demand different equity risk premiums in different parts of the world.

      Global Equity Risk Premiums: General Propositions
      As a prelude to looking at different ways of estimating equity risk premiums across countries, let me lay out two basic propositions about country risk that will animate the discussion.

      Proposition 1: If country risk is diversifiable and investors are globally diversified, the equity risk premium should be the same across countries. If country risk is not fully diversifiable, either because the correlation across markets is high or investors are not global, the equity risk premium should vary across markets.
      One of the central tenets of modern portfolio theory is that investors are rewarded only for risk that cannot be diversified away, even if they choose to be non-diversified, as long as the marginal investors are diversified. Building on this idea, country risk can be ignored, if it is diversifiable, and it is this argument that some high-profile companies and consultants used in the 1980s to argue for the use of a global equity risk premium for all countries. The problem, though, is that country risk is diversifiable only if there is low correlation across equity markets and if the marginal investors in companies hold international portfolios. As investors and companies have globalized, the correlation across equity markets has increased, with market shocks running through the globe; a political crisis in Sao Paulo can drag down stock prices in New York, London, Mumbai and Shanghai. Consequently, being globally diversified is not going to fully protect you against country risk and there should therefore be higher equity risk premiums for emerging markets, which are more exposed to global shocks, than developed markets.

      Proposition 2: If there are variations in equity risk premiums across countries, the exposure of a business to that risk should be determined by where the business operates (in terms of producing and selling its goods and services), not where it is incorporated.
      If you accept the proposition that equity risk premiums vary across countries, the next question becomes how best to measure a company or investment's exposure to that risk. Unfortunately, a combination of inertia and bad logic leads many analysts to estimate the equity risk premium for a company from its country of incorporation, rather than where it does business. This is absurd, since Coca Cola, while a US incorporated company, faces significantly more operating risk exposure when it expands into Myanmar or Bolivia than when it invests in Poland. It stands to reason that to measure a company's equity risk premium, you have to look at where it does business.

      Equity Risk Premiums
      The standard approach for estimating equity risk premiums for emerging markets has been to start with the equity risk premium for a mature market, like the US or Germany, and augment it with the sovereign default spread for the country in question, measured either by a sovereign CDS spread or based on its sovereign rating. Since equities are riskier than bonds, I modify this approach slightly by scaling up the default risk for the higher equity risk, using a relative risk measure; the relative risk measure is computed by dividing the standard deviation of equities in emerging markets by the standard deviation of public sector bonds in these same markets:

      My melded approach, using default spreads and equity market volatilities, yields additional country risk premiums slightly larger than the default spreads. In July 2018, for instance, I started with my estimate of the implied equity risk premium of 5.37% for the S&P 500, as my mature market premium. To estimate the equity risk premium for India, I built on the default spread for India, based upon its Moody's rating of Baa2, of2.20%, and multiplied it by the relative equity market scalar of 1.222 yields a country risk premium of 2.69%. Adding this to my mature market premium of 5.37% at the start of July 2018 gives a premium of 8.06% for India. For the two dozen countries, where there are no sovereign ratings or CDS spreads available, I use the PRS score assigned to the country to find other rated countries with similar PRS scores, to estimate default spreads and equity risk premiums. Applying this approach yields the following picture for global equity risk in July 2018:

      Download full spreadsheet

      Incorporating Country Risk in Valuation
      With the estimates of country risk in hand, let's talk about bringing them into play in valuing companies. Staying true to the proposition that risk comes from where companies operate, not where they are incorporated, we confront the question of how best to measure operating exposure. The simplest and most easily accessible is revenue breakdown. For a company like Coca Cola, for instance, with revenues spread across the globe, the equity risk premium would be a weighted average of their regional exposures:
      Coca Cola 10K for 2017
      If the break down of Coca Cola's revenues, by region, strike you as being overly broad, note that this is the only geographical breakdown that the company provides. If there is one area of corporate reporting that requires more clarity and detail, it is this.

      Using revenues to measure risk exposure does open you up to the criticism that while risk can also come from where a company produces its goods and services. This is especially true for natural resource companies, where risk can be traced back to where the company extracts its commodity, not where it sells it. Applying this to Royal Dutch Shell in 2018, for instance, yields the following:
      Royal Dutch Annual Report for 2017
      You could even create a composite weighting that brings into account both revenues and production for a company, if you have the information.

      Incorporate Country Risk In Investment Analysis
      While country risk plays a key role in valuation, it plays an even bigger one in capital budgeting and investment analysis, as multinationals wrestle with comparing investment decisions made in different parts of the world. Using Coca Cola to illustrate, assume that the company is considering making investments in Nigeria, Chile and US and is trying to estimate the "right" cost of equity to use in its assessment. Even if all of the investments are in identical businesses (soft drinks) and are in the same currency (US dollars), the costs of equity will vary across them (the beta for Coca Cola is 0.80 and the risk free rate is 3%):
      • Nigeria project: Risk Free Rate +Beta*  (Nigeria ERP) = 3% + 0.80 (13.15%) = 13.52%
      • Chile project: Risk Free Rate +Beta*  (Chile ERP) = 3% + 0.80 (6.22%) = 7.98%
      • US project: Risk Free Rate +Beta*  (Canada ERP) = 3% + 0.80 (5.37%) = 7.30%
      It is worth noting that many companies still adopt the practice of using the same hurdle rate for investments in different markets and if Coca Cola adopted this practice, they would be using the cost of equity of 8.52%, computed using their weighted average equity risk premium of 6.90%, or worse still a cost of equity of 7.30%, using an equity risk premium of 5.37%, based upon Coca Cola's  country of incorporation,. Consider the consequences of this practice. It will reduce the cost of equity for the Nigerian investment and raise it for the Chilean and  Canadian investments, and over time, it will lead Coca Cola to over invest and over expand in the riskiest markets.

      For a multi-business, multi-national company like Siemens, the estimation becomes even messier, since to estimate the cost of equity for a project, you will need to know not only where the project is situated (to estimate the equity risk premium) but also which business it is in (to get the right beta).

      Incorporating Country Risk In Pricing
      If you don't do intrinsic valuation, but base your investment decisions on pricing metrics (multiples and comparable firms), you may think that you have dodged a bullet, but that relief is fleeting. If equity risk varies across countries, you should also expect to see it show up in PE ratios or EV/EBITDA multiples, with companies in riskier markets trading at lower values. This can be viewed as an argument for finding comparable firms in markets of equivalent risk, but as we saw with Coca Cola and Royal Dutch, that can be difficult to do. In fact, since there are often far fewer companies listed in many emerging markets, you have no choice but to look outside your market for comparable firms, and when you do so, you have to at least consider differences in country risk, when making your judgments. If you do not, and you are comparing publicly traded retailers across Latin America, companies in riskier markets (like Venezuela, Argentina and Ecuador) will look cheap relative to companies in safer markets (like Chile and Colombia).

      YouTube Video


      Papers
      1. Country Risk Premiums: Determinants, Measures and Implications - The 2018 Edition
      Data
      1. Country Risk - Data tables
      2. Equity Risk Premiums, by Country







      Amazon and Apple at a Trillion $: A Follow-up on Uncertainty and Catalysts!

      In my last post, I looked at Apple and Amazon, as their market caps exceeded a trillion dollars, tracing the journey that they took over the last two decades to get to that threshold and valuing them  given their current standing. While you can check out the stories that I told and the details of my valuation in that post, I valued Apple at $200, about 9% less than the market price, and Amazon at abut $1255, about 35% lower than its market price. I concluded the post with a teaser, promising to come back with my decisions on whether I would sell my existing Apple shareholding and/or sell short on Amazon, after reviewing two loose ends. The first is to lay bare the uncertainties inherent in both valuations, to see if there is something in those uncertainties that I can use to make a better decision. The second is to evaluate whether there are catalysts that will convert the gap that I see between value and price into actual profits.

      Facing up to Uncertainty
      One of the recurrent themes in this blog is that we (as human beings) are not good at dealing with uncertainty. We avoid, evade and deny its existence, and in the process end up making unhealthy choices. When valuing companies, uncertainty is a given, a feature and not a bug, and traditional valuation models often give it short shrift. In fact, looking at my valuations of Apple and Amazon, you can see that the only place that I explicitly deal with uncertainty is in the discount rate, and even that process is rendered opaque, because I use betas and equity risk premiums to get to my final numbers. My cash flows reflect my expectations, and even in my moments of greatest hubris, I don't believe that I know, with precision, what will happen to Apple's revenue growth over time or how Amazon's operating margin will evolve in the future. So, why bother? In investing, you have no choice but to make your best estimates and value companies, knowing fully well that you will be wrong, no matter how much information you have and how good your models are. 

      That said, it is puzzling that we still stick with point estimates (single numbers for revenue growth and operating margins) in conventional valuation, when we have the tools to bring in uncertainty  into our valuation judgments. While our statistics classes in college are a distant (and often painful) memory for most of us, there are statistical tools that can help us. While these tools may have been impractical even a decade ago, they are now more accessible, and when coupled with the richer data that we now have, we have the pieces in place to go beyond single value judgments. It is with this objective in mind that I recently updated a paper that I have on using probabilistic and statistical techniques to enrich valuation online, and you can get the paper by going to this link. Consider it a companion to another paper that I wrote a while back, dealing more expansively with uncertainty and healthy ways of dealing with it in investing and valuation.

      Summarizing the probabilistic techniques that may help in valuation, I suggest three: (1) Scenario Analysis, for valuing companies that may have different valuations depending upon specific and usually discrete scenarios unfolding (for example a change in regulatory regimes for a bank or telecommunications company), (2) Decision Trees, for valuing companies that face sequential risk, i.e., you have to get through one phase of risk to arrive at the next one, as is the case with young drug companies that have new drugs in the regulatory pipeline and (3) Monte Carlo Simulations, the most general technique that can accommodate continuous and even correlated risks that you face in valuation, as is the case when you forecast revenue growth and operating margins for Apple and Amazon, in pursuit of their values.

      Simulated Values: Apple and Amazon
      Before delving into the simulations for Apple and Amazon, it is important that we set up the structure of the simulations first by first deciding what variables to build distributions around. While you may be tempted by the power of the tool to make every input (from risk free rates to terminal growth rates) into a distribution, my suggestion is that you focus on the variables that not only matter the most, but where you feel most uncertain. With Apple, the three inputs that I will build distributions around are revenue growth, operating margins and cost of capital. With Amazon, I will add a fourth variable to the mix, in the sales to invested capital, measuring how efficiently Amazon can deliver its revenue growth.

      Apple: A September 2018 Simulation
      I build around my core story for Apple, which is that it will be a slow growth, cash machine, deriving the bulk of its revenues, profits and value from the iPhone, but allow for uncertainty in each of my key inputs:
      1. Revenue growth: While my expected growth rate stays 3%, I allow for a range of growth rates from no growth (flat revenues) , if the iPhone's higher prices cost it signifiant market share) to 6% growth, which would require that Apple find a new growth source, perhaps from services or a new product.
      2. Operating Margin: In my story, I assumed that operating margin would decline to 25% (from  the current 30%) over the next five years. While I still feel that this is the best estimate, I allow for the possibility that competition will be stronger than expected (with margins dropping to 20%), at one end, and that Apple will be able to use its brand name to keep margins at 30%, at the other. 
      3. Cost of capital: My base case cost of capital is 8.20%, reflecting Apple's mix of businesses, but allowing for errors in my sector risk measures and changes in business mix, I build a distribution centered around 8.20% but with a small standard error (0.40%).  
      Since I want to stay market neutral, taking no stand on either the level of interest rates or overall stock prices, I am leaving the ten-year bond rate and equity risk premium untouched. The results of the simulation are below:

      Valuation & Simulation Output
      Note that the median, mean and base case valuations are all bunched up at $200 and that the range in value, using the 10th and 90th percentiles, is tight ($176 to $229).

      Amazon: A September 2018 Simulation
      Moving from Apple to Amazon, my uncertainties multiply partly because my story is of a company that will move into any business where it believes its disruptive platform can deliver results, and there are very few businesses that are immune. Consequently, every input into the valuation is much more volatile, but I will focus on four:
      1. Revenue Growth: I used an expected growth rate for Amazon of 15% a year for the next 5 years, tapering down to lower levels in the future, to push revenues to $626 billion, ten years from now. While that is an ambitious target, Amazon has proved itself capable of beating sky high expectations before and it is plausible that the growth rate could be as high as 25% (which would translate to revenues of $1.13 trillion, ten years out). There is also the possibility that regulators and anti-trust enforcers may step in and restrain Amazon's growth plans, which could cause the growth rate to drop significantly to 5% (resulting in revenues of $330 billion in year 10).
      2. Operating Margin: While Amazon's margins have been on a slow, but steady, climb in the last few years, much of that improvement has come from the cloud services business, and the future course of margins will depend not only on how well Amazon can bring logistics costs under control but also on what new businesses it targets. I will stay with my base cash assumption of a target operating margin of 12.5%, but allow for the possibility that Amazon's margins will stay stagnant (close to today's margins of about 7%), at one extreme, and that there might be a new, very profitable business that Amazon can enter, pushing up the margins above 18%, at the other.
      3. Sales to Invested Capital: Currently, Amazon is an efficient utilizer of capital, generating $5.95 in revenues for every dollar of capital invested. While this will remain my base case, there may be future businesses that Amazon is targeting that may be more or less capital intensive than its current ones, leading to a significant range (3.95 for the more capital intensive - 7.95 to the less  capital intensive).
      4. Cost of Capital: I will stick with my base case cost of capital of 7.97%, with the possibility that that it could drop as Amazon's older businesses become profitable (but not by much, since the current cost of capital is close to the median for global companies) as well as the very real chance that it could go up significantly, if Amazon targets risky businesses in emerging markets for its growth.
      Valuation & Simulation Output
      The median value across the simulations is $1242, close to the base case valuation of $1,255. The range on value, using the 10th and 90th percentiles is $705 - $2,152, much wider than the range for Apple.

      Lessons from Apple and Amazon Simulations
      Simulations yield pretty pictures and if that is all you get out of them, it is time and energy wasted. There are lessons that we can eke out of the Apple and Amazon simulations that may help us in making more informed judgments:
      1. This is not about getting better estimates of value: If you are running simulations because you think they will give you more precise or better estimates of value than point estimate valuations, you will be disappointed. Since my input distributions are centered around my base case assumptions, and they should be, the median values across 100,000 simulations are close to my base case valuations for both Apple and Amazon.
      2. If it is a risk proxy, it is a very noisy and dangerous one: It is true that the spread of the distributions provides a measure of estimation uncertainty that you bring into your valuation. Using the Apple and Amazon simulations to illustrate, I face far greater uncertainty with my Amazon story than with my Apple story, and you can see it reflected in a larger range of value for the former. You may be puzzled that my cost of capital is lower for Amazon than for Apple, but that reflects the fact that much of the uncertainty that I face with Amazon is company-specific and should be buffered by other stocks in my portfolio. As a diversified investor, the variance in simulated values is a poor proxy for risk. However, if you are an investor who prefers concentrated portfolios, you can use the variance in simulated value as a measure of risk. 
      3. There can be no one margin of safety for all companies: I have written about the margin of safety before, often with skepticism, and one of my critiques has been with the way it is used in practice, where it is set at a fixed number for all companies. Thus, you will find value investors who use a margin of safety of 15% or 20% for all stocks, and the Apple and Amazon simulations show the danger in this practice. A 15% margin of safety for Apple may be too large, given how tightly values are distributed for the company, whereas the same 15% margin of safety may be too small for Amazon, with its wider band of values.
      4. Tails matter: Symmetry or the lack of it in distributions may seem like an inside statistics topic, but with simulated values, it has investment consequences. You can see that Apple's value distribution is  much more symmetric than Amazon's distribution, with the latter having a significant positive skew, reflecting a greater likelihood of big positive surprises in value, than negative ones. With companies with exposure to large and potentially catastrophic news stories (a large lawsuit or debt covenants), you can have value distributions that are negatively skewed.  In general, positive skewed distributions are better for (long) investors than negatively skewed ones, and the reverse is true for investors who are shorting a company.
      I ran the simulations after my base case valuations suggested that Apple and Amazon were over valued, to see how they might affect my decision on whether to sell short on either company. The results are mixed.
      • While the simulations confirm my over valuations (no surprise there), with both companies, the current stock price is well within the realm of possibilities. While my base case valuation suggested that Apple was far less over valued (10%) than Amazon (55%), there is roughly a 15-20% chance that both companies are under valued, not over valued.
      • In addition, with Amazon, there is the added risk, if you are selling short, given the long positive tail on the distribution, that if I am wrong, the price I will pay will be much greater than if I am wrong with Apple.
      The bottom line is that while Amazon seemed like a much better short selling target, after my base case valuations, because it was far more over valued than Apple, the simulations that I did on the two companies even out the scales, at least marginally. Apple is more over valued, but the probability of making money, assuming my valuations are on target is about the same with both stocks, and the downside of being wrong is far greater with Amazon than with Apple.

      Value and Price: The Search for Catalysts
      In the post that initiated this series, I looked at why crossing a trillion-dollar threshold may matter to investors, using the contrast between the value process and the pricing process. In effect, I argued that there can be a gap between value and price, and that even if you are right about your value judgment, you will make money only if the gap between the two closes:

      Investment success thus rides not only on the quality of your value judgment, and how much faith you have in it, but on whether there are catalysts that can cause the gap to change. With companies, these catalysts can take different forms:
      1. Earnings reports: In their earnings reports, in addition to the proverbial bottom line (earnings per share), companies provide information about operating details (growth, margins, capital invested). To the extent that the pricing reflects unrealistic expectations about the future, information that highlights this in an earnings report may cause investors to reassess price. 
      2. Corporate news: News stories about a company's plans to expand, acquire or divest businesses  or to update or introduce new products can reset the pricing game and change the gap.
      3. Management Change/Behavior: A change in the ranks of top management or a managerial misjudgment that is made public can cause investors to hit the pause button, and this is especially true for companies that are bound to a single personality (usually a powerful founder/CEO) or derive their value from a key person. 
      4. Macro/ Government: A change in the macro environment or the regulatory overlay for a company can also cause a reassessment of the gap.
      With all of these catalysts, there may be value effects (because the cash flows, growth and risk) as well, and it should also be noted that when the gap changes, it may not always close. In fact, these catalysts can sometime make a gap bigger, by feeding into pricing momentum.

      As an investor, I look for catalysts when I invest, but I am even more intent on finding them, when I sell short than when I am long a stock. The reason for that divergence is that I am in far greater control of my time horizon, when I buy a stock, since, as long as I stay disciplined and retain faith in my value, only liquidity needs can cause me to sell. When I sell short, my time horizon is far less under my control, exposing me to timing risk. Put different, I can bet on a company being over valued, be right on my thesis, but still lose money on a short sale, because I am forced to close out my position, in the absence of a catalyst.

      Going through the list of catalysts with Apple and Amazon, with both stocks approaching all-time highs, there is no obvious pricing trigger than I can point to, though my technical analyst friends will undoubtedly point to indicators that I did not even know existed. On the earnings front, the earnings reports for both companies are so heavily scripted to expectations that it would take a big surprise to reset stories, and I don't see that happening. In fact, I will predict that Amazon's earnings reports will continue to deliver double digit revenue growth and improving margins for the next few quarters, and investors will react positively, even though the growth may not be high enough or the margin improvement substantial enough to justify the market pricing. On the corporate news front, Apple's smart phone business model, with the pressure it puts on the company every year or two to reinvent itself, with the latest and the best, coupled with its big announcement events, creates catalyst moments. Looking back at Apple's ups and downs over the last few years, the triggers for substantial up and down movements on the stock have been new iPhone models doing better or worse than expected. In contrast, Amazon is remarkably low key in new product introductions, preferring to slip in under the radar. Both companies have well regarded and established CEOs, and neither company is personality-driven, making it unlikely that you will see management changes triggering big price changes. Finally, on the macro front, both companies face potential catalyst moments. For Apple, it is the possibility of a trade war with China, a huge market for its products and devices, and for Amazon, it is talk of regulatory restrictions and anti-trust actions that can constrain the company.  Since I cannot filibuster my way to a non-decision, I decided to compare my Apple and Amazon numbers/analysis, side by side:

      I sold my Apple shares at $220, at the start of trading on Friday (9/21), but while I have not sold short any more shares. I have put in a limit (short) sell, if the price hits $230 (roughly my 90th percentile of value) in the near future. With Amazon, I sold short at $1950 at the start of trading on Friday (9/21).  the first time in twenty years that I have sold short on the company, and one reason that I am pulling the trigger is because I believe that the pushback from regulators and anti-trust enforcers will slow the company down in ways that no competitor ever could. I am doing so, with open eyes, since I believe that Amazon is in one of the best run companies in the world, adept at setting market expectations and beating them, and with a track record of taking short sellers to the graveyard. Time will tell, and I am sure that some of you reading this post will let me know, if my bet goes awry, but I don't plan to lose any sleep over this. 

      YouTube Video


      Trillion Dollar Posts


      Spreadsheets

      1. Apple valuation and simulation results
      2. Amazon valuation and simulation results
      (I use Crystal Ball, an add-on to Excel, for my simulations. If you don't have that extension (available only on the PC version), you cannot recreate my simulations, but you can download the program for a trial run on the Oracle website)

      Papers/Reading
      1. Facing up to Uncertainty: Using Probabilistic Approaches in Valuation
      2. Living with Noise: Investing and Valuation in the Face of Uncertainty



      Apple and Amazon at a Trillion $: Looking Back and Looking Forward!

      For most of us, even envisioning a trillion dollars is difficult to do, a few more zeros than we are used to seeing in numbers. Thus, when Apple’s market capitalization exceeded a trillion on August 2, 2018, it was greeted with commentary, and when Amazon’s market capitalization also exceeded a trillion just over a month later on September 4, 2018, there was more of the same. I have not only admired both companies, but tracked and valued them repeatedly over the last twenty years. There is much that I have learned about business and finance from both companies, and I thought this would be a good occasion to look at how these two companies got to where they are today, as well as their similarities and differences. In the process, I will make my assessment of where Apple and Amazon stand today, and update my valuations and investment judgments on both companies. I am sure that your assessments will be different, but it is of these differences that markets are made.

      The Road to a Trillion Dollars

      Markets give and markets take away, and this is true not just for the laggards in the market, but even the most successful companies. Apple and Amazon have had amazing runs, but without taking anything away from their success, it is worth noting that during their march towards trillion dollar market capitalizations, each has had to endure periods in the wilderness, and the way they dealt with market adversity is what has made them the companies that they are today.

      Apple is the older of the two companies, founded in 1976, and igniting the shift away from mainframe computers to personal computers, first with its Apple computers and later with its Macs. My first personal computer was a Mac 128K, which I still own, and I have been an investor in the stock off and on, for decades. In the chart below, I graph the market capitalization of the company from 1990 to September 2018:

      After its auspicious beginnings, Apple endured a decade in the wilderness in the 1990s, after the departure of Steve Jobs, its visionary but headstrong co-founder, in 1975, and a series of inept successors. As testimonial that there are sometimes second acts for both people and companies, Apple found its mojo in the first decade of this century, headed again by Steve Jobs but this time with a stronger supporting cast. That success has continued into this decade, with Tim Cook stepping in as CEO, after the untimely demise of Jobs. In the last few years, the company has also chosen to use its capacity to borrow money, increasing its debt ratio from close to nothing to just over 10% of equity (in market value terms).

      Just as Apple presided over one major change in our lives, Amazon’s entrée into markets reflected a different shift, one that has changed the way we buy goods, and, in the process, and has upended the retail business. Amazon's sprint from start-up to trillion dollar value is captured below:
      From a barely registering market capitalization in 1996, Amazon zoomed to success during the dot-com boom, but as that boom turned to bust, the company lost more than 80% of its market capitalization in 2000. After its near-death experience in 2000, Amazon spent the bulk of the following decade, consolidating and getting ready for its next phase of growth, increasing its market capitalization almost eight-fold between 2012 and 2018.

      Along the way, both companies have had their detractors, who have not only scoffed at the capacity both companies to scale up, but have also sold short on the stock, making both stocks among the most shorted in the market. Little seems to have changed on that front, since Apple and Amazon remain among the most heavily shorted stocks in September 2018, though neither Jeff Bezos nor Tim Cook seems to be paying any attention to the short sellers. (Elon Musk, Please take note!)

      The Back Story: Revenues and Operating Income

      We can debate whether Amazon and Apple are worth a trillion dollars, but there can be no denying that both companies have been successful in their businesses, and that it is these operating success that best explain their high market values. That said, as we will see in the section following, the way these companies have evolved over time have been very different, and looking at the pathways that they used to get to where they are,  I will lay the foundations for valuing them today.

      Revenue Growth and Profitability
      Every investigation of operations starts with revenues and operating income, and with Apple, the picture of revenues and operating income over the last three decades illustrates the transformation wrought by its decision to shift away from personal computers to hand held devices, starting with the iPod and then expanding into the iPhone and iPad, in the the last decade:


      The revenue growth rate, which languished in the 1990s, zoomed in 2000-08 time period, and operating margins almost doubled. However, it was in the 2009-13 period that Apple saw the full benefits of its rebirth, with operating margins almost quadrupling, with the iPhone being the primary contributor. During the 2014-18 period, the good news for Apple is that margins have stayed mostly intact but it has seen a fairly dramatic drop off in growth, as the smart phone market matures.

      The Amazon operating story also starts with revenue growth, but the company's evolution on operating margins has followed a different path from Apple's:
      The company's growth was stratospheric in the early years, partly because it was a start-up, scaling up from less than a million dollars in revenues in 1995 to $2.76 billion in 2000. While scaling up did slow down growth, the company weathered the dot com bust to grow revenues at 28.61% a year from 2000 to 2010, with revenues reaching $34.2 billion in 2010. The most impressive phase for Amazon has been the 2011-2018 period, because it has been able to continue to grow revenues at almost the same rate as in the prior decade, but this time with a much larger base, increasing revenues to $208.1 billion in the last twelve months, ending June 2018. On the income front, the story has not been as positive. While the initial losses in try 1990s can be explained by Amazon's status as a young, growth company, it becomes more difficult to justify the continuation of these losses into 2002 (six years after its public listing) and the trend lines in operating margins since then. Rather than improving over time, as economies of scale kick in, which is what you would expect in growth companies, Amazon's margins have not only stayed low but have often headed lower, suggesting either that the company is not reaping scaling benefits or that it is playing a very different game, and my bet is on the latter. 

      The Cash Flow Contrast
      If you are a value investor, I know that you will probably be taking me to task at this point by noting that you don't get to collect on revenues or operating income and that you invest for the cash flows. That is true, and it is on this dimension the the difference between Apple and Amazon becomes a yawning gap.  With Apple, the evolution of the company from a has-been in the 1990s to a disruptive force in the 2001-2010 period to its more mature phase between 2011 and 2018 plays out in its cash flows. Using the free cash flow to equity, which measures cash left over for equity investors after reinvestment and taxes, as the measure of cash that can potentially be returned to shareholders, here is what I see:

      I have described Apple as the greatest cash machine in history and you can see why, by looking at the cumulative cash flows generated by the firm. After getting a start in the 2000-08 time period, the cash machine kicked into high gear between 2009 snd 2013, with $124 billion in free cash flow to equity generated cumulatively over the period. You can also see the company's initial reluctance to return the cash, both in the fact that only about a third of the cash flow during this period was returned in dividends and buybacks and in the increase in the cash balance of just over $122 billion. Prodded by activist investors (Einhorn and Icahn, in particular), the company switched gears and began returning more cash, increasing dividends and buying back more stock. Between 2014 and 2018, the company returned an astonishing $277 billion in cash to investors ($61 billion in dividends and $216 billion in buybacks), which is higher than the $242 billion that the firm generated as free cash flows to equity. While it was returning more cash than any other company has in history, Apple pulled off an even more amazing feat, increasing its cash balance by $96 billion, as it used it dipped into it debt capacity, to borrow almost $100 billion.

      Amazon's cash flows are a distinct contrast to Apple's, though you should not be surprised, given the lead up. As noted in the earlier section, it is a company that has gone for higher revenue growth, often at the expense of profit margins, and has been willing to wait for its profits. The graph below looks at net income and free cash flows to equity at the company over its lifetime:

      It is not the negative FCFE in the early years that is the surprise, since that is what you would expect in a high growth, money losing company, but the evolution of the FCFE in the later years. Initially, Amazon follows the script of a successful growth company, as both profits and FCFE turn positive between 2001 and 2010, but in the years since, Amazon seems to have reverted back to the cash flow patterns of its earlier years, albeit on a much larger scale, with huge negative free cash flows to equity. During all of this period, Amazon has never paid dividends and bought back stock in small quantities in a few years, more to cover management stock option exercises than to return cash to stockholders.

      Story and Valuation

      With the historical assessment of Apple and Amazon behind us, it is time to turn to the more interesting and relevant question of what to make of each company today, since Apple and Amazon are clearly are on different paths, with very different operating make ups and at different stages in the life cycle. Apple is a mature company, with low growth, and is behaving like one, returning large amounts of cash to stockholders. Amazon is not just a growing company, but one that seems intent on continuing to grow, even if it means delayed profit gratification. In the section below, I will lay out my story and valuation for each company, with the emphasis on the word "my", since I am sure that you have your own story for each company. I will leave my valuation spreadsheet open for you to download, with the story levers easily changed to reflect different stories. 

      Apple: The Smartphone Cash Machine
      Apple's success over the last two decades has been largely fueled by one product primarily, the iPhone, and that success has come with two costs. The first is that Apple is now predominately a smart phone company, generating almost 62% of its revenues and an even higher percentage of its profits from the iPhone. The second is that the smart phone business has not only matured, with lower growth rates globally, but is intensely competitive, with both traditional competitors like Samsung and new entrants roiling the business. While there remains a possibility that Apple will find another market to disrupt, I think it will be difficult to do so, partly because with Apple's size, any new disruptive product has to not only be of a big market, but one that is immensely profitable, to make a difference to Apple's cash flow stream.

      My story for Apple is therefore relatively unchanged from my story last year, though I am a little bit more optimistic that Apple will be able to use its immense iPhone owner base to sell more services
      Download spreadsheet
      I am valuing Apple as a mature company, growing at the same rate as the economy in perpetuity, while seeing its operating margins decline from their current level (30%) to about 25% over the next 5 years, and with these assumptions, I estimate a $200 value per share, roughly 9% lower than the $219 stock price on September 18, 2018.

      Amazon: The Disruptive Platform
      In my earlier valuations of Amazon, I called it a Field of Dreams company, because investing in it required investors to buy into its vision of "if we build it (revenues), they (profits) will come". In my most recent valuation of Amazon, I noted that the company was finally starting to deliver on the second half of the promise, increasing its profits margins, with its cloud business contributing large profits, and significant investments in logistics keeping shipping costs in check. Along the way, and especially since 2012, the company has also moved from being predominantly a retailer of goods and services to one that is unafraid to enter any new business, where it can use its disruptive platform to good effect. In effect, it has seemed to have transitioned from being a disruptive retail company to a disruption platform that can be aimed at other businesses, with an army of Prime members at its command.

      My story is that will continue to do more of the same, with high revenue growth coming from new businesses and markets and a continued growth in margins, as established businesses start to find their footing. 
      Download spreadsheet
      My revenue growth rate of 15% may seem modest, given Amazon's growth rate in the last decade, but note that if this growth rate can be delivered, Amazon's revenues will be $626 billion in 2027, and if it can improve its overall operating margin to 12.5%, its operating profit will be $78 billion in that year. With this story, I estimate a $1,255 value per share for Amazon, well below its market price of $1,944 a share, making it over valued by almost 35%. I will admit, with no shame, that Amazon is a company that I have consistently under estimated, and it is entirely possible, perhaps even plausible, that the real story for Amazon is even bigger (in terms of revenue growth) and more profitable. 

      End Game
      I have always operated on the premise that if you value companies, you should be willing to act on those valuations. In the case of Apple and Amazon, that would suggest that the next step that I should be taking with each company is to sell. With Apple, a stock that I have held for close to three years and which has served me well over the period, that would be accomplished by selling my holding. With Amazon, a stock that I have not held for more than five years, that would imply joining the legions of short sellers. Like an Avengers' movie, I am going to leave you in suspense until my next post, because I have two loose ends to tie up, before I can act. The first is to grapple with the uncertainties that I have about my own stories for the two companies, and the resulting effects on their valuations. The second is what I will mysteriously term "the catalyst effect", which I believe is indispensable, especially when you sell short. 

      YouTube video

      Valuation Spreadsheets



      Trillion Dollar Toppers: Market Triggers, Value Drivers and Pricing Catalysts!

      In the last few weeks, the market capitalization of Apple and Amazon each hit a trillion dollars, a threshold not seen before in public markets. Predictably, that has drawn press attention and commentary about what this moment means for markets, investors and the companies themselves. As readers of this blog know, I have followed both companies and valued them for more than two decades, and this is as good a time as any to see how they got to where they are today, and what the future holds for each company. I will do that in my next post, but in this one, I want to look at the far more basic question of whether hitting a trillion dollar value (or a hundred billion or a billion or any other number) should matter to investors.

      Market Triggers
      Does the market capitalization rising above a trillion dollars change Amazon or Apple as companies? After all, $1,000,000,000,000 is only a dollar higher than $999,999,999,999 and nothing is changed fundamentally in either company by the event. That said, as human beings, we do make more of a fuss around some numbers than others, especially with age and birthdays. In some cases, the fuss is merited, as when you turn eighteen, since you will be able to vote and be treated as an adult in the legal system, or sixty five, since you may be entitled to your pension and social security benefits. In others, it is a concocted milestone, as is the case when you turn thirty or forty or fifty years old, since little changes in your life, as a consequence.

      Investors also seem to endow some numbers with more weight than others, sometimes with reason, and sometimes without. When a publicly traded company’s stock price drops below a dollar, it is often punished, often because it risks being delisted, putting liquidity at risk. When the stock prices rises above $1,000, the company may come under pressure to do a stock split, because it has become “too expensive” for retail investors to buy. With young, privately owned companies, getting a pricing of more than a billion dollars gets you unicorn status, though it not clear what that branding entitles you to, other than a little public attention. Within corporate finance, there are similar triggers built around revenues and profits, with management contracts tied to revenues reaching a billion dollars or EBITDA cresting one hundred million. Collectively, I will call these market triggers, and the focus of this post is to examine how much attention we should pay to them, if any.

      The Market Reaction to Triggers
      Before we embark on the discussion on whether, and if yes, how much attention to pay to market triggers, note that the degree to which these triggers matter varies widely across investors. While some investors view them as side games, there are others who build much of their investing around market triggers. Value investors, and especially those raised on the classics, scoff at price triggers as distractions from their focus on earnings and moats but they often have their own triggers, based upon earnings or book value. In contrast, a great deal of technical analysis, as an investment philosophy, is built on triggers, many built around price per share. Support and resistance lines, the cresting of which have long been viewed as an indicator of future price movements, are based upon prices that may reflect the company’s past history but often have no intrinsic basis. Similarly, chartists often pay heed to historical high and low prices for the stock, arguing that cresting either number could have consequences for future returns. Many technical indicators are built around price or volume metrics with rules of thumb that often have no fundamental justification. 

      At this stage, by making this a contest between value investors and chartists, I have probably already forced you to pick a side, and that would be a pity, since I think that both sides have something to learn from the other. For those who believe in efficient markets, it remains an enduring frustration that markets seem to move in response to what looks like, at least on the surface, to be a cosmetic change in the company. In particular, there is research that stock prices seem to react to stock splits, 
      • With stock splits, where the share count changes in proportion to existing holdings, and nothing fundamentally changes about the company, the market not only reacts positively to the split but these stocks continue to do better than expected in the months after.
      • When a stock approaches its 52-week high, there is some evidence that the high price acts as a barrier, making it more likely that the stock will go down than up.
      • There is some evidence that support and resistance lines have price effects; one study focusing on exchange rates concluded that pricing trends in currency rates are more likely to be interrupted at support and resistance lines. 
      • A general study of technical analysis (and price patterns) concludes that technical indicators, such as head-and-shoulders and double bottoms do have a price impact, though it is unclear that you can make money of these price movements.
      In short, much as you may be inclined to dismiss technical research as baseless, there is evidence that past price paths can drive future returns.

      Some researchers have managed to convince themselves that the market behavior is consistent with an efficient market, with the rationale that these actions operate as signals about future fundamentals, thus explaining the price changes. A stock split, we are therefore told, is a signal to markets that companies feel that they have the cash flows to sustain higher dividends in the future, translating into higher value. I find most signaling stories to be unconvincing, reflecting almost desperate attempts to reconcile a belief in efficient markets with market behavior that is not consistent with that belief. In my experience, market triggers often affect stock prices, sometimes substantially, and it has little to do with signals. Rather than dismiss these triggers as irrational and useless, I need to understand them better, with the intent of separating ones that may be able to incorporate into my investing from those that I am better off ignoring.

      Value Drivers and Pricing Catalysts
      In the pursuit of understanding why market triggers matter, I find it useful to go back to a contrast between pricing and value that I have talked about before, and draw a distinction between value drivers and price movers.

      In short, the value of a business is driven by its fundamentals, but the pricing of a business is determined by demand and supply, and the two processes can yield different numbers, resulting in a gap between price and value. In this framework, market trigger effects can be classified into three groups:
      1. Value effects: If a market trigger has an effect on one or more of the three drivers of value, which are cash flows, growth and business risk, it can affect value. Revenue or earnings triggers set by companies can have an effect on value, if management compensation is tied to them. With some corporate borrowings, there are covenants tied to stock prices or earnings, the violation of which may lead to consequences for the firm, sometimes taking the form of higher interest expenses and sometimes a change in control. With convertible bonds and preferred shares, the conversion price can become a trigger for a change in value, if it results in a significant increase in shares outstanding and in debt ratios. Consider the grant that Tesla’s board of directors gave Elon Musk in March 2018, where he will get billions of dollars in shares and options in the company, if he can deliver on a variety of targets, some related to market capitalization and some to operating performance. Specifically, the board of directors has listed 12 market capitalization tiggers, each of which can result in shares being granted to Mr. Mush, and 16 operating triggers, with eight relating to revenues and  eight to EBITDA. For a Tesla investor, meeting each of these thresholds will be a cause for mixed feelings, joy that revenues, EBITDA and capitalization are increasing, tempered by dilution occurring at the same time. 
      2. Pricing effects: If a market trigger has an effect on market mood or momentum, it can affect prices, even though it has no effect on fundamentals. For instance, the argument that technical analysts use for paying attention to support lines, often based upon historical prices, is that when a company’s stock price drops below its support line, it creates a negative psychological effect that can cause more selling, with prices falling even further. A pricing trigger can also have a liquidity effect, which can affect prices. This has often been the rationale used by some companies, especially those with high priced shares, for stock splits, arguing that retail investors are more likely to trade a $100 stock than a $1000 stock, and that the increased liquidity can translate into higher prices. The liquidity story can also be used the push by many start-ups to get to unicorn status, since doing so may attract more venture capital money, which, in turn, can push up pricing. Finally, there is the herd effect, where crossing a pricing or value trigger can lead people who have been sitting on the sidelines to act, pushing up prices if they decide to buy and pushing down prices when they sell.
      3. Gap (Catalyst) effects: There is a third and more subtle effect from market triggers, which comes from the attention garnered by crossing even an arbitrary threshold. This is especially the case with smaller and lower profile companies, which can often be ignored by investors and analysts, in a market where larger and higher profile companies garner the bulk of coverage. To the extent that these companies are being mispriced, the attention leading from hitting a trigger can lead to a reassessment of the company and perhaps a closing of the gap. Note that this reassessment can cut in both directions, with unnoticed strengths coming to the surface, and increasing the prices of some companies, and unnoticed weaknesses being unearthed in other companies, resulting in prices dropping. 
      This framework can be used to judge whether and why market triggers can affect prices. Some do so, because they have value consequences, some because they affect mood and liquidity, some because they are attention gatherers and some because they have all three effects. Most pricing and volume indicators used by technical analysts, for instance, are pure pricing effects, but since the name of the game in pricing is to gauge shifts in mood and momentum, that is understandable. With companies that have management options and convertibles outstanding, crossing some price barriers can create value effects, by diluting share ownership. With companies that have been operating under the radar, a market trigger can lead to more attention being paid to the company, leading to a closing in gaps between value and price.

      So, what effect will crossing the trillion-dollar threshold have on Apple and Amazon? Neither company has options or convertibles that will unlock at the trillion dollar capitalization and thus there should be no value effect. There may be a pricing effect, but it is not clear in which direction. On the one hand, you can argue that for some long term holders of the stock, crossing the trillion dollars may be a culmination of a long and successful journey, leading to selling. On the other hand, there are others who may have resisted both stocks as overpriced, who may decide that this is the time to capitulate and buy the stock. As two of the most widely tracked and followed companies in the world already, it is not likely that there will be any major reassessments in either company, on the part of stockholders, nullifying the gap effect. There is one potential black cloud that comes with the increased attention, at least for Amazon, which is that the company's success may be drawing the attention of anti-trust and regulatory authorities, perhaps putting a crimp on its future growth plans globally. I will return to that issue in my next post.

      Market Triggers and Investment Philosophies
      If market triggers can have value, price and gap effects, how do you incorporate them into investing? The answer depends upon your investment philosophy:
      1. If you are a trader: The essence of trading is that you are playing the pricing game, and to the extent that you are, your success will depend upon how well you can ride the trend and how quickly you spot changes in momentum. Thus, it does not surprise me that charting and technical indicators are built heavily around these triggers. If you are a good trader, and I believe that they are some, your strength is in assessing how these triggers change mood  and getting ahead of the market on these shifts.
      2. If you are a value investor: As someone focused on value, your first instinct may be to ignore market triggers, viewing them as a distraction from your central mission of valuing companies based upon their fundamentals, and then buying undervalued stocks and selling overvalued ones. While I understand that focus, I think that you should consider incorporating pricing triggers into your value mission for two reasons. The first is that a few of these triggers have value effects and ignoring them will mean that you are mis-valuing companies. The second is that to make money as a value investor, you not only have to get value right, but you have to trust the market to correct its mistake, by moving price towards value. Since the latter is often out of your control, I believe that one of the keys to being a good value investor is finding catalysts that can cause the price correction. If market triggers can operate as catalysts, incorporating them into your investment process can unlock the value mistake that you have found. 
      I am a value investor, albeit one with perhaps a broader definition of what comprises value than some old time value investors, but I do look at pricing triggers, especially with small cap, lightly followed and emerging market companies. Thus, if I value a stock at $6 a share and it is trading at $4.10/share, but its historical low price is $4 (the support line), I may wait to buy it, hoping for one of two outcomes. The first is that it hits the support line and does not drop below it, signaling a positive shift in momentum, indicating that this would be a good time to buy. The second is that it drops below its support line, resulting in a negative shift in momentum and more selling, allowing me to buy the stock at an even lower price. Thus, while my primary decision of whether to buy or sell a stock is driven by value judgments, the question of when to do it can be affected by market triggers.

      My Bottom Line
      I own shares in Apple and I don’t own any (right now) in Amazon, and I have explained why in prior posts on both companies.  With my Apple shares, I have been rewarded well over my almost three-year holding period, and the question then becomes whether the trillion dollar market capitalization should make a difference in whether I continue to hold the shares. With Amazon, I saw little reason to buy the stock a few months ago, as I noted in this post, where I argued that it was a great company but not a great investment. The question then becomes whether market capitalization crossing trillion dollars changes that assessment. The final judgment has to wait until the next post, where I will revalue both companies, and look at whether the trillion-dollar trigger has made a difference.

      YouTube Video



      An October Surprise? Making Sense of the Market Mayhem!

      I don't know what it is about October that spooks markets, but it certainly feels like big market corrections happen in the month. As stocks have gone through contortions this month, more down than up, like many of you, I have been looking at my portfolio, wondering whether this is the crash that the market bears have been warning me about since 2012, just a pause in a continuing bull market or perhaps a prognosticator of economic troubles to come. If you are expecting me to give you the answer in this post, I would stop reading, since reading market tea leaves is not my strength. That said,  I have been wrestling with what, if anything, I should be doing, as an investor, in response to the market movements. As in previous market crises, I find myself going back to a four-step process that I hope gets me through with my sanity intact. 

      Step 1: Hit the pause button
      The first casualty of crisis is good sense, as I mistake my panic response for instinct, and almost every action that I feel the urge to take in the heat of the moment is driven by fear and greed, not reason. No amount of rational thinking or studying behavioral finance will cure me of this affliction, since it is part of my make up as a human being, but there are three things that I find help me manage my reactions:
      1. Take a breath:  When faced with fast-moving markets, I have to force myself to consciously slow down. It helps that I don't work as a trader or a portfolio manager, since part of your job is to look like you are in control, even when you are not. 
      2. Turn off the noise: Turn back the clock about four decades and assume that you were a doctor, a lawyer or a factory worker with much of your wealth invested in stocks. If markets were having a bad day, odds were that you would not even have heard about it until you got home and turned on the news, and even then, you would have been fed scraps of information about Dow, perhaps a 2-minute discussion with a market expert, and you would have then turned on your favorite sitcom. Today, not only can you monitor your stocks every moment of your working day, you can trade on your lunch break and stream CNBC on to your desktop. That may make you a more informed investor, or at least an investor with more information, but I am not sure that constant feedback is healthy for your portfolio, especially in periods like this one. I don't have a Bloomberg terminal on my desk, a ticker tape running on  my computer or stock apps on my phone, and I am happy that I don't during periods like this month.
      3. Don't play the blame game: Every market correction has its villains, and investors like to tag them. Central banks and governments are always good targets, since they have few defenders and have a history of triggering market meltdowns. The problem that I find with assigning blame to others is that it then relieves me of any responsibility, even for own mistakes, and thus makes it impossible to learn from them and take corrective action.
      Step 2: Assess the damage
      In an age of instant analysis and expert opinion, it is easy to get a skewed view of not only what is causing the market damage, but also where that damage is greatest. In my (limited) reading of market analyses during the last four weeks, I have seen at least a half a dozen hypotheses about the stock swoon, from it being the Fed's fault (as usual) to a long overdue tech company correction to it being a response to global crises (in Italy and Saudi Arabia). In keeping with the old adage of "trust, but verify", I decided to take a look at the data to see if there are answers in it to these questions. 

      1.The Fed's fault? 
      As those of you who read my blog know well, I believe that the Fed has far less power than we think it does to set interest rates, but it is a convenient bogeyman. One explanation for the stock drop that has been making the rounds is that it is fear that Fed will raise rates too quickly in the future, that is causing stocks to swoon. Is that a plausible story? Yes, but if it is the reason for the market decline, you would have a difficult time explaining the movement in interest rates during October 2018:
      Source: Federal Reserve (FRED)
      As stocks have gone through their pains since October 1, treasury bill and bond rates have remained steady, which would make little sense if the expectation is that they will rise in the near future. After all, if investors expect rates to rise soon, those rates will start going up now and not on cue, when the Fed acts.

      There is the possibility that this could be a delayed reaction to rates having gone up over the year already, with the 10-year treasury bond rate moving from 2.41% at the start of the year to 3.06% at the start of October 2018 and to a flattening yield curve (which has historically been a precursor to slower economic growth). Note though, that much of this movement in interest rates happened in the first six months of the year and you would need a reason for why stock prices would be moving four months later.

      2. A Tech Meltdown?
      My view, based upon what I had been hearing and reading, and before I looked at the data, was that the October 2018 stock drop was being caused by tech companies, in general, and the large tech companies, especially the FANG+Apple combination, specifically. To see if this is true, I looked at the returns on all US stocks, classified by sectors (as defined by S&P), in October, in the year to date and for 1-year and 5-year time periods.
      US Sector Market Cap Change. Source: S&P Capital IQ
      I know that the S&P sector classifications are imperfect, but my priors seem to be wrong. While information technology, as a group, lost 8.76% of aggregate market capitalization in October 2018, the three worst sectors in the US market were energy, industrials and materials, all of which lost much more, in percentage terms, than technology. In fact, the two sectors that did the best were consumer staples and utilities, with the latter's performance also providing evidence that it is not interest rate fears that are primarily driving this market correction. 

      I have argued that, unlike two decades ago, technology companies now are now a diverse group, and many of them don't fit the "high growth, high risk" profile that people seem to still automatically give all tech companies. Using the terminology of corporate life cycles, tech companies  run the gamut from old tech to middle-aged tech to young tech, and I have looked at how tech companies in each age grouping in the graph below (age is defined, relative to year of founding):

      The median percentage change, in both October 2018 and YTD 2018,  in market capitalization was greatest at the youngest tech companies. The median percentage change becomes smaller for older tech companies, in October 2018, but the effect for the four highest age classes is more mixed for the YTD numbers. That said, a much smaller median percentage change at the largest tech companies has a much biggest effect on the market, because of the market capitalization of these companies. That is the reason I look at the FANG stocks and Apple in the table below:
      While the percentage change in stock prices at these companies is in line with the market drop, if Apple is included in the mix, the five companies collectively lost a staggering $276 billion in market capitalization between October 1 and October 26. accounting for almost 11.7% of the overall drop in market capitalization of US stocks. While investors in these stocks may feel merited in complaining about their losses, I would draw their attention to the third column, where I look at what these stocks have done since January 1, 2018, with the losses in October incorporated. Collectively, these five companies have added almost $521 billion in market capitalization since the start of the year, and without them, the overall market would have been down substantially.

      3. A Correction in Overvalued Stocks?
      For some value investors who have argued that investors were pushing up some stocks to unsustainable levels, the market correction has been vindication, a sign that the market is correcting its pricing mistakes and marking down the stocks that it had over priced the most. That may be plausible, and to see if it holds, I broke all US stocks, at the start of October, based upon PE ratios into six groupings (low to high PE and a separate one for negative earnings companies):
      PE Ratio at start of October 2018, using trailing 12 month earnings
      If the selective correction argument is correct, you should expect to see the highest PE ratio and negative earnings companies drop the most in value and the companies with the lowest PE ratios be less affected. While negative earnings stocks have seen the market correction, during October 2018, there is no pattern across the other PE classes. In fact, the lowest PE ratio companies had the second worst record, in terms of price performance, among the groupings. 

      4. A US Problem?

      One of the lessons of the last decade is that much as countries would like to disconnect from the rest of the world and chart their own pathway to economic prosperity, they are joined at the hip by globalization, with crisis in one part of the world quickly affecting economies and markets in other parts. In October 2018, we had our share of global shocks, with the standoff between Italy and the EU and Saudi Arabia's Khashoggi problem taking top billing. To see how the market correction has played out in world markets, I broke global markets down into broad regional groupings and arrived at the following:
      Source: S&P Capital IQ, based upon headquarters geography
      Note that these returns are all in US dollars, reflecting both the performance of the market and the currencies of each region. Asia seems to have been hit the worst this month, with China, Small Asia (South East Asia, Pakistan, Bangladesh) and Japan all seeing double digit declines in aggregate market capitalization. Latin America has had the best performance of the regional groupings, with the election surprise in Brazil driving its markets upwards during the month.  The year-to-date numbers do tell a bigger story that has been glossed over in analysis. For much of 2018, the US market & economy has diverged from the rest of the globe, posting solid numbers (prior to October) whereas the rest of the world was struggling. It is possible that we are seeing an end to that divergence, suggesting that the US markets will move more closely with the other global markets going forward.

      5. Panic Attack?

      One of the more striking features of the markets during October 2018 has been that the stock market retreat, while substantial, has, for the most part, been orderly. In a panic-driven stock market sell off, you usually see a surge in government bond prices (and a drop in rates), a general flight to quality (US $ and safer companies) and a rise in the price of gold. As we noted in the earlier section, the market drop does not seem to be smaller at larger and more profitable companies, and government bond rates have not dropped. In addition, while the US dollar has had a strong year so far, especially against emerging market currencies, it generally did not see a flight to it in October 2018:

      The dollar strengthened mildly against almost every currency during the month, and the only currency where there was a big move was against the Brazilian Reai, where it weakened, again on political news in Brazil. Note again that the market correction may be, at least partly, a delayed reaction to the strength of the US dollar leading into October, but the timing is still difficult to explain. Finally, I looked at gold prices in October 2018, in conjunction with bitcoin, since the latter has been promoted as millennial gold:
      It has been a good month for gold, with prices up 4.44%, though there is little sign of panic buying pushing up prices. It may be a little unfair to be passing judgment on Bitcoin, after one crisis, but if it is millennial gold, either millennials are unaware that there is a stock market sell off or they do not care. 

      Step 3: Review the fundamentals
      With the assessment of market pain behind us, we can turn to looking at the fundamentals, again looking for clues in why stocks have had such a tough month. While almost every factor affects stock prices, the effects have to show up in one of four places for fundamental value to change significantly: a shock to base year earnings or cash flows, a change in expected earnings/cash flow growth, a increase in the risk free rate or a change in the price of risk:

      Since treasury bond rates have been stable through much of the month, I am going to look at one of the other three variables as the potential culprit.
      1. Base Year Earnings/Cashflows: The earnings reports that have come out for companies in diverse sectors in the last two weeks seem to reinforce the strong earnings story. While there were a few like Caterpillar and 3M that reported headwinds from a stronger dollar, both companies also conveyed the message that they were able to pass the higher costs through to the customers.
        On the cash flow front, there were no high profile cessations of buybacks or dividends, and all signs point to the market delivering and perhaps beating the earnings and cash flows that we have estimated for 2018.
      2. Earnings Growth: This is a trickier component, since it is driven as much by actual data, as it is by perception. At the start of the year, the expectation that earnings growth would be strong for this year, helped both the tax law changes of last year and a strong economy. That growth has been delivered, but it is possible that investors are now doubtful about the sustainability of that earnings growth. That has not shown up yet in forecasted growth for next year, but it bears watching.
      3. Price of Equity Risk (Equity Risk Premium): If you have been reading my blog for a while, you are probably aware of my implied equity risk premium calculation, one that backs out a price of equity risk (equity risk premium) from the level of the index, expected cash flows and a growth rate. Holding cash flows and growth rate fixed for October, I have computed the implied equity risk premium by day. 

      End of DayUS 10-yr T.BondS&P 500Implied ERPSpreadsheet
      9/28/183.06%2913.985.38%Download
      10/1/183.09%2924.595.36%Download
      10/2/183.05%2923.435.36%Download
      10/3/183.15%2925.515.35%Download
      10/4/183.19%2901.615.39%Download
      10/5/183.23%2885.575.41%Download
      10/8/183.22%2884.435.42%Download
      10/9/183.21%2880.345.43%Download
      10/10/183.22%2785.685.61%Download
      10/11/183.14%2728.375.73%Download
      10/12/183.15%2767.135.65%Download
      10/15/183.16%2750.795.68%Download
      10/16/183.16%2809.925.57%Download
      10/17/183.19%2809.215.56%Download
      10/18/183.17%2768.785.65%Download
      10/19/183.20%2767.785.64%Download
      10/22/183.20%2755.885.67%Download
      10/23/183.17%2740.695.70%Download
      10/24/183.10%2656.105.89%Download
      10/25/183.14%2705.575.78%Download
      10/26/183.08%2658.695.89%%Download
      If cash flows and expected growth have not changed over the month, the price of equity risk has jumped from 5.38% at the start of the month to the 5.89% on October 26, putting it at the high end of equity risk premiums in the last decade.

      You could attribute the higher equity risk premiums to global crises (in Italy and Saudi Arabia) but that would be a reach since the increase in risk premiums predates both crises. If you do lower expected earnings growth going forward, perhaps reflecting a delayed response to the stronger dollar and higher rates, the equity risk premium will drop. In fact, halving the expected growth rate from 2019 on from the current estimate of 7.29% to 4.71% (the compounded average annual earnings growth rate over the last 10 years) reduces the equity risk premium to 5.28%, but even that number is a healthy one, relative to historic norms. The bottom line is that, at least by my calculations, I am estimating an equity risk premium that seems fair, given macro and micro fundamentals and my risk preferences.

      Step 4: Investment Action
      One of the biggest perils of being reactive in a  crisis is that it can knock you off your investment game and cause you to abandon your core philosophy. I don't believe that there is one investment philosophy that is right for every one, but I do believe that there is one that is right for you, and shifting away from it is a recipe for bad results. I am a “value” investor, though my definition of value is different from old-time value investing in two ways:
      1. Under valued stocks can be found across sectors and the life cycle: I believe that we should try to assess fair value, not a conservative estimate of value, and that the value should include expected value added from future growth. To the critique that this is speculative, my answer is that everything other than cash-in-hand requires making assumptions about the future, and I am willing to go the distance. That is why, at different points in time, you have seen Twitter and Facebook in my portfolio in the past and may well see Netflix and Tesla in the future (just not now).
      2. Intrinsic value can change over time: I believe that intrinsic value is a dynamic number that changes over time, not only because new information may come out about a company. but also because the price of equity risk can change over time. That said, intrinsic values generally change less than market prices do, as mood and momentum shift. This has been a month of significant price drops in many companies, but assuming that they are therefore more likely to be under valued is a mistake, since the intrinsic values of these companies have also changed, because the ERP that I will be using to value the stocks on October 26, 2018, will be 5.89%, much higher than the 5.38% at the start of the month.
      Given my philosophy and a reading of the data, here is what I plan to do.

      1. No change in asset allocation:  I am not changing my asset allocation mix in significant ways, since I don't see a fundamental reason to do so. 
      2. Revisit existing holdings: I normally revalue every company in my portfolio at least once a year, but after a month like this one, I will have to accelerate the process. Put simply, I have to make sure that at the current price for equity risk, and given expected cash flows, that my buys still remain buys and the sells remain sells.
      3. Bonus from short sales: I do have a portion of my portfolio that benefits from a sell off, primarily in short sales and those have provided partial offsets to my losses. I did sell short on Amazon and Apple at the start of the month, and while I would like to claim prescience, it was pure luck on timing, and the market downdraft during the month has helped me. 
      4. Check out the biggest market losers: I plan to take a closer look at the stocks that have been pummeled the most during the month, including 3M and Caterpillar, to see if they are cheap at October 26 prices, and using an October 26 ERP in my valuation. 
      Please note that this is not meant to be investment advice and your path back to investment serenity may be very different from mine! 

      YouTube Video



      High and higher: The Money in Marijuana!

      In 1992, when Bill Clinton was running for president of the United States, and was asked whether he had ever smoked marijuana, he responded that he had, but that he did not inhale, reflecting the fear that being viewed as a weed-smoker would lay low his presidential ambitions. How times have changed! Today, smoking marijuana recreationally is legal in nine states, and medical marijuana in twenty nine states, in the United States. Outside the United States, much of Europe has always taken a much more sanguine view of cannabis, and on October 17, 2018, Canada will become the second country (after Uruguay) in the world to legalize the recreational use of the product. In conjunction with this development, new companies are entering the market, hoping to take advantage of what they see as a “big” market, and excited investors are rewarding them with large market capitalizations. I have never smoked marijuana, but on my daily walks on the boardwalks of San Diego, I have been inhaling a lot of second-hand smoke, leaving me a little light headed as I write this post. So, read on at your own risk!

      The Macro Big Picture
      While there is much to debate about how this market will evolve over time, and whether investors and businesses can make money of that evolution, there is one fact that is not debatable. The cannabis market will be a big one, in terms of users and revenues, drawing in large numbers of the population. To get a sense of the growth in this business, consider some nascent statistics from the soon-to-be legalized Canadian recreational market:
      1. Lots of people smoke weed: According to the Canadian national census, 42.5% of Canadians have tried Marijuana and about 16% had used it in the recent past (last 3 months), with the percentages climbing among younger Canadians, where one in three being recent users.
      2. And spend money to do so: The total revenues from recreational marijuana sales in Canada alone is expected to be $7-8 billion in 2020 and grow at a healthy rate after that. Some of this will represent a shifting from the illegal market (estimated at close to $5 billion in 2017) and some of it will represent new users drawn in its legal status.
      There is also information that can be gleaned about the future of this business from the states in the United States that have legalized marijuana.
      1. In California, where legalization occurred at the start of 2018, revenues from cannabis are expected to be about $3.4 billion in 2018, but that is not a huge jump from the $3 billion in revenues in the illegal market in 2017. One reason, at least in California, is that legal marijuana, with testing, regulation and taxes, is much more expensive than that obtained in the illegal markets that existed pre-legalization. 
      2. In Colorado, where recreational marijuana use has been legal since 2014, the revenues from selling marijuana have increased from $996 million in 2015 to $1,25 billion in 2016 to $1,47 billion in 2017, representing solid, but not spectacular, growth. Marijuana-related businesses in Colorado have benefited from the revenue growth but have, for the most part, been unable to convert that growth into solid profits, partly because of the regulatory and tax overlay that they have had to navigate. 
      With the limited data that we have from both Canada and the US states that have legalized marijuana, here are some general conclusions that come to mind.
      1. The illegal marijuana market will persist after legalization: The illegal weed business will continue, even after legalization, for many reasons. One is that legalization brings costs, regulations and taxes, which make the cost of legal weed higher than its illegal counterpart. The other is cultural, where a segment of long-time weed smokers will be reluctant to give up their traditional ways of acquiring and using weed. From a business standpoint, this will mean that the legal weed businesses will have to share the market with unregulated and untaxed competitors, reducing both revenues and profitability.
      2. There will be growth in recreational marijuana sales, but it will not be exponential: For those who are expecting a sudden surge of new users, as a result of legalization, the results from the parts of the world that have legalized should be sobering. In most of these parts, to the extent that society and law enforcement had already turned a blind eye to enforcing marijuana laws before legalization, there was no sea change in legal consequences from weed smoking. 
      3. The medical marijuana market growth will be driven more by research indicating its value in health care than by popularity contests. The bad news is that this will require navigating the time-consuming and cash-burning FDA regulatory approval process but the good news is that once approved, there is less likely to be pushback, cultural or legal, against its use. It is a safe prediction that medical marijuana will be legal in all of the United States far sooner than recreational marijuana.
      4. Federal laws matter: If you are a company in the weed business in one of the nine states that has legalized recreational marijuana, you still face a quandary. While your operations may be legal in the state that you operate in, you are at risk any time your operations require you to cross state lines and as we noted with Colorado businesses, when you pay federal taxes. Since most financial service firms operate across state borders and are regulated by Federal entities, it has also meant that even legal businesses in this space have had trouble raising funding or borrowing money from banks.
      In spite of all of these caveats, there is optimism about growth in this market, with the more conservative forecasters predicting that global revenues from marijuana sales will increase to $70 billion in 2024, triple the sales today, and the more daring ones predicting close to $150 billion in sales.

      The Business Question
      If the marijuana market is likely to grow strongly, it should be a good market to operate a business in, right? Not all big businesses are profitable or value creating, since for a big business to be value creating, it has to come with competitive advantages or barriers to entry. If you are an investor in this space, you also have to start thinking about how companies will set themselves apart from each other, once the business matures. To see how companies in this business will evolve, it is important that you separate the recreational from the medical cannabis businesses, since each will face different challenges.

      I. Recreational Cannabis
      Like tobacco and alcohol, the recreational marijuana business will grow with a wink and a nod towards its  side costs, and potential to be a gateway to more potent and addictive substances. Like tobacco and alcohol, marijuana will face both constraints on who it can be sold to, as well as lawsuits down the road. Before you take issue with me for taking a negative view of marijuana, note that this is not a bad path to follow, given that tobacco and alcohol have been solid money-makers for decades. The question then becomes whether, like alcohol and tobacco, cannabis will become a brand-name driven business, where having a stronger brand name allows the winners to charge higher prices and earn better margins, or whether it devolves into a commodity business, where there is little to differentiate between the offerings of different companies, leading to commoditization and low margins. If it is the former, the most successful businesses in the space will bring marketing and branding skills to the table and if it is the latter, it will be economies of scale, and low-cost production that will be the differentiator.

      II. Medical Cannabis
      The medical marijuana business will more closely resemble the pharmaceutical business, where you will have to work with health care regulations and economics. Success in this business will come from finding a blockbuster cannabis-based drug that can then be sold at premium prices. If our experience with young pharmaceutical and biotech companies is an indicator, this would suggest that to succeed in this business, a company will need continued access to capital from investors with patience, a strong research presence and an understanding of the regulatory approval process. The company will also generate more value in health care systems where drug companies have pricing power, making the US market a much more lucrative one than the Canadian one. The differences between the two businesses are stark enough that you can argue that it will be difficult for a company to operate in both businesses without running into problems, sooner or later.

      Investment considerations
      So, should you invest in this business or stay away until it becomes more mature? While there is an argument for waiting, if you are risk averse, it will also mean that you will lose out on the biggest rewards. If you are exploring your options today, you have to start by assessing your investment choices and pick the one that you are most comfortable with.

      The Investment Landscape
      This is a young and evolving business, with the  Canadian legalization drawing more firms into the market. Not only are the companies on the list of public companies in the sector recent listings, but almost all of them have small revenues and big losses. While that, by itself, is likely to drive away old time value investors, it is worth noting that at a this early stage in the business life cycle, these losses are a feature, not a bug. Looking at just the top 10 companies, in terms of market cap, on the cannabis business, here is what I see:
      Largest Publicly Traded Cannabis Companies- October 2018 
      Note that the biggest company on the list is Tilray, a company that went publicly only a few months ago, with revenues that barely register ($28 million) and operating losses. Tilray made the news right after its IPO, with its stock price increasing ten-fold in the weeks after, before losing almost half of its value in the weeks after. Canopy Growth, the largest and most established company on this list, has the highest revenues at $68 million. More generally, Canadian companies dominate the list and all of them trade at astronomical multiples of book value.

      As new companies flock into the market, the list of publicly traded companies is only going to get longer, and at least for the foreseeable future, most of them will continue to lose money. Adding to the chaos, existing companies that have logical reasons to enter this business (tobacco & alcohol in the recreational and pharmaceuticals in the medical) but have held back will enter, as the stigma of being in the business fades, and with it, the federal handicaps imposed for being in the business. Put simply, this business, like many other young and potentially big markets, seems to be in the throes of what I called the big market delusion in a post that I had about online advertising companies a few years ago.

      Trading and Investing
      Like all young businesses, this segment is currently dominated by trading and pricing, not investing and valuation. Put differently, companies are being priced based upon the size of the potential market and incremental information. Put simply, small and seemingly insignificant news stories will cause big swings in stock prices. Thus, there is no fundamental rationale you can give for why Tilray’s stock has behaved the way it has since it's IPO. It is driven by mood and momentum. If you are a good trader, this is a great time to play the game, since you can use your skills at detecting momentum shifts to make money as the stock goes up and again as it goes down. Since I am a terrible trader, I will leave it up to to you to decide whether you want to play the game.

      If you are an investor, you want to invest on the expectation that there is more value in these companies than you are paying up front, for your equity stake. As I see it, here are your choices:
      1. The Concentrated Pick: Pick a stock or two that you believe is most suited to succeed in the  business, as it matures. Thus, if you believe that the business is going to get commoditized and that the winner will be the one with the lowest costs, you should target a company like Canopy Growth, a company that seems to be pushing towards making itself the low-cost leader in the growth end of the business. If, in contrast, you believe that this is a business where branding and marketing will set you apart, you should focus on a company that is building itself up through marketing and celebrity endorsements. To succeed at this strategy, you have to be right on both your macro assessment and your company pick, but if you are, this approach has the potential to have the biggest payoff. 
      2. Spread your bets: If your views about how the business will evolve are diffuse, but you do believe that there will be strong overall revenue growth and ultimate profitability, you can buy a portfolio of marijuana stocks. In fact, there is an ETF (MJ) composed primarily of cannabis-related stocks, with a modest expense ratio; its ten biggest holdings are all marijuana stocks, comprising 62% of the portfolio. The upside is that you just have to be right, on average, for this strategy to pay off, but the downside is that these companies are all richly priced, given the overall optimism about the market today. You also have to worry that the ultimate winner may not be on the list of stocks that are listed today, but a new entrant who has not shown up yet. If you are willing to wait for a correction, and there will be one, you may be able to get into the ETF at a much more reasonable price.
      3. The Indirect Play: Watch for established players to also jump in, with tobacco and alcohol stocks entering the recreational weed business, and pharmaceutical companies the medical weed business. You may get a better payoff investing in these established companies, many of which are priced for low growth and declining margins. One example is Scott’s Miracle-Gro, for instance, which has a growing weed subsidiary called Hawthorne Gardening. Another is GW Pharmaceuticals that has cannabis-based drugs in production for epilepsy and MS.
      It may be indication of my age, but I really don’t have a strong enough handle on this market and what makes it tick to make an early bet on competitive advantages. So, I will pass on picking the one or two winners in the market. Given how euphoric investors have been since the legalization of weed in Canada in pushing up cannabis stock prices, I think this is the wrong time to buy the ETF, especially since sector is going to draw in new players.  That leaves me with the third and final choice, which is to invest in a company that is not viewed as being in the business but has a significant stake in it nevertheless. At current stock prices, neither Scott Miracle-Gro nor GW Pharmaceuticals looks like a good bet (I valued Scott Miracle-Gro at about $55, below its current stock price of $70.), but I think that my choices will get richer in the years to come.  I can wait, and while I do, I think I will take another walk on the boardwalk!

      YouTube Video



      The GE End Game: Bataan Death March or Turnaround Play?

      It seems like ancient history, but it was just 2001, when GE was the most valuable company in the world, commanding a market capitalization in excess of $500 billion. The quintessential conglomerate, with a presence in almost every part of the global economy, it seemed to have been built to withstand economic shocks and was the choice for conservative investors, scared of the short life cycles and the volatile fortunes of its tech challengers. Unlike other aging companies like Sears that have decayed gradually over decades, GE's fall from grace has been precipitous , with the rate of decline accelerating the in the last two years. As a new CEO is brought in, with hopes that he will be a savior, it is the right time to both look back and look forward at one of the globe's most iconic companies.

      GE: A Compressed History
      GE's roots can be traced back to Thomas Edison and his invention of the light bulb. The company that Edison founded in 1878, Edison General Electric, was combined with two other electric companies to create General Electric in 1892. The company established its first industrial lab in 1900 and it would not be an exaggeration to say that it revolutionized not just the American home, with its appliances, but changed the way Americans live. For much of of the twentieth century, though, GE remained an appliance company, though it made forays into other businesses. It was in 1980, when Jack Welch became the CEO of the company, that the company started its march towards what it has become today.

      The Market History
      The first place to start, when looking at GE, is to see how markets have viewed it, over its life. Skipping over the first half of GE's life, the graph below looks at the growth (and recent decline) of GE's market capitalization over time:

      As you can see, GE was a solid but unspectacular investment from 1950 to 1980, and exploded in value in the 1980s and 1990s, with Jack Welch at its helm, and reached its most valuable company in the world status in 2001. Under Jeff Immelt, his successor, the stock continued to do well, but it dropped with the rest of the market as the dot com bubble burst, but then recovered leaving into the 2008 crisis. That crisis was devastating for the company and while it did recover somewhat in the years after, the bottom has clearly dropped out in the last two years, with Jeff Flannery at the top of the company.

      The Operating History
      To get operating perspective on how the company has evolved over time, we looked at how GE"s key operating metrics (revenues, EBITDA, net income) have evolved since 1950:

      In keeping with our earlier market cap assessment, between 1950 and 1970, GE was a good but not exceptional company, delivering solid revenue growth and decent margins. Under two CEOS, Reginald Jones in the 1970s and Jack Welch in the two decades thereafter, the company transformed itself. Jones helped the company navigate through the turbulent period of high inflation and oil prices, holding margins steady and delivering double digit revenue growth. Welch made himself the stuff of legend, by doubling margins and pushing the company to the top of the market cap ranks by the time he left the firm. His successor Jeff Immelt faced the unenviable task of following Welch, but managed to keep revenues growing and delivered high margins until 2008, when the bottom fell out for the company. 

      The Business Mix Shift
      To understand GE's current plight, we have to go back to Welch's tenure as CEO, when he remade the firm, by moving it away from its domestic and manufacturing roots and giving it a global and multi-business focus. GE's biggest leap during that period was into the financial services business, and one reason Welch was attracted to the financial services business was its capacity to generate high profits with relatively little investment. By the late 1990s, GE Capital was the engine driving GE's growth, accounting for almost 48% of revenues in 1998 and as you can see in the graph below, it continued to do so for much of the first decade of Immelt's stewardship:

      In 2008, when the crisis hit financial service firms had, GE was significantly exposed, and in the years since, GE has retreated not just from the financial services business but also from its entertainment bets (with the sale of NBC to Comcast) and from the appliance business (now owned by Haier). GE's current business mix, broken down into more detail, is shown in the pie chart below:
      GE Annual Report for 2017 (Invested Capital, allocated based upon assets by business)
      Today, GE is in three businesses (aviation, healthcare and transportation) that have low growth and high profitability (margins and returns on capital), in three energy-related businesses (power, renewable energy and oil) with higher growth but low profitability (margins & returns on capital), one business (lighting) that is fading quickly and one (capital) that is declining, but dragging value down with it. Note also that the collective profits reported across businesses is  before corporate expenses and eliminations of $3.83 billion (not counting a one-time restructuring charge of $4.1 billion) that effectively wipe out about half of the operating profits. When computing return on capital, I allocated these expenses to the businesses, based upon revenues, and used a 25% effective tax rate, and while GE as a whole did not deliver a return that meets its cost of capital requirements in 2017, aviation, healthcare and transportation clear their hurdle rates by plenty. Replacing 2017 income in each business with a normalized value (computed using the average margins in each business between 2013 and 2017) improves the return on capital at the power and renewable energy businesses, but the overall conclusion remains the same. GE, as a company, does not look good, but it does have significant value creating businesses.

      Corporate Life Cycle
      While there are different ways of framing GE's current standing, I will use the corporate life cycle, since it encapsulates the challenges facing the company.

      GE's light bulb moment might have been in Thomas Edison's lab in 1878, but at an official corporate age of 126 years, GE is an ancient company and its problems reflect its age. Other than renewable energy, all of GE's businesses are mature or declining, and by the laws of mathematics, GE itself is a mature to declining company.  Any story that you tell about GE going forward has to reflect this reality, and there are three possible ones that can lead to different values.
      1. Break it up: If GE at its peak represented the glory of conglomerates, its current plight is a sign of how far conglomerates have fallen in the world. Across the world, multi business companies are finding themselves under pressure to break up and in many cases, their stockholders will be better off if they do. To gain from a break up, though, here are some of the things that have to be true. 
      • Separable businesses: The different businesses have to be separable, since leakages and synergies across businesses can make it more difficult to cleave off pieces to sell or spin off. On this count, GE is probably on safe ground, since its businesses (other than GE Capital) are self standing, for the most part, with little in terms of cross business effects. 
      • Willing buyers: There have to be potential buyers who are willing to pay prices for the pieces that exceed what they will generate as value for the holding company, as going concerns, and those higher prices either have to come from potential synergies or changed management. None of GE's businesses seem alluring enough to attract multiple bidders, willing to pay premium prices, and given GE's shaky bargaining position, it is more likely than not that a rush to unload businesses will do more harm than good. 
      • Corporate Waste (at HQ):  A large chunk of the corporate overhead has to viewed as wasteful, with a big drop in corporate expenses accompanying the breakup. How much of the corporate expense of $3.8 billion that GE reported in 2017 is wasteful and could be eliminated with targeted cost cuts? Looking at the breakdown of these expenses, just about $2.2 billion in for covering pension obligations and breaking up the company will not relieve the company of its contractual obligations. Some of the remaining $1.6 billion may be fat that can be cut, but even cutting the entire amount (which would be a tall order) will not turn the company around.
      Since GE will be trying to sell these businesses to buyers today, this is a pricing and not a valuation exercise, and I have estimate a pricing for GE's businesses below, using an EBITDA recomputed using the average operating margin in each business over the last five years to compute operating income and allocating corporate expenses to the divisions, based upon revenues. To convert the EBITDA to an estimated value, I used the EV/EBITDA multiples of the peer group:
      Download spreadsheet
      If GE is able to get buyers to pay industry-level multiples of EBITDA for each of these businesses, it will be able to net about $103 billion for its equity investors, higher than the market capitalization on November 14 of $72 billion. The problem, though, is that fire sales of entire companies almost never deliver the expected proceeds, as buyers, recognizing desperation, hold back. In fact, GE's attempts to extricate itself from a portion of its Baker-Hughes investment in the last few days show that these sales will occur at a discount.

      2. Retrench and Reshape: The second choice for GE is to retrench and perhaps renew itself, not as a growth company, but as a stable, high margin company in businesses where it has a competitive advantage. In broad terms, the roadmap for GE to succeed in this path is a simple one,  shrinking or selling off pieces of its low-margin businesses, exiting the capital business and consolidating its presence in the aviation, healthcare and transportation businesses. To get a better sense of what the businesses would be worth, as continuing operations, I valued each of GE's business, using simplistic assumptions: I used the sector cost of capital for each business, set growth in the next five years equal to revenue growth in each of GE's businesses in the last five years and normalized operating income based upon the average operating margin that each of GE's businesses have delivered over the last five years:
      Download spreadsheet
      The value that I derive for equity is lower than the $103 billion that I estimated in the last section, but it does not require any near term fire sales at discounts. There are two big challenges that GE will face along the way. The first is that GE is saddled with a significant debt obligation, a legacy of GE Capital, that will not fade away quickly, and the debt obligations represent a clear and present danger to the firm.  One reason for the rapid drop in GE's stock price in the last few weeks has been the deterioration in the company's credit standing, as can be seen in the rising default spreads for the company in the CDS market.

      The reason that GE is trying to sell some of its stake in Baker and Hughes to pay down debt, but bond markets are skeptical, with good reason. The second is that GE Capital is now more burden than benefit to investors. In the valuation table, note that the value that I have estimated for GE Capital's operations ($27 billion) is much lower than GE Capital debt ($51 billion); in fact, I derive very similar results in the pricing. Put differently, in my valuation, I foresee the cost of exiting GE capital to be $24 billion in today's terms, but spread out over time.  If GE can navigate its way through its debt payments to becoming a more focused company, with constrained ambitions, it could survive and reclaim its place as a holding for a conservative value investor.

      3. Reincarnate (or the Bataan Death March): There is a third option that GE shareholders have to hope and pray that GE does not take, where the company tries to recapture its old glory, throwing caution to the winds and reinvesting large amounts in new businesses, or worse still, large acquisitions. While there is no indication that Larry Culp, GE's new CEO, has grandiose plans for the company, that may be because the company is in crisis today. If as the crisis passes, Culp is tempted to make himself the second coming of Jack Welch, the company will follow the path of other aging companies that refuse to act their age, spending billions on cosmetic surgery (acquisitions) before finally capitulating. If there is a role model that Mr. Culp should follow, it is less that of Steve the Visionary, and more that of Larry the Liquidator

      General Lessons
      Given its age, it should come as no surprise that GE has been the subject of more case studies than perhaps any other company in the world. In its earlier days, it was used as an example of professional management, and during Jack Welch's years, it was held up as an illustration of how aging manufacturing companies can remake themselves, with enlightened management at the top. Now that it is in trouble, I think that we look back at the last four decades and draw a different set of lessons:
      1. Conglomeration was, is and always will be a bad idea: I never understood the allure of conglomerates, even in their heyday. Only a corporate strategist could argue that combining companies in different businesses under one corporate umbrella, paying hefty premiums along the way to acquire these holdings, creates value, ignoring the logic that you and I as stockholders can create our own diversified and customized portfolios, without paying the same premium. If there is a lesson to learn from GE's fall from grace, it is that even the best conglomerates are built on foundations of sand. Note, though, that while this lesson may be learned for the moment, it will be forgotten soon, as are most other business lessons are, and we will surely repeat the cycle again in the future.
      2. Complexity has a cost: As I was going through GE's annual report, I was reminded again of why I have always described my vision of hell as having to value GE over and over and over again, for eternity. This company, through its actions and by design, made itself into one of the most complex companies in history, operating in dozens of businesses and across the world, with GE Capital acting as the cherry on the complexity cake, a gigantic financial service firm embedded in a large conglomerate. While that complexity served GE well in its glory days, allowing it to hide mistakes from sloppy acquisition practices and bets gone bad, it has bedeviled the company since 2008. Investors trying to navigate their way through the company's financials often give up and move on to easier prey. It may be too late for GE to do much about this problem, but as Asian companies rise in market capitalization, you are seeing new complex behemoths coming into play across the world.
      3. Easy money has a catch: I know that 20/20 hindsight is both easy and unfair, but GE's experiences with GE Capital bring home an age-old business truth that when a business looks like it can make you easy money, there is always a catch. Jack Welch initial foray into and subsequent expansion of GE Capital was built on the allure that it was a lot easier to make money in financial services than in manufacturing. From the perspective of having limited capital investment and growing quickly, that was true, but financial service firms through history have always had periods of plenty interspersed with bouts of gut-wrenching and intense pain, when borrowers start defaulting and capital markets freeze up. By making GE Capital such a big part of GE, Welch bet the farm on its continued success, and that bet went sour in 2008.
      4. The Savior CEO is a myth: I come to neither bury nor praise Jack Welch, but notwithstanding the fact that he has been gone almost two decades from the firm, GE remains the house that Jack built. Since Welch got the glory that came from GE's rise in the last twenty years of the last century, he deserves a portion of the blame for what has happened since. Don't get me wrong! Jack Welch was an inspirational top manager, a man with vision and drive, but he was also an imperial CEO, who made his board of directors a rubber stamp for his actions. As we look at a new generation of successful companies, this time in the technology space (the FANG stocks and the Chinese giants), with visionary founders at the top, it is worth remembering that power left unchecked in any person (no matter how smart and visionary) is dangerous.
      The Bottom Line
      As many of you know, I believe that every valuation has to have a story. With some companies, like Amazon and Google, the story is uplifting and optimistic, and the valuations follow, but they still might not be good investments, since their prices may be even higher. My story for GE is not an upbeat one, but if it (and its management) acts its age, accepts that slower or no growth is what lies in the future and does not over reach, it is a good investment. I believe that the market has over corrected for GE's many faults, and at the current stock price, that it is significantly under valued. I will buy GE, but I will do so with open eyes, not expecting (or wanting) dividends to be paid until the debt gets paid down and the company exits the capital business with as much grace (and as few costs) as it can muster. 

      YouTube Video

      Attachments




      Is there a signal in the noise? Yield Curves, Economic Growth and Stock Prices!

      The title of this post is not original and draws from Nate Silver's book on why so many predictions in politics, sports and economics fail. It reflects the skepticism with which I view many 'can't fail" predictors of economic growth or stock markets, since they tend to have horrendous track records. Over the last few weeks, as markets have gyrated, market commentators have been hard pressed to explain day-to-day swings, but that has not stopped them from trying. The explanations have shifted and morphed, often in contradictory ways, but few of them have had staying power. On Tuesday (December 4), as the Dow dropped 800 points, following a 300-point up day on Monday, the experts found a new reason for the market drop, in the yield curve, with an "inverted yield curve", or at least a portion of one, predicting an imminent recession. As with all market rules of thumb, there is some basis for the rule, but there are shades of gray that can be seen only by looking at all of the data.

      Yield Curves over time
      The yield curve is a simple device, plotting yields across bonds with different maturities for a given issuing entity. US treasuries, historically viewed as close to default free, provide the cleanest measure of the yield curve,  and the graph below compares the US treasury yield curve at the start of every year from 2009 to 2018, i.e., the post-crisis years:
      The yield curve has been upward sloping, with yields on longer term maturities higher than yields on short term maturities, every year, but it has flattened out the last two years. On December 4, 2018, the yields on treasuries of different maturities were as follows:
      The market freak out is in the highlighted portion, with 5-year rates being lower (by 0.01-0.02%) than 2-year or 3-year rates, creating an inverted portion of the yield curve. 

      Yield Curves and Economic Growth: Intuition
      To understand yield curves, let's start with a simple economic proposition. Embedded in every treasury rate are expectations of expected inflation and expected real real interest rates, and the latter
      Interest Rate = Expected Inflation Rate + Expected Real Interest Rate
      Over much of the last century, the US treasury yield curve has been upward sloping, and the standard economic rationalization for it is a simple one. In a market where expectations of inflation are similar for the short term and the long term, investors will demand a "maturity premium" (or a higher real interest rate) for buying longer term bonds, thus causing the upward tilt in the yield curve.  That said, there have been periods where the yield curve slopes downwards, and to understand why this may have a link with future economic growth, let's focus on the mechanics of yield curve inversions. Almost every single yield curve inversion historically, in the US,  has come from the short end of the curve rising significantly, not a big drop in long term rates. Digging deeper, in almost every single instance of this occurring, short term rates have risen because central banks have hit the brakes on money, either in response to higher inflation or an overheated economy. You can see this in the chart below, where the Fed Funds rate (the Fed's primary mechanism for signaling tight or loose money) is graphed with the 3 month, 2 year and 10 year rates:
      Interest Rate Raw Data
      As you can see in this graph, the rises in short term rates that give rise to each of the inverted yield curve episodes are accompanied by increases in the Fed Funds rate. To the extent that the Fed's monetary policy action (of raising the Fed funds rate) accomplishes its objective of slowing down growth, the yield slope metric becomes a stand-in for the Fed effect on the economy, with a more positive slope associated with easier monetary policy. You may or may not find any of these hypotheses to be convincing, but the proof is in the pudding, and the graph below, excerpted from a recent Fed study, seems to indicate that there has been a Fed effect in the US economy, and that the slope of the yield curve has operated as proxy for that effect:
      Federal Reserve of San Francisco
      The track record of the inverted yield curve as a predictor of recessions is impressive, since it has preceded the last eight recessions, with only only one false signal in the mid-sixties. If this graph holds, and December 4 was the opening salvo in a full fledged yield curve invasion, the US economy is headed into rough waters in the next year.

      Yield Curves and Economic Growth: The Data
      The fact that every inversion in the last few decades has been followed by a recession will strike fear into the hearts of investors, but is it that fool proof a predictor? Perhaps, but given that the yield curve slope metrics and economic growth are continuous, not discrete, variables, a more complete assessment of the yield curve's predictive power for the economy would require that we look at the strength of the link between the slope of the yield curve (and not just whether it is inverted or not) and the level of economic growth (and not just whether it is positive or negative).

      To begin this assessment, I looked at the rates on  three-month and one-year T.Bills and the two, five and ten-year treasury bonds at the end of every quarter from 1962 through the third quarter of 2018:
      Following up, I look at five yield curve metrics (1 year versus 3 month, 2 year versus 3 month, 5 year versus 2 year, 10 year versus 2 year and 10 year versus 3 month), on a quarterly basis from 1962 through 2018, with an updated number for December 4, 2018. 
      For the most part, the yield curve metrics move together, albeit at different rates. I picked four measures of the spread, one short term (1 year versus 3 month), one medium term (5 year versus 2 year) and two long term (10 year versus 2 year, 10 year versus 3 month) and plotted them against GDP growth in the next quarter and the year after. 
      Interest Rate Raw Data
      The graph does back up what the earlier Fed study showed, i.e., that negatively sloped yield curves have preceded recessions, but even a cursory glance indicates that the relationship is weak. Not only does there seem to be no relationship between how downwardly sloped the yield curve is and the depth of the recessions that follow, but in periods where the yield curve is flat or mildly positive, subsequent economic growth is unpredictable. To get a little more precision into the analysis, I computed the correlations between the different yield curve slope metrics and GDP growth:

      Taking a closer look at the data, here is what I see;
      1. It is the short end that has predictive power for the economy: Over the entire time period (1962-2018), the slope of the short end of the yield curve is positively related with economic growth, with more upward sloping yield curves connected to higher economic growth in subsequent time periods. The slope at the long end of the yield curve, including the widely used differential between the 10-year and 2-year rate not only is close to uncorrelated with economic growth (the correlation is very mildly negative).
      2. Even that predictive power is muted: Over the entire time period, even for the most strongly linked metric (which is the 2 year versus 1 year), the correlation is only 29%, for GDP growth over the next year, suggesting that there is significant noise in the prediction. 
      3. And 2008 may have been a structural break: Looking only at the last ten years, the relationship seems to have reversed sign, with flatter yield curves, even at the short end, associated with higher real growth. This may be a hangover from the slow economic growth in the years after the crisis, but it does raise red flags about using this indicator today.
      How do you reconcile these findings with both the conventional wisdom that inverted yield curves are negative indicators of future growth and the empirical evidence that almost every inversion is followed by a recession? It is possible that it is the moment of inversion that is significant, perhaps as a sign of the Fed's conviction, and that while the slope of the yield curve itself may not be predictive, that moment that the yield curve inverts remains a strong indicator. 

      Yield Curves and Stock Returns
      As investors, your focus is often less on the economy, and more on stock prices. After all, strong economies don't always deliver superior stock returns, and weak ones can often be accompanied by strong market performance. From that perspective, the question becomes what the slope of the yield curve and inverted yield curves tell you about future stock returns,  not economic growth. I begin the analysis by looking at yield curve metrics over time, graphed against return on US stocks in the next quarter and the next year:
      If you see a pattern here, you are a much better chart reader than I am. I therefore followed up the analysis by replicating the correlation table that I reported in the economic growth section, but looking at stock returns in subsequent periods, rather than real GDP growth:
      As with the economic growth numbers, if there is any predictive power in the yield curve slope, it is at the short end of the curve and not the long end. And as with the growth numbers, the post-2008 time period is a clear break from the overall numbers.

      What does all of this mean for investors today? I think that we may be making two mistakes. One is to take a blip on a day (the inversion in the 2 and 5 year bonds on December 4) and read too much into it, as we are apt to do when we are confused or scared. It is true that a portion of the yield curve inverted, but if history is any guide, its predictive power for the economy is weak and for the market, even weaker. The other is that we are taking rules of thumb developed in the US in the last century and assuming that they still work in a  vastly different economic environment. 

      Bottom Line
      There is information in the slope of the US treasury yield curve, but I think that we need to use it with caution. In my view, the flattening of the yield curve in the last two years has been more good news than bad, an indication that we are coming out of the low growth mindset of the post-2008 crisis years. However, I also think that the stalling of the US 10-year treasury bond rate at 3% or less is sobering, a warning that investors are scaling back growth expectations for both the global and US economies, going into 2019. The key tests for stocks lie in whether they can not only sustain earnings growth, in the face of slower economic growth and without the tailwind of a tax cut (like they did last year), but also in whether they can continue to return cash at the rates that they have for the last few years.

      YouTube Video


      Data

      1. Raw data on US treasury rates, GDP growth and Stock Returns





      Investing Whiplash: Looking for Closure with Apple and Amazon!

      In September, I took a look, in a series of posts, at two companies that had crested the trillion dollar market cap mark, Apple and Amazon, and concluded that series with a post where I argued that both companies were over valued. I also mentioned that I was selling short on both stocks, Amazon for the first time in 22 years of tracking the company, and Apple at a limit price of $230. Two months later, both stocks have taken serious hits in the market, down almost 25% apiece, and one of my short sales has been covered and the other is still looking profitable. It is always nice to have happy endings to my investment stories, but rather than use this as vindication of my valuation or timing skills, I will argue that I just got lucky in terms of timing. That said, given how much these stocks have dropped over the last two months, it is an opportunity to not just revisit my valuations and investment judgments, but also to draw some general lessons about intrinsic valuation and pricing.

      My September Valuations: A Look Back
      In September, I valued Apple and Amazon and arrived at a value per share of roughly $200 for Apple and $1255 for Amazon, well below their prevailing stock prices of $220 (Apple) and $1950 (Amazon). I was also open about the fact that my valuations reflected my stories for the companies, and that my assumptions were open for debate. In fact, I estimated value distributions for both companies and noted that not only did I face more uncertainty in my Amazon valuation, but also that there was a significant probability in both companies that my assessment (that the stocks were over valued) was wrong. I summarized my results in a table that I reproduce below:
      Apple Valuation & Amazon Valuation in September 2018
      I did follow through on my judgments, albeit with some trepidation, selling short on Amazon at the prevailing market price (about $1950) and putting in a limit short sell at $230, which was fulfilled on October 3, as the stock opened above $230. With both stocks, I also put in open orders to cover my short sales at the 60th percentile of my value distributions, i.e., $205 at Apple and $1412 at Amazon, not expecting either to happen in the near term. (Why 60%? Read on...) Over the years, I have learned that investment stories and theses, no matter how well thought out and reasoned, don't always have happy endings, but this one did, and at a speed which I did not expect:
      My Apple short sale which was initiated on October 3 was closed out on November 5 at $205, while Amazon got tantalizingly close to my trigger price for covering of $1412 (with a low of $1420 on November 20), before rebounding. 

      Intrinsic Value Lessons
      Every investment, whether it is a winner or a loser, carries investment lessons, and here are mine from my AAPL/AMZN experiences, at least so far:
      1. Auto pilot rules to fight behavioral minefields: If you are wondering why I put in limit orders on both my Apple short sale and my covering trades on both stocks, it is because I know my weaknesses and left to my own biases, the havoc that they can wreak on my investment actions. I have never hidden the fact that I love Apple as a company and I was worried that if I did not put in my limit short sell order at $230, and the stock rose to that level, I would find a way to justify not doing it. For the limit buys to cover my short sales, I used the 60th percentile of the value distribution, because my trigger for buying a stock is that it be at least at the 40th percentile of its value distribution and to be consistent, my trigger for selling is set at the 60th percentile. It is my version of margin of safety, with the caveat being that for stocks like Amazon, where uncertainty abounds, this rule can translate into a much bigger percentage price difference than for a stock like Apple, where there is less uncertainty. (The price difference between the 60th and 90th percentile for Apple was just over 10%, whereas the price difference between those same percentiles was 35% for Amazon, in September 2018.)
      2. Intrinsic value changes over time: Among some value investors, there is a misplaced belief that intrinsic value is a timeless constant, and that it is the market that is subject to wild swings, driven by changes in mood and momentum. That is not true, since not only do the determinants of value (cash flows, growth and risk) change over time, but so does the price of risk (default spreads, equity risk premiums) in the market. The former occurs every time a company has a financial disclosure, which is one reason that I revalue companies just after earnings reports, or a major news story (acquisition, divestiture, new CEO),  and the latter is driven by macro forces. That sounds abstract, but I can use Apple and Amazon to illustrate my point. Since my September valuations for both companies occurred after their most recent earnings reports, there have been no new financial disclosures from either company. There have been a few news stories and we can argue about their consequentiality for future cash flows and growth, but the big change has been in the market. Since September 21, the date of my valuation, equity markets have been in turmoil, with the S&P 500 dropping about 5.5% (through November 30) and the US 10-year treasury bond rate have dropped slightly from 3.07%  to 3.01%, over the same period. If you are wondering why this should affect terminal value, it is worth remembering that the price of risk (risk premium) is set by the market, and the mechanism it has for adjusting this price is the level of stock prices, with a higher equity risk premium leading to lower stock prices. In my post at the end of a turbulent October, I traced the change in equity risk premiums, by day, through October and noted that equity risk premiums at the end of the month were up about 0.38% from the start of the month and almost 0.72% higher than they were at the start of September 2018. In contrast, November saw less change in the ERP, with the ERP adjusting to 5.68% at the end of the month.
        Plugging in the higher equity risk premium and the slightly lower risk free rate into my Apple valuation, leaving the rest of my inputs unchanged, yields a value of $197 for the company, about 1.5% less than my $200 estimate on September 21. With Amazon, the effect is slightly larger, with the value per share dropping from $1255 per share to $1212, about 3.5%. Those changes may seem trivial but if the market correction had been larger and the treasury rate had changed more, the value effect would have been larger.
      3. But price changes even more: If the fact that value changes over time, even in the absence of company-specific information, makes you uncomfortable, keep in mind that the market price usually changes even more. In the case of Apple and Amazon, this is illustrated in the graph below, where I compare value to price on September 21 and November 30 for both companies:
        In just over two months, Apple's value has declined from $201 to $196, but the stock price has dropped from $220 to $179, shifting it from being overvalued by 9.54% to undervalued by 9.14%. Amazon has become less over valued over time, with the percentage over valuation dropping from  55.38% to 39.44%. I have watched Apple's value dance with its price for  much of this decade and the graph below provides the highlights:
        From my perspective, the story for Apple has remained largely the same for the last eight years, a slow-growth, cash machine that gets the bulk of its profits from one product: the iPhone. However, at regular intervals, usually around a new iPhone model, the market becomes either giddily optimistic about it becoming a growth company (and pushes up the price) or overly pessimistic about the end of the iPhone cash franchise (and pushes the price down too much). In the face of this market  bipolarity, this is my fourth round of holding Apple in the last seven years, and I have a feeling that it will not be the last one.
      4. Act with no regrets:  I did cover my short sale, by buying back Apple at $205, but the stock continued to slide, dropping below $175 early last week. I almost covered my Amazon position at $1412, but since the price dropped only as low as $1420, my limit buy was not triggered, and the stock price is back up to almost $1700. Am I regretful that I closed too early with Apple and did not close out early enough with Amazon? I am not, because if there is one thing I have learned in my years as an investor, it is that you have stay true to your investment philosophy, even if it means that you leave profits on the table sometimes, and lose money at other times. I have faith in value, and that faith requires me to act consistently. I will continue to value Amazon at regular intervals, and it is entirely possible that I missed my moment to sell, but if so, it is a price that I am willing to pay.
      5. And flexible time horizons: A contrast that is often drawn between investors and traders is that to be an investor, you need to have a long time horizon, whereas traders operate with windows measured in months, weeks, days or even hours. In fact, one widely quoted precept in value investing is that you should buy good companies and hold them forever. Buy and hold is not a bad strategy, since it minimizes transactions costs, taxes and impulsive actions, but I hope that my Apple analysis leads you to at least question its wisdom. My short sale on Apple was predicated on value, but it lasted only a month and four days, before being unwound. In fact, early last week, I bought Apple at $175, because I believe that it under valued today, giving me a serious case of investing whiplash. I am willing to wait a long time for Apple's price to adjust to value, but I am not required to do so. If the price adjusts quickly to value and then moves upwards, I have to be willing to sell, even if that is only a few weeks from today. In my version of value investing, investors have to be ready to hold for long periods, but also be willing to close out positions sooner, either because their theses have been vindicated (by the market price moving towards value) or because their theses have broken down (in which case they need to revisit their valuations).
      Bottom Line
      As investors, we are often quick to claim credit for our successes and equally quick to blame others for our failures, and I am no exception. While I am sorely tempted to view what has happened at Apple and Amazon as vindication of my value judgments, I know better. I got lucky in terms of timing, catching a market correction and one targeted at tech stocks, and I am inclined to believe that  is the main reason why my Apple and Amazon positions have made me money in the last two months. With Amazon, in particular, there is little that has happened in the last two months that would represent the catalysts that I saw in my initial analysis, since it was government actions and regulatory pushback that I saw as the likely triggers for a correction. With Apple, I do have a longer history and a better basis for believing that this is market bipolarity at play, with the stock price over shooting its value, after good news, and over correcting after bad news, but nothing that has happened  to the company in the last two month would explain the correction. Needless to say, I will bank my profits, even if they are entirely fortuitous, but I will not delude myself into chalking this up to my investing skills. It is better to be lucky than good!

      YouTube Video


      Blog Posts
      1. Apple and Amazon at a Trillion $: A Follow-up on Uncertainty and Catalysts (September 2018)
      2. An October Surprise: Making Sense of Market Mayhem (October 2018)






      January 2019 Data Update 6: Profitability and Value Creation!

      In my last post, I looked at hurdle rates for companies, across industries and across regions, and argued that these hurdle rates represent benchmarks that companies have to beat, to create value. That said, many companies measure success using lower thresholds, with some arguing that making money (having positive profits) is good enough and others positing that being more profitable than competitors in the same business makes you a good company. In this post, I will look at all three measures of success, starting with the minimal (making money), moving on to relative judgments (and how best to compare profitability across companies of different scales) and ending with the most rigorous one of whether the profits are sufficient to create value.

      Measuring Financial Success
      You may start a business with the intent of meeting a customer need or a societal shortfall but your financial success will ultimately determine your longevity. Put bluntly, a socially responsible company with an incredible product may reap good press and have case studies written about it, but if it cannot establish a pathway to profitability, it will not survive. But how do you measure financial success? In this portion of the post, I will start with the simplest measure of financial viability, which is whether the company is making money, usually from an accounting perspective, then move the goal posts to see if the company is more or less profitable than its competitors, and end with the toughest test, which is whether it is generating enough profits on the capital invested in it, to be a value creator.

      Profit Measures
      Before I present multiple measures of profitability, it is useful to step back and think about how profits should be measured. I will use the financial balance sheet construct that I used in my last post to explain how you can choose the measure of profitability that is right for your analysis:

      Just as hurdle rates can vary, depending on whether you take the perspective of equity investors (cost of equity) or the entire business (cost of capital), the profit measures that you use will also be different, depending on perspective. If looked at through the eyes of equity investors, profits should be measured after all other claim holders (like debt) and have been paid their dues (interest expenses), whereas using the perspective of the entire firm, profits should be estimated prior to debt payments. In the table below, I have highlighted the various measures of profits and cash flows, depending on claim holder perspective:
      The key, no matter which claim holder perspective you adopt, is to stay internally consistent. Thus, you can discount cash flows to equity (firm) at the cost of equity (capital) or compare the return on equity (capital) to the cost of equity (capital), but you cannot mix and match.

      The Minimal Test: Making money?
      The lowest threshold for success in business is to generate positive profits, perhaps the reason why accountants create measures like breakeven, to determine when that will happen. In my post on measuring risk, I looked at the percentages of firms that meet this threshold on net income (for equity claim holders), an operating income (for all claim holders) and EBITDA (a very rough measure of operating cash flow for all claim holders). Using that statistic for the income over the last twelve month, a significant percentage of publicly traded firms are profitable:
      Data, by country
      The push back, even on this simplistic measure, is that just as one swallow does not a summer make, one year of profitability is not a measure of continuing profitability. Thus, you could expand this measure to not just look at average income over a longer period (say 5 to 10 years) and even add criteria to measure sustained profitability (number of consecutive profitable years). No matter which approach you use, you still will have two problems. The first is that because this measure is either on (profitable) or off (money losing), it cannot be used to rank or grade firms, once they have become profitable. The other is that making money is only the first step towards establishing viability, since the capital invested in the firm could have been invested elsewhere and made more money. It is absurd to argue that a company with $10 billion in capital invested in it is successful if it generates $100 in profits, since that capital invested even in treasury bills could have generated vastly more money.

      The Relative Test: Scaled Profitability
      Once a company starts making money, it is obvious that higher profits are better than  lower ones, but unless these profits are scaled to the size of the firm, comparing dollar profits will bias you towards larger firms. The simplest scaling measure is revenues, a data item available for all but financial service firms, and one that is least likely to be affected by accounting choices, and profits scaled to revenues yields profit margins. In a data update post from a year ago, I provided a picture of different margin measures and why they might provide different information about business profitability:

      As I noted in my section on claimholders above, you would use net margins to measure profitability to equity investors and operating margins (before or after taxes) to measure profitability to the entire firm. Gross and EBITDA margins are intermediate stops that can be used to assess other aspects of profitability, with gross margins measuring profitability after production costs (but before selling and G&A costs) and EBITDA margins providing a crude measure of operating cash flows.

      In the graph below, I look at the distribution of pre-tax operating margins and net margins globally, and provide regional medians for the margin measures:

      The regional comparisons of margins are difficult to analyze because they reflect the fact that different industries dominate different regions, and margins vary across industries. You can get the different margin measures broken down by industry, in January 2019, for US firms by clicking here. You can download the regional averages using the links at the end of this post.

      The Value Test: Beating the Hurdle Rate
      As a business, making money is easier than creating value, since to create value, you have to not just make money, but more money than you could have if you had invested your capital elsewhere. This innocuous statement lies at the heart of value, and it is in fleshing out the details that we run into practical problems on the three components that go into it:
      1. Profits: The profit measures we have for companies reflect their past, not the future, and even the past measures vary over time, and for different proxies for profitability. You could look at net income in the most recent twelve months or average net income over the last ten years, and you  could do the same with operating income. Since value is driven by expectations of future profits, it remains an open question whether any of these past measures are good predictors.
      2. Invested Capital: You would think that a company would keep a running tab of all the money that is invested in its projects/assets, and in a sense, that is what the book value is supposed to do. However, since this capital gets invested over time, the question of how to adjust capital invested for inflation has remained a thorny one. If you add to that the reality that the invested capital will change as companies take restructuring charges or buy back stock, and that not all capital expenses finds their way on to the balance sheet, the book value of capital may no longer be a good measure of capital invested in existing investments.
      3. Opportunity Cost: Since I spent my last post entirely on this question, I will not belabor the estimation challenges that you face in estimating a hurdle rate for a company that is reflective of the risk of its investments.
      In a perfect world, you would scale your expected cashflows in future years, adjusted for time value of money, to the correct amount of capital invested in the business and compare it to a hurdle rate that reflects both your claim holder choice (equity or the business) but also the risk of the business. In fact, that is exactly what you are trying to do in a good intrinsic or DCF valuation. 

      Since it is impossible to do this for 42000 plus companies, on a company-by-company basis, I used blunt instrument measures of each component, measuring profits with last year's operating income after taxes, using book value of capital (book value of debt + book value of equity - cash) as invested capital:

      Similarly, to estimate cost of capital, I used short cuts I would not use, if I were called up to analyze a single company: 


      Comparing the return on capital to the cost of capital allows me to estimate excess returns for each of my firms, as the difference between the return on invested capital and the cost of capital. The distribution of this excess return measure globally is in the graph below:
      I am aware of the limitations of this comparison. First, I am using the trailing twelve month operating income as profits, and it is possible that some of the firms that measure up well and badly just had a really good (bad) year. It is also biased against young and growing firms, where future income will be much higher than the trailing 12-month value. Second, operating income is an accounting measure, and are affected not just by accounting choices, but are also affected by the accounting mis-categorization of lease and R&D expenses. Third, using book value of capital as a proxy for invested capital can be undercut by not only whether accounting capitalizes expenses correctly but also by well motivated attempts by accountants to write off past mistakes (which create charges that lower invested capital and make return on capital look better than it should). In fact, the litany of corrections that have to be made to return on capital to make it usable and listed in this long and very boring paper of mine. Notwithstanding these critiques, the numbers in this graph tell a depressing story, and one that investors should keep in mind, before they fall for the siren song of growth and still more growth that so many corporate management teams sing. Globally, approximately 60% of all firms globally earn less than their cost of capital, about 12% earn roughly their cost of capital and only 28% earn more than their cost of capital. There is no region of the world that is immune from this problem, with value destroyers outnumbering value creators in every region.

      Implications
      From a corporate finance perspective, there are lessons to be learned from the cross section of excess returns, and here are two immediate ones:
      1. Growth is a mixed blessing: In 60% of companies, it looks like it destroys value, does not add to it. While that proportion may be inflated by the presence of bad years or companies that are early in the life cycle, I am sure that the proportion of companies where value is being destroyed, when new investments are made, is higher than those where value is created.
      2. Value destruction is more the rule than the exception: There are lots of bad companies, if bad is defined as not making your hurdle rate. In some companies, it can be attributed to bad managed that is entrenched and set in its ways. In others, it is because the businesses these companies are in have become bad business, where no matter what management tries, it will be impossible to eke out excess returns.
      You can see the variations in excess returns across industries, for US companies, by clicking on this link, but there are clearly lots of bad businesses to be in. The same data is available for other regions in the datasets that are linked at the end of this post.

      If there is a consolation prize for investors in this graph, it is that the returns you make on your investment in a company are driven by a different dynamic. If stocks are value driven, the stock price for a company will reflect its investment choices, and companies that invest their money badly will be priced lower than companies that invest their money well. The returns you will make on these companies, though, will depend upon whether the excess returns that they deliver in the future are greater or lower than expectations. Thus, a company that earns a return on capital of 5%, much lower than its cost of capital of 10%, which is priced to continue earning the same return will see if its stock price increase, if it can improve its return on capital to 7%, still lower than the cost of capital, but higher than expected. By the same token, a company that earns a return on capital of 25%, well above its cost of capital of 10%, and priced on the assumption that it can continue on its value generating path, will see its stock price drop, if the returns it generates on capital drop to 20%, well above the cost of capital, but still below expectations. That may explain a graph like the following, where researchers found that investing in bad (unexcellent) companies generated far better returns than investing in good (excellent) companies:
      Original Paper: Excellence Revisited, by Michelle Klayman
      The paper is dated, but its results are not, and they have been reproduced using other categorizations for good and bad firms. Thus, investing in the most admired firms generates worse returns for investors than investing in the least admired and investing in popular (with investors) firms under performs investing in unpopular ones. While these results may seem perverse, at first sight, that bad (good) companies can be good (bad) investments, it makes sense, once you factor in the expectations game

      Finally, on the corporate governance front, I feel that we have lost our way. Corporate governance laws and measures have focused on check boxes on director independence and corporate rules, rather than furthering the end game of better managed companies. From my perspective, corporate governance should give stockholders a chance to change the way companies are run, and if corporate governance works well, you should see more management turnover at companies that don't earn what they need to on capital. The fact that six in ten companies across the globe earned well below their cost of capital in 2018, added to the reality that many of these companies have not only been under performing for years, but are still run by the same management, makes me wonder whether the push towards better corporate governance is more talk than action.

      YouTube Video


      Data Links
      1. Profit Margins: USGlobalEmerging MarketsEuropeJapanIndiaChinaAus & Canada
      2. Excess Returns to Equity and Capital: USGlobalEmerging MarketsEuropeJapanIndiaChinaAus & Canada



      January 2019 Data Update 5: Hurdle Rates and Costs of Financing

      In the last post, I looked at how to measure risk from different perspectives, with the intent of bringing these risk measures into both corporate finance and valuation. In this post, I will close the circle by converting risk measures into hurdle rates, critical in corporate finance, since they drive whether companies should invest or not, and in valuation, because they determine the values of businesses. As with my other data posts, the focus will remain on what these hurdle rates look like for companies around the world at the start of 2019.

      A Quick Introduction
      The simplest way to introduce hurdle rates is to look at them from the perspectives of the capital providers to a business. Using a financial balance sheet as my construct, here is a big picture view of these costs:

      Thus. the hurdle rate for equity investors, i.e., the cost of equity, is the rate that they need to make, to break even, given the risk that they perceive in their equity investments. Lenders, on the other hand, incorporate their concerns about default risk into the interest rates they set on leans, i.e., the cost of debt. From the perspective of a business that raises funds from both equity investors and lenders, it is a weighted average of what equity investors need to make and what lenders demand as interest rates on borrowing, that represents the overall cost of funding, i.e., the cost of capital.

      I have described the cost of capital as the Swiss Army Knife of finance, used in many different contexts and with very different meanings. I have reproduced below the different uses in a picture:
      Paper on cost of capital
      It is precisely because the cost of capital is used in so many different places that it is also one of the most misunderstood and misused numbers in finance. The best way to reconcile the different perspectives is to remember that the cost of capital is ultimately determined by the risk of the enterprise raising the funding, and that all of the many risks that a firm faces have to find their way into it. I have always found it easiest to break the cost of capital into parts, and let each part convey a specific risk, since if I am careless, I end up missing or double counting risk. In this post, I will break the risks that a company faces into four groups: the business or businesses the company operates in (business risk), the geographies that it operates in (country risk), how much it has chosen to borrow (financial leverage risk) and the currencies its cash flows are in (currency effects). 

      Note that each part of the cost of capital has a key risk embedded in it. Thus, when valuing a company, in US dollars, in a safe business in a risky country, with very little financial leverage, you will see the 10-year US treasury bond rate as my risk free rate, a low beta (reflecting the safety of the business and low debt), but a high equity risk premium (reflecting the risk of the country).  The rest of this post will look at each of the outlined risks.

      I. Business Risk
      In my last post, where I updated risk measures across the world, I also looked at how these measures varied across different industries/businesses. In particular, I highlighted the ten most risky and safest industries, based upon both price variability and earnings variability, and noted the overlap between the two measures. I also looked at how the perceived risk in a business can change, depending upon investor diversification, and captured this effect with the correlation with the overall market.  If you are diversified, I argued that you would measure the risk in an investment with the covariance of that investment with the market, or in its standardized form, its beta.

      To get the beta for a company, then, you can adopt one of two approaches.
      • The first, and the one that is taught in every finance class, is to run a regression of returns on the stock against a market index and to use the regression beta. 
      • The second, and my preferred approach, is to estimate a beta by looking at the business or businesses a company operates in, and taking a weighted average of the betas of companies in that business. 
      To use the second approach, you need betas by business, and each year, I estimate these numbers by averaging the betas of publicly traded companies in each business. These betas, in addition to reflecting the risk of the business, also reflect the financial leverage of companies in that business (with more debt pushing up betas) and their holdings in cash and marketable securities (which, being close to risk less, push down betas). Consequently, I adjust the average beta for both variables to estimate what is called a pure play or a business beta for each business. (Rather than bore you with the mechanics, please watch this video on how I make these adjustments). The resulting estimates are shown at this link, for US companies. (You can also download the spreadsheets that contain the estimates for other parts of the world, as well as global averages, by going to the end of this post).

      To get from these business betas to the beta of a company, you need to first identify what businesses the company operates in, and then how much value it derives from each of the businesses. The first part is usually simple to do, though you may face the challenge of finding the right bucket to put a business into, but the second part is usually difficult, because the individual businesses do not trade. You can use revenues or operating income by business as approximations to estimate weights or apply multiples to each of these variables (by looking at what other companies in the business trade at) to arrive at value weights. 

      II. Financial Leverage
      You can run a company, without ever using debt financing, or you can choose to borrow money to finance operations. In some cases, your lack of access to new equity may force you to borrow money and, in others, you may borrow money because you believe it will lower your cost of capital. In general, the choice of whether you use debt or equity remains one of the key parts of corporate finance, and I will discuss it in one of my upcoming data posts. In this post, though, I will just posit that your cost of capital can be affected by how much you borrow, unless you live in a world where there are no taxes, default risk or agency problems, in which case your cost of capital will remain unchanged as your funding mix changes.  If you do borrow money to fund some or a significant portion of your operations, there are three numbers that you need to estimate for your cost of capital:
      1. Debt Ratio: Th mix of debt and equity that you use represents the weights in your cost of capital.
      2. Beta Effect: As you borrow money, your equity will become riskier, because it is a residual claim, and having more interest expenses will make that claim more volatile. If you use beta as your measure of risk, this will require you to adjust upwards the business (or unlettered) beta that you obtained in the last part, using the debt to equity ratio of the company. 
      3. Cost of Debt: The cost of debt, which is set by lenders based upon how much default risk that they see in a company, will enter the cost of capital equation, with an added twist. To the extent that the tax law is tilted towards debt, the after-tax cost of borrowing will reflect that tax benefit. Since this cost of debt is a cost of borrowing money, long term and today, you cannot use a book interest rate or the interest rate on existing debt. Instead, you have to estimate a default spread for the company, based upon either its bond ratings or financial ratios, and add that spread on to the risk free rate:
      I look at the debt effect on the cost of capital in each of the industries that I follow, with all three effects incorporated in this link, for US companies. The data, broken down, by other regional sub-groupings is available at the end of this post.

      III. Country Risk
      It strikes me as common sense that operating in some countries will expose you to more risk than operating in others, and that the cost of capital (hurdle rate) you use should reflect that additional risk. While there are some who are resistant to this proposition, making the argument that country risk can be diversified by having a global portfolio, that argument is undercut by rising correlations across markets. Consequently, the question becomes not whether you should incorporate country risk, but how best to do it. There are three broad choices:
      1. Sovereign Ratings and Default Spreads: The vast majority of countries have sovereign ratings, measuring their default risk, and since these ratings go with default spreads, there are many who use these default spreads as measures of country risk. 
      2. Sovereign CDS spreads: The Credit Default Swap (CDS) market is one where you can buy insurance against sovereign default, and it offers a market-based estimate of sovereign risk. While the coverage is less than what you get from sovereign ratings, the number of countries where you can obtain these spreads has increased over time to reach 71 in 2019. 
      3. Country Risk Premiums: I start with the default spreads, but I add a scaling factor to reflect the reality that equities are riskier than government bonds to come up with country risk premiums. The scaling factor that I use is obtained by dividing the volatility of an emerging market equity index by the volatility of emerging market bonds. 
      To incorporate the country risk into my cost of capital calculations, I start with the implied equity risk premium that I estimated for the US (see my first data post for 2019) or 5.96% and add to it the country risk premium for each country. The full adjustment process is described in this picture:

      I also bring in frontier markets, which have no sovereign ratings, using a country risk score estimated by Political Risk Services. The final estimates of equity risk premiums around the world can be seen in the picture below:

      You can see these equity risk premiums as a list by clicking here, or download the entire spreadsheet here. If you prefer a picture of equity risk around the world, my map is below:
      Download spreadsheet
      I also report regional equity risk premiums, computed by taking GDP-weighted averages of the equity risk premiums of the countries int he region.

      IV. Currency Risk
      It is natural to mix up countries and currencies, when you do your analysis, because the countries with the most risk often have the most volatile currencies. That said, my suggestion is that you keep it simple, when it comes to currencies, recognizing that they are scaling or measurement variables rather than fundamental risk drivers. Put differently, you can choose to value a Brazilian companies in US dollars, but doing so does not make Brazilian country risk go away.

      So, why do currencies matter? It is because each one has different expectations of inflation embedded in it, and when using a currency, you have to remain inflation-consistent. In other words, if you decide to do your analysis in a high inflation currency, your discount rate has to be higher, to incorporate the higher inflation, and so do your cash flows, for the same reason:

      There are two ways in which you can bring inflation into discount rates.  The first is to use the risk free rate in that currency as your starting point for the calculation, since risk free rates will be higher for high inflation currencies. The challenge is finding a risk free investment in many emerging market currencies, since even the governments bonds, in those currencies, have default risk embedded in them. I attempt to overcome this problem by starting with the government bond but then netting the default spread for the government in question from that bond to arrive at risk free rates:
      Download raw data
      These rates are only as reliable as the government bond rates that you start with, and since more than two thirds of all currencies don't even have government bonds and even on those that do, the government bond rate does not come from liquid markets, there a second approach that you can use to adjust for currencies. In this approach, you estimate the cost of capital in a currency that you feel comfortable with (in terms of estimating risk free rates and risk premiums) and then add on or incorporate the differential inflation between that currency and the local currency that you want to convert the cost of capital to. Thus, to convert the cost of capital in US $ terms to a different currency, you would do the following:

      To illustrate, assume that you have a US dollar cost of capital of 12% for an Egyptian company and that the inflation rates are 15% and 2% in Egyptian Pounds and US dollars respectively:
      The Egyptian pound cost of capital is 26.27%. Note that there is an approximation that is often used, where the differential inflation is added to the US dollar cost of capital; in this case your answer would have been 25%. The key to this approach is getting estimates of expected inflation, and while every source will come with warts, you can find the IMF's estimates of expected inflation in different currencies at this link.

      General Propositions
      Every company, small or large, has a hurdle rate, though the origins of the number are murky at most companies. The approach laid out in this post has implications for how hurdle rates get calculated and used.
      1. A hurdle rate for an investment should be more a reflection the risk in the investment, and less your cost of raising funding: I fault terminology for this, but most people, when asked what a cost of capital is, will respond with the answer that it is the cost of raising capital. In the context of its usage as a hurdle rate, that is not true. It is an opportunity cost, a rate of return that you (as a company or investor) can earn on other investments in the market of equivalent risk. That is why, when valuing a target firm in an acquisition, you should always use the risk characteristics of the target firm (its beta and debt capacity) to compute a cost of capital, rather than the cost of capital of the acquiring firm.
      2. A company-wide hurdle rate can be misleading and dangerous: In corporate finance, the hurdle rate becomes the number to beat, when you do investment analysis. A project that earns more than the hurdle rate becomes an acceptable one, whether you use cash flows (and compute a positive net present value) or income (and generate a return greater than the hurdle rate). Most companies claim to have a corporate hurdle rate, a number that all projects that are assessed within the company get measured against. If your company operates in only one business and one country, this may work, but to the extent that companies operate in many businesses across multiple countries, you can already see that there can be no one hurdle rate. Even if you use only one currency in analysis, your cost of capital will be a function of which business a project is in, and what country it is aimed at. The consequences of not making these differential adjustments will be that your safe businesses will end up subsidizing your risky businesses, and over time, both will be hurt, in what I term the "curse of the lazy conglomerate".
      3. Currency is a choice, but once chosen, should not change the outcome of your analysis: We spend far too much time, in my view, debating what currency to do an analysis in, and too little time working through the implications. If you follow the consistency rule on currency, incorporating inflation into both cash flows and discount rates, your analyses should be currency neutral. In other words, a project that looks like it is a bad project, when the analysis is done in US dollar terms, cannot become a good project, just because you decide to do the analysis in Indian rupees. I know that, in practice, you do get divergent answers with different currencies, but when you do, it is because there are inflation inconsistencies in your assessments of discount rates and cash flows.
      4. You cannot (and should not) insulate your cost of capital from market forces: In both corporate finance and investing, there are many who remain wary of financial markets and their capacity to be irrational and volatile. Consequently, they try to generate hurdle rates that are unaffected by market movements, a futile and dangerous exercise, because we have to be price takers on at least some of the inputs into hurdle rates. Take the risk free rate, for instance. For the last decade, there are many analysts who have replaced the actual risk free rate (US 10-year T.Bond rate, for instance) with a "normalized' higher number, using the logic that interest rates are too low and will go up. Holding all else constant, this will push up hurdle rates and make it less likely that you will invest (either as an investor or as a company), but to what end? That uninvested money cannot be invested at the normalized rate, since it is fictional and exists only in the minds of those who created it, but is invested instead at the "too low" rate. 
      5. Have perspective: In conjunction with the prior point, there seems to be a view in some companies and for some investors, that they can use whatever number they feel comfortable with as hurdle rates. To the extent that hurdle rates are opportunity costs in the market, this is not true. The cost of capital brings together all of the risks that we have listed in this section. If nothing else, to get perspective on what comprises high or low, when it comes to cost of capital, I have computed a histogram of global and US company costs of capital, in US $ terms.

        You can convert this table into any currency you want. The bottom line is that, at least at the start of 2019, a dollar cost of capital of 14% or 15% is an extremely high number for any publicly traded company. You can see the costs of capital, in dollar terms, for US companies at this link, and as with betas, you can download the cost of capital, by industry, for other parts of the world in the data links below this post.
      In short, if you work at a company, and you are given a hurdle rate to use, it behooves you to ask questions about its origins and logic. Often, you will find that no one really seems to know and/or the logic is questionable.

      YouTube Video


      Data Sets
      1. Betas by Business: US, Global, Emerging Markets, Europe, Japan, India, China, Aus & Canada
      2. Sovereign Ratings and CDS Spreads by Country in January 2019
      3. Equity Risk Premiums by Country in January 2019
      4. Risk free Rates by Currency: Government bond based
      5. Cost of Capital in US $ (with conversion equation for other currencies): USGlobalEmerging MarketsEuropeJapanIndiaChinaAus & Canada



      January 2019 Data Update 4: The Many Faces of Risk!

      I think that all investors would buy into the precept that investing in equities comes with risk, but that is where the consensus seems to end. Everything else about risk is contested, starting with whether it is a good or a bad, whether it should be sought out or avoided, and how it should be measured. It is therefore with trepidation that I approach this post, knowing fully well that I will be saying things about risk that you strongly disagree with, but it is worth the debate.

      Risk: Basic Propositions
      I. Risk falls on a continuum: Risk is not an on-off switch, where some assets are risky and others are not. Instead, it is better to think of it on a continuum, with investments with very little or close to no risk at one extreme (riskless) to extraordinarily risky investments at the other.

      In fact, while most risk and return models start off with the presumption that there exists a riskless asset, one in which you can invest for a guaranteed return and no loss of principal, I think that a reasonable argument can be made that there are no such investments. In abstract settings, we often evade the question by using government bond rates (like the US treasury) as risk free rates, but that assumes:
      1. That governments don't default, an assumption that conflicts with the empirical evidence that they do, on both local currency and foreign currency borrowings
      2. That if the government delivers it's promised coupon we are made whole again, also not true since inflation can be a wild card, rendering the real return on a government bond negative, in some periods. A nominal risk free rate is not a real risk free rate, which is one reason that I track the inflation indexed treasury bond (TIPs) in conjunction with the conventional US treasury bond; the yield on the former is closer to a real risk free rate, if you assume the US treasury has no default risk.
      If there is one lesson that emerged from the 2008 crisis, it is that there are some periods in market history where there are truly no absolutely safe havens left and investors have to settle for the least stomach churning alternative that they can find, during these crises.

      II. For a company, risk has many sources: Following up on the proposition that investing in the equity of a business can expose you to risk, it is worth noting that this risk can come from multiple sources. While a risk profile for a company can have a laundry list of potential risks,  I break these risks into broad categories:
      Note that some of these risks are more difficult to estimate and deal with than others, but that does not mean that you can avoid them or not deal with them. In fact, as I have argued repeatedly, your best investment opportunities may be where it is darkest.

      III. For investors, risk standing alone can be different from risk added to a portfolio: This is perhaps the most controversial divide in finance, but I will dive right in. The risk of an investment can be different, if it is assessed as a stand-alone investment, as opposed to being part of a portfolio of investments and the reason is simple. Some of the risks that we listed in the table above, to the extent that they are specific to the firm, and can cut in either direction (be positive or negative surprises) will average out across a portfolio. It is simply the law of large numbers at work. In the graph below, I present a simplistic version of diversification at play, by looking at how the standard deviation of returns in a portfolio changes, as the number of investments in it goes up, in a world where the typical investment has a standard deviation of 40%, and for varying correlations across investments.
      Download diversification benefits spreadsheet
      If the assets are uncorrelated, the standard deviation of the portfolio drops to just above 5%, but note that the benefits persist as long as the assets in your portfolio are not perfectly positively correlated, which is good news since stocks are usually positively correlated with each other. Furthermore, the greatest savings occur with the first few stocks that are added on, with about 80% of the benefits accruing by the time you get to a dozen stocks, if they are not all in the same sector or share the same characteristics (in which case the correlation across those stocks will be higher, and the benefit lower).

      I know that I am now opening up an age old debate in investing as to whether it is better to have a concentrated portfolio or a diversified one. Rather than argue that one side is right and the other wrong, I will posit that it depends upon how certain you feel about your investment thesis, i.e., that your estimate of value is right and that the market price will correct to that value, with more certainty associated with less diversification. Speaking for myself, I am always uncertain about whether the value that I have estimated is right and even more so about whether the market will come around to my point of view, which also means that it is best for me to spread my bets. You can be a value investor and be diversified at the same time.

      IV. Your risk measurement will depend on how and why you invest and your time horizon: Broadly speaking, there are three groups of metrics that you can use to measure the risk in an investment. 
      1. Price Measures: If an asset/investment is traded,  the first set of metrics drawn on the price path  and what you can extract from that path as a measure of risk. There are many in investing who bemoan the Markowitz revolution and the rise of modern finance, but one of the byproducts of modern portfolio theory is that price-based measures of risk dominate the risk measurement landscape. 
      2. Earnings/Cashflow Measures: There are many investors who believe that it is uncertainty about earnings and cash flows that are a true measure of risk. While their argument is that value is driven by earnings and cash flows, not stock price movements, their case is weakened by the fact that (a) earnings are measured by accountants, who tend to smooth out variations in earnings over time and (b) even when earnings are measured right, they are measured, at the most, four times a year, for companies that have quarterly reporting, and less often, for firms that report only annually or semi-annually.
      3. Risk Proxies: Some investors measure the risk of an asset, by looking at the grouping it belongs to, arguing that some groupings are more risky than others. For instance, in the four decades since technology stocks became part of the market landscape, "tech" has become a stand in for both high growth and high risk. Similarly, there is the perception that small companies are riskier than larger companies, and that the market capitalization, or level of revenues, should be a good proxy for the risk of a company.
      While I will report on each of these three groups of  risk measures in this post, you can decide which measure best fits you, as an investor, given your investment philosophy.

      Price Risk Measures
      The most widely accessible measures of risk come from the market, for publicly traded assets, where trading generate prices that change with each trade. That price data is then used to extract risk measures, ranging from intuitive ones (high to low ranges) to statistical measures (such as standard deviation and covariance). 

      Price Range 
      When looking at a stock's current price, it is natural to also look at where it stands relative to that stock's own history, which is one reason most stock tables report high and low prices over a period (the most recent 12 months, for instance). While technical analysts use these high/low prices to determine whether a stock is breaking out or breaking down,  these prices can also be used as a rough proxy for risk. Put simply, riskier stocks will trade with a wider range of prices than safer stocks.

      HiLo Risk Measure
      To compute a risk measure from high and low prices that is comparable across stocks, the range has to be scaled to the price level. Otherwise, highly priced stocks will look more risky,  because the range between the high and the low price will be greater for a $100 stock than for a $5 stock. One simple scalar is the sum of the high and the low prices, giving the following measure of risk:
      HiLo Risk = (High Price - Low Price)/ (High Price + Low Price)
      To illustrate, consider two stocks, A with a high of $50 and a low of $25 and B with a high of $12 and a low of $8. The risk measures computed will be:
      • HiLo Risk of stock A = (50-25)/ (50+25) = 0.333
      • HiLo Risk of stock B = (12-8)/ (12 +8) = 0.20
      Based upon this measure, stock A is riskier than stock B.

      Distribution
      I compute the HiLo risk measure for all stocks in my data set, to get a sense of what would be high or low, and the results are captured in the distribution below (Q1: First Quartile, Q3: Third Quartile):
      Data at country level 
      Embedded in the distribution is the variation of this measure across regions, with some, at first sight, counterintuitive results. The US, Canada and Australia seem to be riskier than most emerging market regions, but that says more about the risk measure than it does about companies in these countries, as we will argue in the next section. If you want to see these risk measures on a country basis, try this link.

      Pluses and Minuses
      The high/low risk measure is simple to compute and requires minimal data, since all you need is the high price and the low price for the year. It is even intuitive, especially if you track market prices continuously. It does come with two problems. The first is the flip side of its minimal data usage, insofar as it throws away all data other than the high and the low price. The second is a more general problem with any price based risk measure, which is that for the price to move, there has to be trading, and markets that are liquid will therefore see more price movements, especially over shorter time period, than markets that are not. It is therefore not surprising that US stocks look riskier than African stocks, simply because liquidity is greater in the US. So, why bother? If you are comparing stocks within the same liquidity bucket, say the S&P 500, the high-low risk measure may correlate well with the true risk of the company. However, if your comparisons require you to look across stocks with different liquidity, and especially so if some are traded in small, emerging markets, you should use this or any other price-based measure with caution.

      Standard Deviation/Variance
      If you have data on stock prices over a period, it would be statistical malpractice not to compute a standard deviation in these prices over time. Those standard deviations are a measure, albeit incomplete and imperfect, of how much price volatility you would have faced as an investor, with the intuitive follow up that safer stocks should be less volatile.

      Returns on Stocks
      As with the HiLo risk measure, computing a standard deviation in stock prices, without adjusting for price levels, would yield the unsurprising conclusion that higher prices stocks have higher standard deviations. With this measure, the scaling adjustment becomes a simpler one, since using percentage price changes, instead of prices themselves, should level the playing field. In fact, if you wanted a fully integrated measure of returns, you should also include dividends in the periods where you receive them. However, since dividends get paid, at most, once every quarter, analysts who use daily or weekly returns often ignore them.

      Distribution
      To compute and compare standard deviations in stock returns across companies, I have to make some estimation judgments first, starting with the time period that I plan to look over to compute the standard deviation and the return intervals (daily, weekly, monthly) over that period. I use 2-year weekly standard deviations for all firms in my sample, using the time period available for companies that have listed less than 2 years, and the distribution of  annualized standard deviations is in the graph below.
      Data at country level  
      As with the HiLo risk measure, and for the same reasons, the US, Canada and Australia look riskier than most emerging markets. Again, I report on the regional differences in the table embedded in the graph, with country-level statistics available at this link.

      Pluses and Minuses
      It is Statistics 101! After all, when presented with raw data, one of the first measures that we compute to detect how much spread there is in the data is the standard deviation. Furthermore, the standard deviation can be computed for returns in any asset class, thus allowing us to compare it across stocks, high yield bonds, corporate bonds, real estate or crypto currencies. To the extent that we can also compute historical returns on these same assets, it allows us to relate those returns to the standard deviations and compute the payoff to taking risk in the form of Sharpe ratios or information ratios.
      Sharpe Ratio = (Return on Risky Asset - Risk free Rate)/ Standard Deviation of Risky Asset
      That said, the flaws in using just standard deviation as a measure of risk in investing have been pointed out by legions of practitioners and researchers.
      1. Not Normal: The only statistical distribution which is completely characterized by the expected return and standard deviation is a normal distribution, and very little in the investment world is normally distributed. To the extent that investment return distributions are skewed (often with long positive tails and sometimes with long negative tails) and have fat tails, there is information in the other moments in the distribution that is relevant to investors.
      2. Upside versus Downside Variance: One of the intuitive stumbling blocks that investors have with standard deviation is that it will higher if you have outsized returns, whether they are higher or lower than the average. Since we tend to think of downside movements as risk, not upside, the fact that stocks that have moved up strongly and dropped precipitously can both have high standard deviations makes some investors queasy about using them as measures of risk.
      3. Liquidity effects: As with the high low risk measure, liquidity plays a role in how volatile a stock is, with more liquid stocks being characterized with higher standard deviations in stock prices than less liquid ones.
      4. Total Risk, rather than risk added to a portfolio: The standard deviation in stock prices measures the total risk in a stock, rather than how much risk it adds to a portfolio, which may make it a poor measure of risk for diversified investors. Put differently, adding a very risky stock, with a high standard deviation, to a portfolio may not add much risk to the portfolio if it does not move with the rest of the investments in the portfolio.
      In summary, the combination of richer pricing data and access to statistical tools has made it easier than ever to compute standard deviation in prices, but using it as your sole measure of risk can lead you to make bad investment decisions.

      Covariance/Beta
      In the graph on the effect of diversification on portfolio risk, I noted that the key variable that determines how much benefit there is to adding a stock to portfolio is its correlation with the rest of the portfolio, with higher and more positive correlations associated with less diversification benefit. Building on that theme, you can measure the risk added by an investment to a diversified portfolio by looking at how it moves in relation to the rest of the portfolio with its covariance, a measure that incorporates both the volatility in the investment and its correlation with the portfolio.
      This equation for added risk holds only if the investment added is a small proportion of the diversified portfolio, but if that is the case, you can have a risky investment (with a high standard deviation) that adds very little risk to a portfolio, if the correlation is low enough.

      Standardized Measure (Beta)
      The covariance measure of risk added to a portfolio, left as is, yields values that are not standardized. Thus, if you were told that the covariance of a stock with a well diversified portfolio is 25%, you may have no sense of whether that is high, low or average. It is to obtain a scaled measure of covariance that we divide the covariance of every investment by the variance of the portfolio that we are measuring it against:

      If you are willing to add on whole layers of assumptions about no transactions costs, well functioning markets and complete information, the diversified portfolio that we will all hold will include every traded asset, in proportion to its market value, the capital asset pricing model will unfold and the betas for investments will be computed against this market portfolio. Note though, that even if you are unwilling to go the distance and accept the assumptions of the CAPM, the covariance and correlation remain measures of the risk added by an investment to a portfolio.

      Distribution
      If you already are well versed in financial theory, and find the lead in to beta in this section simplistic and unnecessary, I apologize, but I think that any discussion of the CAPM and betas very quickly veers off topic into heated debates about efficient markets and the limitations of modern finance. I think it is good to revisit the basics of the model, and even if you disagree with the model's precepts (and I do not think that there is anyone who fully buys into all of its assumptions), decide what parts of the model you want to keep and which ones you want to abandon. Since the key number that drives the covariance and beta of an investment is its correlation with, I report on the global distribution of this statistics:
      Data at country level 
      Unlike the high low risk measure and the standard deviation, where my estimation choices were limited to time period and return interval, the correlation coefficient is also a function of the index or market that is used to compute it. That said, the distribution yields some interesting numbers that you can use, even as a non-believer in the CAPM. The median correlation for a US stock with the market is about 20%, and if you check the graph for savings, that would imply that having a portfolio of ten, twenty or thirty stocks yield substantial benefits. As you move to emerging markets, where the correlations are even lower, especially if you are a global investor, the benefits become even larger. Again, if you want to see this statistic on a country-by-country basis, try this link.

      Pluses and Minuses
      If you have bought into the benefits of diversification and have your wealth spread out across multiple investments, there is a strong argument to be made that you should be looking at covariance-based measures of risk, when investing. If you use a beta or betas to measure risk in an investment, you get an added bonus, since the number is self standing and gives you all the information you need to make judgments about relative risk. A beta higher (lower) than one is a stock that is riskier (safer) than average, but only if you define risk as risk added to a portfolio.

      I use covariance based measures of risk in valuation but I recognize that these measures come with limitations. In addition to all of the caveats that we noted about liquidity's effect on price based measures, the most critical ingredient into covariance is the correlation coefficient and that statistic is both unstable and varies over time. Thus, the covariance (and beta) of the stock of a company that is going through a merger or is in distress will often decrease, since the stock price will move for reasons unrelated to the market. As a result, the covariance measures (and this includes the beta) have substantial estimation error in them, which is one reason that I have long argued against using the beta that you get for one company with one pass of history (a regression beta) in financial analysis.  What can you do instead? Since covariance and beta are measures of risk added to a portfolio, they should be more reflective of the businesses (or industries) a company operates in than of company-specific characteristics. Using an industry average beta for steel companies, when valuing US Steel or Nucor, or an industry average beta for software companies, when valuing Adobe, is more prudent than using the regression betas for any of these companies. I will build on this theme in my next post.

      Earnings Risk Measures
      For many value investors, the biggest problem with using standard deviations or betas is that they come from stock prices. So what? In the value world, it is not markets that should drive our perception of risk, but the fundamentals of the company. Thus, using a price based risk measure when doing intrinsic value is viewed as inconsistent. In this section, I will look at proxies for risk that are built upon a company's performance over time.

      Money Losing or Money Making
      If we define success in a business in terms of making money, the simplest measure of whether a company is risky is whether it generates profits or not. Simplistic though it might be,  a money losing company, all held held constant, is riskier than a money making company. That said, investors take multiple cracks at measuring profitability, with some defining it as net profits (after taxes and interest expenses), some more expansively as operating income (to look at pre-debt earnings) and some even more broadly as EBITDA. In the table below, I break down the percentages of companies globally that report positive and negative values, using each measure:

      Data at country level 
      Not surprisingly, in every part of the world, the percentage of firms that have positive EBITDA exceeds the percentage with positive operating income or positive net income. Looking across regions, Japan has the highest percentage of money making firms, with 88.80% making positive net income, and Canada and Australia, with their preponderance of natural resource companies, have the highest percentage of money losers.

      Earnings Variance
      It is true that whether a company makes money is a very rough measure of risk and a more complete measure of earnings risk would look at earnings variability over time. This is more difficult than it sounds, for three reasons. First, unlike pricing data, earnings data is available only once every quarter in much of the world, and even more infrequently (semi annual or annual) in the rest. Second, unlike price data, which can never be negative, earnings can, and computing variance in earnings, when earnings are negative, are messy. Third, even if you can compute the variance or standard deviation in earnings, it is difficult to compare that number across companies, since companies with higher dollar earnings will have more variance in those earnings in dollar terms. It is for this reason that I compute a coefficient of variation in earnings for each firm, where I divide the standard deviation in earnings by the average earnings over the period of analysis:
      Coefficient of variation in earnings = Standard Deviation in Earnings/ Average Earnings over estimation period
      When the average earnings are negative, I use the absolute value in the denominator. I computed this measure of earnings variability in both operating and net income for companies that have data going back at least five years, and the distribution is captured below:
      Download country level statistics
      There are some surprises here. While Australia and Canada again score near the top of the risk table, with the highest variation in earnings, Latin American companies have the lowest volatility in operating and net income, if you compare medians. You can take this to mean that Latin American companies are not risky or that there are perils to trusting accountants to measure performance. Finally, the country level risk statistics are available at this link.

      Pluses and Minuses
      While I sympathize with the argument that value investors pose, i.e., that using price based risk measures in intrinsic valuation is inconsistent, I am very quickly brought back to earth by the recognition that computing risk from accounting earnings or financial statements comes with its own limitations, which in my view, quickly overwhelm its benefits. The accounting tendency to smooth things out shows up in earnings streams and if you add to that how the numerous discretionary accounting plays (from how to account for acquisitions to how to measure inventory) play out in stated earnings, I am not sure that I learn much about risk from looking at a time series of accounting earnings. You may find that there are other items in accounting statements that are less susceptible to accounting choices, such as revenues or cash flows, but, for the moment, I remain unconvinced that any of these beat price-based measures of risk.

      Risk Proxies
      The vast majority of investors never attach risk measures to stocks, choosing instead to proxies or stand-ins for risk. Thus, tech stocks are viewed as riskier than non-tech stocks, small cap stocks are perceived as more risky than large cap stocks and, in some value investing circles, stocks that trade at low PE ratios or have high dividend yields are viewed as safer than stocks with high PE ratios or do not pay dividends. In this section, I look at how the measures of risk that I have computed from price and accounting data correlate with these proxies.

      Market Capitalization
      It seems like common sense to argue that smaller companies must be riskier than larger companies. After all, they often operate in niche markets, have less access to capital and are often dependent on a few customers for success. That said, though, even these common sense arguments start to break down if you think about investing in portfolios of small cap stocks, as opposed to large ones, since many of these risks are firm specific and could be diversified away across stocks. To examine, whether risk varies across market capitalization classes, I looked at the risk measures that we have computed already in this post:
      Download full market cap risk statistics
      The market capitalization correlates remarkably well with measures of both price and earnings risk, with smaller companies exposed to far more risk than larger firms. The note of caution, though, comes in the correlation numbers, where the smallest companies have the lowest correlation with the market, suggesting that much of the added risk in these companies can be diversified away. Put simply, if you want to own only three or four stocks in your portfolio, it is perfectly appropriate to think of small companies as riskier than large ones, but if you choose to be diversified, company size may no longer be a good proxy for the risk added to your portfolio.

      PE Ratios and Dividend Yields
      For some value investors, it is an article of faith that the stocks that trade at low multiples of earnings  and pay large dividends are safer than stocks that trade at higher multiples and or pay low dividends. That is perhaps the reason why the Graham screens for cheap stocks include ones for low PE and high dividend yields. In the table below, we look at how stocks in different PE ratio classes vary on  price and earnings risk measures:
      Download risk data for PE ratio classes
      We follow up by looking at how stocks broken down into dividend yield classes diverge on price and earnings risk measures:
      Download data for Dividend Yield classes
      With both groups, we notice an interesting pattern. While there is no clear link between how low or high a stock's PE ratio is and its risk measures, money losing companies (where PE ratios are not computed or are not meaningful) are riskier than the rest of the market. Similarly, with dividend yields the link between dividend yields and risk measures is weak, but non-dividend paying companies are riskier than the rest of the market.

      Industry Grouping
      For decades, investors have used the industry groupings that companies belong to as the basis for risk judgments. Not only does this take the form of conventional investment advice, where risk averse investors are asked to invest in utility stocks, but it is also used to make broad brush statements about tech stocks being risky. Again, there is probably a good reason why these views came into being, at the time that they did, but economies and markets change, and it behooves us to look at the data to see if these rules of thumb still hold. Just as with the market capitalization classes, I have computed the risk statistics for the 94 industries that I categorize all companies into, and you can get the entire list by clicking here. The ten most risky and least risky industries, using price based  risk measures are listed below:
      Download full industry list
      The least risky firms, looking globally, on a price risk basis, are financial service firms (with banks an and insurance companies making the list) and the most risky firms include natural resource, technology and entertainment companies. Looking at earnings based risk measures, we get the following listing:
      Download full industry list
      There is significant overlap between the two measures, with the same industries, for the most part, showing up on both lists. The caveat I would add is that some of these sectors have thousands of companies in them, and that there are wide differences in risk across these companies.

      Picking your Poison
      This has become a far longer post than I intended and I want to wrap it up with three suggestions, when it comes to risk.
      1. Risk avoidance is not a strategy: During periods of high volatility and market tumult, investors often obsess about risk. While that is natural, it is worth remembering that avoiding risk is not a risk strategy, but a desperation ploy. In investing, the objective is to earn the highest returns you can, with risk operating as a constraint. Unfortunately, in corporate finance, this lesson has been forgotten by risk managers, where the focus has been on products (hedging, derivatives) that companies can use to minimize risk exposure rather than on determining what risks to avoid, what risks to pass through to investors and what risks too seek out to maximize value. (See my book on risk management for an eraboration)
      2. Disagree with models but don't abandon first principles: Finance, in both theory and practice, is full of models for and measures of risk. Since these models/measures are built on assumptions, some of which you may disagree with vehemently, you may find yourself unwilling to use them in your investing. That is not only understandable, but healthy, but please do not throw the baby out with the bathwater and abandon first principles. Thus, refusing to use betas to estimate discount rates is okay but leaping to the conclusion that risk should not be considered in investing is absurd.
      3. Pick the risk measure that is right for you: We are lucky enough to be able to estimate or access different risk measures, price or earnings based, for companies that we might be interested in investing in. Rather than lecturing you on what I think is the best measure of risk, I would recommend that you look inwards, because you have to find a risk measure that works for you, not for me. Thus, if you are a value investor who buys companies for the long term, because you like their businesses, and you trust accountants, an earnings-based risk measure may appeal to you. In contrast, if you are more of a trader, buying stocks on the expectation that you can sell to someone else at a higher price, a price-based risk measure will fit you better. With both price and earnings measures, the question of whether you want to use individual company risk or risk added to a portfolio will depend upon whether you have a concentrated or diversified portfolio. Finally, the different risk measures that I have listed in this section often move together, as can be seen in this correlation matrix.
        Thus, while you may use market capitalization as your risk measure and I might use beta, our risk rankings may not be very different.  
      In closing, whatever risk measure you pick to assess investments, I hope that you earn returns that justify the risk taking!


      YouTube Video



      Data Links
      1. Country Risk Measures (January 2019)
      2. Industry Risk Measures (January 2019)
      3. Market Cap Risk Measures (January 2019)
      4. PE Ratio Risk Measures (January 2019)
      5. Dividend Yield Risk Measure (January 2019)



      The Perils of Investing Idol Worship: The Kraft Heinz Lessons!

      On February 22, Kraft Heinz shocked investors with a trifecta of bad news in its earnings report: sub-par operating results, a mention of accounting irregularities and a massive impairment of goodwill, and followed up by cutting dividends per share almost 40%. Investors in the company reacted by selling their shares, causing the stock price to drop more than 25% overnight. While Kraft is neither the first, nor will it be the last company, to have a bad quarter, its travails are noteworthy for a simple reason. Significant portions of the stock were held by Berkshire Hathaway (26.7%) and 3G Capital (29%), a Brazil-based private equity group. Berkshire Hathaway’s lead oracle is Warren Buffett, venerated by some who track his every utterance, and try to imitate his actions. 3G Capital might not have Buffett’s name recognition, but its lead players are viewed as ruthlessly efficient managers, capable of delivering large cost cuts. In fact, their initial joint deal to bring together Heinz and Kraft, two of the biggest names in the food business, was viewed as a master stroke, and given the pedigree of the two investors, guaranteed to succeed. As the promised benefits have failed to materialize, the investors who followed them into the deal seem to view their failure as a betrayal.

      The Back Story
      You don’t have to like ketchup or processed cheese to know that Kraft and Heinz are part of American culinary history. Heinz, the older of the two companies, traces its history back to 1869, when Henry Heinz started packing and selling horseradish, and after a brief bout of bankruptcy, turned to making 57 varieties of ketchup. After a century of growth and profitability, the company hit a rough patch in the 1990s, and was targeted by activist investor, Nelson Peltz, in 2013. Shortly thereafter, Heinz was acquired by Berkshire Hathaway and 3G Capital for $23 billion, becoming a private company. Kraft started life as a cheese company in 1903, and over the next century, it expanded first into other dairy products, and then widened its repertoire to includes other processed foods. In 1981, it merged with Dart Industries, maker of Duracell batteries and Tupperware, before it was acquired by Philip Morris in 1988. After a series of convulsions, where parts of it were sold and rest merged with Nabisco, Kraft was spun off by Philip Morris (renamed Altria), and targeted by Nelson Peltz (yes, the same gentleman) in 2008. Through all the mergers, divestitures and spin offs, managers made promises of synergy and new beginnings, deal makers made money, but little of substance actually changed in the products.

      In 2015, the two companies were brought together, with Berkshire Hathaway and 3G playing both match makers and deal funders, as Kraft Heinz, and the merger was completed in July 2015. At the time of the deal, there was unbridled enthusiasm on the part of investors and market observers, and part of the unquestioning acceptance that the new company would become a force in the global food business was the pedigree of the main investors. In the years since the merger, though, the company has had trouble delivering on expectations of revenue growth and cost cutting:

      The bottom line is that while much was promised in terms of revenue growth, from expanding its global footprint, and increased margins, from cost cutting, at the time of the deal, the numbers tell a different story. In fact, if investors were surprised by the low growth and declining margins in the most recent earnings report, they should not have been, since this has been a long, slow bleed.

      The Earnings Report
      The earnings report that triggered the stock price collapse, for Kraft-Heinz, was released on February 22, and it contained bad news on many fronts:
      1. Flatlining Operations: Revenues for 2018 were unchanged from revenues in 2017, but operating income dipped (before impairment charges) from $6.2 billion in 2017 to $5.8 billion in 2018; the operating margin dropped from 23.5% in 2017 to 22% in 2018.
      2. Accounting Irregularities: In a surprise, the company also announced that it was under SEC investigation for accounting irregularities in its procurement area, and took a charge of $25 million to reflect expected adjustments to its costs.
      3. Goodwill Impairment: The company took a charge of $15.4 billion for impairment of goodwill, primarily on their US Refrigerated and Canadian Retail segments, an admission that they paid too much for acquisitions in prior years.
      4. Dividend Cuts: The company, a perennial big-dividend payer, cut its dividend per share from $2.50 to $1.60, to prepare itself for what it said would be a difficult 2019.
      While investors were shocked, the crumb trail leading up to this report contained key clues. Revenues had already flattened out in 2017, relative to 2016, and the decline in margins reflected difficulties that 3G faced in trying to cut costs, after the deal was made. The only people who care about impairment charges, a pointless and delayed admission of overpayment on acquisitions, are those who use book value of equity as a proxy for overall value. The dividend cuts were perhaps a surprise, but more in what they say about how panicked management must be about future operations, since a company this attached to dividends cuts them only as a last resort.

      The Value Effects
      With the bad news in the earnings report still fresh, let’s consider the implications for the story for, and the value of, Kraft Heinz. The flat revenues and the declining margins, as I see them, are part of a long term trend that will be difficult, if not impossible, to reverse. While Kraft-Heinz may have a quarter or two with positive blips, I see more of the same going forward. In my valuation, I have forecast a revenue growth of 1% a year in perpetuity, less than the inflation rate, reflecting the headwinds the company faces. That downbeat revenue growth story will be accompanied by a matching “bad news” story on operating margins, where the company will face pricing pressures in its product markets, leading to a drop (though a small and gradual one) in operating margins over time, from 22% in 2018 (already down from 2017) to 20% over the next five years. The company’s cost of capital is currently 6%, reflecting the nature of its products and its use of debt, but over time, the benefits from the latter will wear thin, and since that is close to the average for the industry (US food processing companies have an average cost of capital of 6.12%), I will leave it unchanged. Finally, the mistakes of the past few years will leave at least one positive residue in the form of restructuring charges, that I assume will provide partial shelter from taxes, at least for the next two years.
      Spreadsheet with valuation
      The good news is that, even with a stilted story, Kraft Heinz has a value ($34.88) that is close to the stock price ($34.23). The bad news is that the potential upside looks limited, as you can see in the results of a simulation that I did, allowing expected revenue growth, operating margin and cost of capital to be drawn from distributions, rather than using point estimates.
      Simulation Results
      The finding the value falls within a tight range, with the first decile at about $26 and the ninth at close to $47 should not surprise you, since the ranges on the inputs are also not wide. As an investor, here are the actions that would follow this valuation. 
      • If you owned Kraft Heinz prior to the earnings report (and I thankfully did not), selling now will accomplish little. The damage has been done already, and the stock as priced now, is a fair value investment. I know that 3G sold almost one quarter of its holding in September 2018, good timing given the earnings report, but any attempts to sell now will gain them nothing. (I made a mistake in an earlier version of the post, and I thank those of you who pointed it out.)
      • If you don’t own Kraft Heinz, the valuation suggests that the stock is fairly valued, at today’s price, but at a lower price, it would be a good investment. I have a limit buy on the stock at a $30 price (close the 25th percentile of the distribution), and if it does hit that price, I will be a Kraft Heinz stockholder, notwithstanding the fact that I think its future does not hold promise. If it does not drop that low, there are other fish to catch and I will move on.
      There are two concerns, though, that investors looking at this stock have to consider. The first is that when companies claim that they have discovered accounting irregularities, but that they have cleaned up their acts, they are often dissembling and that there are more shocks to come. With Kraft Heinz, the magnitude of the irregularity is small, and given that they have no history of playing accounting games, I am willing to given them the benefit of the doubt. The second is that the company does carry $32 billion in debt, and while that debt has no toxic side effects today, that is because the company is perceived to have stable and positive cash flows. If the margin decline that I forecast becomes a margin rout, the debt will expose the company to a clear and present danger of default. Put simply, it will make the bad case scenarios that are embedded in the simulation worse, and perhaps threaten the company’s existence. 

      The Lessons
      There are lessons in the Kraft-Heinz blow-up, but I will tread carefully, since I risk offending some, with talk that you may view as not just incorrect but sacrilegious:
      1. It is human to err: At the risk of stating the obvious, Warren Buffett and 3G’s key operators are human, and are prone to not only making mistakes, like the rest of us, but also to have blind spots in investing that hurt them. In fact, Buffett has been open about his mistakes, and how much they have cost him and Berkshire Hathaway shareholders. He has also been candid about his blind spots, which include an unwillingness to invest in businesses that he does not understand, a sphere that only grows as he gets older and the economy changes, and an excessive trust in the managers of the companies that he invests in. While he is, for the most part, an excellent judge of character, his investments in Wells Fargo, Coca Cola and Kraft-Heinz show that he is not perfect. The fault, in my view, is not with Buffett, but with the legions of investors, analysts and journalists who treat him as an investment deity, quoting his words as gospel and tarring and feathering anyone who dares to question them. 
      2. Stocks are not bonds: In my data posts, I looked at how companies in the United States have moved away from dividends to buybacks, as a way of returning cash. That trend, though, has not been universally welcomed by investors, and there remains a significant subset of investors, with strategies built around buying stocks with big dividends. One reason that stocks like Kraft  Heinz become attractive to conservative value investors is because they offer high dividend yields, often much higher than what you could earn investing in treasury or even safe corporate bonds. In effect, the rationale that investors use is that by buying these shares, they are in effect getting a bond (with the dividends replacing coupons), with price appreciation. From the Dogs of the Dow to screening based upon dividend yields, the underlying premise is that investors can count more on dividends than on buybacks. While it is true that dividends are stickier than buybacks, with many companies maintaining or increasing dividends over time, these dividend-based strategies become delusional when they treat dividends as obligated payments, rather than expected ones. After all, much as companies do not like to cut dividends, they are not contractually obligated to pay dividends. In fact, when a stock carries a dividend yield that looks too good to be true, it is usually almost always an unsustainable dividends, and it is only a question of time before dividends are cut (or even stopped) or the company drives itself into a financial ditch. 
      3. Brand Names last a long time, but nothing lasts forever: A major lodestone of conventional value investing is that while technology, cost efficiencies and new products are all competitive advantages that can generate value, it is brand name that is the moat that has the most staying power. Again, that statement reflects a truth, which is that brand names last long, often stretching over decades, but even brand name benefits fade, as customers change and companies seek to become global. The troubles at Kraft-Heinz are part of a much bigger story, where some of the most recognized and valued brand names of the twentieth century, from Coca Cola to McDonalds, are finding that their magic fading. Using my life cycle terminology, these companies are aging and no amount of financial engineering or strategic repositioning is going to make them young again. 
      4. Cost cutting can take you far, but no further: For the last few decades, we have cut a great deal of slack for those who use cost cutting as their pathway for creating value, with many leveraged buyouts and restructurings built almost entirely on its promise. Don’t get me wrong! In firms with significant cost inefficiencies and bloat, cost cutting can deliver significant gains in profits, but even with these firms, those gains will be time limited, since there is only so much fat to cut out. Worse, there are firms that find themselves in trouble for a myriad of reasons that have little to do with cost inefficiencies and cutting costs as these firms is a recipe for disaster. It is true that 3G did a masterful job, cutting costs and increasing margins at Mexico's Grupo Modelo, the Mexican brewer that they acquired through Inbev, but that was because Modelo’s problems lent themselves to a cost-cutting solution. It may even have worked at Kraft-Heinz initially, but at this point, the company’s problems may have little to do with cost inefficiencies, and much to do with a stable of products that is less appealing to customers than it used to be, and cost cutting is the wrong medicine for whatever ails them.
      Conclusion
      I hope that you do not read this as a hit piece on Warren Buffett and/or 3G. I admire Buffett’s adherence to a core philosophy and his willingness to be open about his mistakes, but I think he is ill served by some of his devotees, who insist on putting him on a pedestal and refuse to accept the reality that his philosophy has its limits, and that like the rest of us, he has an ego and makes mistakes. If you have faith in value investing, you should be willing to have that faith tested by the mistakes that you and the people you admire make in its pursuit. If your investment views are dogma, and you believe that your path is only the correct one to success, I wish you the best, but your righteousness and rigidity will only set you up for more disappointments like Kraft Heinz.

      YouTube Video

      Data



      January 2019 Data Update 9: The Pricing Game

      In my last eight posts, I looked at aspects of corporate behavior from investments to financing to dividend policy, using the data that I collected at the start of 2019, to examine what companies share in common, and what makes them different. In summary, I found that the rise in risk premiums in both equity and bond markets in 2018 have pushed up costs of equity and capital, that companies across the globe are finding it difficult to generate returns on their investments that exceed their costs of funding, and that many of them, especially in mature businesses, are returning more cash, much of it in the form of buybacks. Since all of the companies in my data set are publicly traded, there is one final number that I have not addressed directly in my posts so far, and that is the market pricing of these companies. In this post, I  complete my data update series, by looking at how pricing varies across companies, sectors and geographies, and what lessons investors can draw from the data.

      Value versus Price: The Difference
      I have posted many times on the between the value of an asset and its' pricing, but I don't think it hurts to revisit that difference. The determinants of value are simple, although not always easy to estimate. Whether you are valuing start-up businesses, emerging market firms, or commodity companies, the values are driven by expected cash flows, growth, and risk. Although a discounted cash flow valuation is often the tool that we used to give form to these fundamentals, in the form of cash flows, growth rates in these cash flows, and discount rates, it is not the only pathway to intrinsic value.  The determinants of price are demand and supply, and while fundamentals do affect both, mood and momentum are also strong forces in pricing. These “animal spirits,” as behavioral economists might tag them, can not only cause price to diverge from value, but also require different tools to be used to assess the right pricing for an asset. With many assets and businesses, pricing an asset usually involves standardizing a price (a multiple), finding similar or comparable assets that are already priced in the marketplace, and controlling for differences. The picture below, which I have used many times before, captures the two processes:

      The reason that I reuse this picture so much is because, to me, it is an all-encompassing snapshot of every conceivable investment philosophy that exists in the market:
      1. Efficient Marketers: If you believe that markets are efficient, the two processes will generate the same number, and any gap that exists will be purely random and quickly closed.
      2. Investors: If you are an investor, whether value or growth, and you truly mean it, your view is that the pricing process, for one reason or the other, can deliver a price different from your estimate of value and that the gap that exists will close, as the price converges to value. The difference between value and growth investors lies in where you think markets are most likely to make mistakes (in valuing existing assets or growth opportunities) and correct them. In essence, you are as much a believer in efficient markets as the first group, with the only difference being that you believe markets become efficient after you have taken your position on a stock. 
      3. Traders: If you are a trader, you start off with either the presumption that there is no such thing as intrinsic value, or that it exists, but that no one can estimate it. You play the pricing game, effectively using your skills at gauging momentum and forecasting the effects of corporate news on prices, to buy at a low price and sell at a high price.
      Market participants are most exposed to danger when they are delusional about the game that they are playing. Many portfolio managers, for instance, claim to be investors, playing the value game, while using pricing screens (PE and growth, PBV and ROE) and adding to their holdings of momentum stocks. Many traders seem to think that they will be viewed as deeper and more accomplished if they talk the value talk, while using charts and technical indicators in the closet, to make their stock picks.

      The Pricing Process
      The essence of pricing is attaching a number to an asset or company, based upon how similar assets and companies are being priced in the market. To get insight into how to price an asset, a business or a company, you should break down the pricing process into steps:

      You may be a little puzzled by the first step in the process, where I standardize the price, but the reason is simple. You cannot compare price per share across companies, since it is a function of the share count, which can be changed overnight in a stock split. To standardize prices, you scale them to some variable that all of the assets in the peer group share. With real estate properties, you divide the price of each property by its square footage to arrive at a price/square foot that can be compared across properties. With businesses, you scale pricing to an operating variable, with earnings being the most obvious choice, but it can be revenues, cash flows or book value. Note that any multiple that you find on a stock or company is embedded in this definition, ranging from PE ratios to EV/EBITDA multiples to revenue multiples, and even beyond, to market price per subscriber or user. The second step in the process, i.e., finding similar assets and companies, should make clear the fact that this is a process that requires subjective judgments and is open to bias, just as is the case in intrinsic valuation. If you are pricing Nvidia, for instance, you determine how narrowly or broadly you define the peer group, and which companies to deem to be "similar".  The third step int he process requires controlling for differences across companies. Put simply, if the company that you are pricing has higher growth or lower risk or better returns on its investments on it projects that the companies in the peer group, you have to adjust the pricing to reflect it, either subjectively, as many analysts do, with story telling, or objectively, by bringing in key variables into the estimation process.

      Pricing the Markets in January 2019
      Rather than taking you through multiple after multiple, and overwhelming with pictures and tables on each one, I will list out what I learned by looking at the pricing of all publicly traded stocks around the world, in early 2019, in a series of pricing propositions.

      Pricing Proposition 1: Absolute rules don't belong in a relative world!
      Paraphrasing Einstein, everything is relative, if you are pricing companies. Is a PE ratio of five low? Not if half the stocks in the market trade at less than five. Is an EV/EBITDA of forty high? Perhaps in some sectors, but not if you are comparing high growth companies in a highly priced sector. Old time value investing is filled with rules of thumb, and many of these rules are devised around absolute values for PE or PEG ratios or Price to Book, at odds with the very notion of pricing. If you want to make pricing statements about what comprises cheap or expensive, you should be looking at the distribution of the multiple across the market. Thus, to form pricing rules on US stocks at the start of 2019, I looked the distribution of current, forward and trailing PE ratios for US stocks on January 1, 2019:

      At the start of 2019, a low trailing PE ratio for a US stock would have been 6.09, if you used the lowest decile or 10.36, if you moved to the first quartile, and a high PE ratio, using the same approach, would have been 27.31, with the third quartile, or 53.70, with the top decile. Lest I be accused of picking on value investors, they are not the only or even the biggest culprits, when it comes to absolute rules. Private equity investors and LBO initiators have built their own set of screens. I have lost count of the number of times I have heard it said that an EV to EBITDA less than six (or five or seven) must mean that a company is not just cheap, but a good candidate for leverage, but is that true? To answer the question, I looked at the EV to EBITDA multiples across companies, across regions of the world.
      If you wield a pricing bludgeon and declare all companies that trade at less than six times EBITDA to be cheap, you will find about half of all stocks in Russia to be bargains. Even globally, you should hav no trouble finding investments to make with this rule, since almost one quarter of all companies trade at less than six times EBITDA.  My point is not that that you cannot have rules of thumb, since they do exist for a reason, but that those rules, in a pricing world, have to be scaled to the data. Thus, if you want to define the first decile as your measure of what comprises cheap, why not make it the first decile? That would mean that an EV to EBITDA multiple less than 5.16 would be cheap in the US on January 1, 2019, but that number would have to recalibrated as the market moves up or down.

      Pricing Proposition 2: Markets have a great deal in common, when it comes to pricing, but the differences can be revealing!
      Much is made about the differences across global equity markets, and especially about the divide between emerging and developed market companies, when it comes to pricing, with delusions running deep on both sides. Emerging market analysts are convinced that stocks are priced very differently, and often more irrationally, in their local markets, leaving them free to devise their own rules for their markets. Conversely, developed market analysts often bring perspectives about what comprises high, low or average pricing ratios, built up through decades of exposure to US and European markets, to emerging markets and find them puzzling. The data tells a different story, with pricing ratios around the world having distributional characteristics that are surprisingly similar across different parts of the world:

      While the levels of PE ratios vary across regions, with Chinese stocks having the highest median PE ratios (20.63) and Russian and East European stocks the lowest (9.40), they all have the same asymmetric look, with a peak to the left (since PE ratios cannot be lower than zero) and a tail to the right (there is no cap on PE ratios). That asymmetry, which is shared by all pricing multiples, is the reason that you should always be cautious about any pricing argument that is built on comparisons to the average PE or PBV, since those numbers will be skewed upwards because of the asymmetry.  While it is true that markets share common characteristics, when it comes to pricing, the differences in levels are also worth paying attention to, when investing. A global fund manager who ignores these differences, and picks stocks based upon PE ratios alone, will end up with a portfolio that is dominated by African, Midde East and Russian stocks, not a recipe for investing success.

      Pricing Proposition 3: Book value is the most overrated metric in investing
      I have never understood the reverence that some investors seem to hold for book value, as revealed in the number of investing adages built around it. Stocks that trade at less than book value are considered cheap, and companies that build up book value are considered to be value creating. At the root of the "book value" focus are two assumptions, sometimes stated but often implicit. The first is that the book value is a measure of liquidation value, an estimate of what investors would get if they shut down the company today and sold its assets. The second is that accountants are consistent and conservative in estimating asset value, unlike markets, which are prone to mood swings. Both assumptions are built on foundations of sand, since book value is not a good measure of liquidation value in most sectors, and accountants are both inconsistent and slow-moving, when it comes to estimating and adjusting book value. Again, to get perspective, let's look at the price to book ratios around the world, at the start of 2019:
      If you believe that stocks that trade at less than book value are cheap, you will again find lots of bargains in the Middle East, Africa and Russia, but even in markets like the United States, where less than a quarter of all companies trade at less than book value, they tend to be clustered in industries that are in capital intensive (at least as defined by accountants) and declining businesses.
      PBV by Industry (US)
      Note that among the US industries with the fewest stocks that trade at less than book value are a large number of technology and consumer product companies, with utilities and basic chemicals being the only surprises. On the list of US industry groups with the highest percentage of stocks that trade at less than book value are oil companies (at different stages of the business), old time manufacturing companies and life insurance. If you pick your stocks based upon low price to book, in January 2019, your portfolio will be weighted with companies in the latter group, a prospect that should concern you.

      Pricing Proposition 4: Most stocks that look cheap deserve to be cheap!
      There are traders who have little time for fundamentals, arguing that they have little or no role to play in day to day movements of stock prices. That is probably true, but fundamentals do have significant explanatory power, when it comes to why some companies trade at low multiples of earnings or book value and others are high multiples. To understand the link, I find it most useful to go back to a simple intrinsic value model, and with simple algebraic manipulation, make it a model for a pricing multiple. The picture below shows the paths you would take with an equity multiple (Price to Book) and an enterprise value (EV/Sales) to arrive at their determinants:

      Now what? If you buy into the intrinsic view of a price to book ratio, it should be higher for firms that earn high returns on equity, have higher growth and lower risk, and lower for firms that earn low returns on equity, have lower growth and higher risk. Does the market price in fundamentals? For the most part, the answer is yes, as you can see even in the tables that I have provided in this post so far. Russian stocks have the lowest PE ratios, but that reflects the corporate governance concerns and country risk that investors have when investing in them. Chinese stocks in contrast have the highest PE ratios, because even with stepped down growth prospects for the country, they have higher expected growth than most developed market companies. Looking at stocks with the lowest price to book ratios, Middle Eastern stocks have a disproportionate representation because they earn low returns on equity and the industry groupings with the lowest price to book (oil industry groups, steel etc.) also share that feature. Pricing, done right, is therefore a search for mismatches, i.e., companies that look cheap on a pricing multiple without an obvious fundamental that explains it. This table captures some of the mismatches:

      MultipleKey DriverValuation Mismatch
      PE ratioExpected growthLow PE stock with high expected growth rate in earnings per share
      PBV ratioROELow PBV stock with high ROE
      EV/EBITDAReinvestment rateLow EV/EBITDA stock with low reinvestment needs
      EV/capitalReturn on capitalLow EV/capital stock with high return on capital
      EV/salesAfter-tax operating marginLow EV/sales ratio with a high after-tax operating margin

      Pricing Proposition 5: In pricing, it is not about what "should be" priced in, but "what is" priced in!
      In the last proposition, I argued that markets for the most part are sensible, pricing in fundamentals when pricing stocks, but there will be exceptions, and sometimes large ones, where entire sectors are priced on variables that have little to do with fundamentals, at least on the surface. This is especially true if the companies in a sector are early in their life cycles and have little to show in revenues, very little (or even negative) book value and are losing money on every earnings measure. Desperation drives investors to look for other variables to explain prices, resulting in companies being priced based upon website visitors (at the peak of the dot com boom), numbers of users (at the start of the social media craze) and numbers of subscribers.

      I noted this phenomenon, when I priced Twitter ahead of its IPO in 2013, and argued that to price Twitter, you should look at its user base (about 240 million at the time) and what markets were paying per user at the time (about $130) to arrive at a pricing of $24 billion, well above my estimate of intrinsic value of $11 billion for the company at a time, but much closer to the actual pricing, right after the IPO.  It is therefore neither surprising nor newsworthy that venture capitalists and equity research analysts are more focused on these pricing metrics, when assessing how much to pay for stocks, and companies, knowing this, play along, by emphasizing them in their earnings reports and news releases.

      Conclusion
      I do believe in intrinsic value, and think of myself more as an investor than a trader, but I am not a valuation snob. I chose the path I did because it works for me and reflects my beliefs, but it would be both arrogant and wrong for me to argue that being a trader and playing the pricing game is somehow less worthy of respect or returns. In fact, the end game for both investors and traders is to make money, and if you can make money by screening stocks using PE ratios or technical indicators, and timing your entry/exit by looking at charts, all the more power to you! If there is a point to this post, it is that a great deal of pricing, as practiced today, is sloppy and ignores, or throws away, data that can be used to make pricing better.

      YouTube Video

      Data Links
      1. PE ratios by industry grouping: USEuropeEmerging MarketsJapanAustralia & CanadaIndia and China
      2. Book Value Multiples by industry grouping: USEuropeEmerging MarketsJapanAustralia & CanadaIndia and China
      3. EV to EBIT & EBITDA by industry grouping: USEuropeEmerging MarketsJapanAustralia & CanadaIndia and China
      4. EV to Sales by industry grouping: USEuropeEmerging MarketsJapanAustralia & CanadaIndia and China
      5. Pricing Multiples, by country



      January 2019 Data Update 8: Dividends and Buybacks - Fact and Fiction

      In my series of data posts, I had always planned to get to dividends and buybacks, the two mechanisms that companies have for returning cash to stockholders, at this point, but an op ed on buybacks by Senators Schumer and Sanders this week, in the New York Times, will undoubtedly make this post seem reactive. The senators argue that the hundreds of billions of dollars that US companies have expended buying back their own shares could have been put to better use, if it had been reinvested back in their businesses or used to increase wages for their employees, and offer a preview of legislation that they plan to introduce to counter the menace. Like the senators, I am concerned about the declining manufacturing base and income inequality in the US, but I believe that their legislative proposal is built on premises that are at war with the data, and has the potential for making things worse, not better.


      The Buyback Effect: Benign Phenomenon, Managerial Short-termism or Corporate Malignancy?
      'The very mention of buybacks often creates heated debate, because people seem to have very different views on its causes and consequences. All too often, at the end of debate, each side walks away with its views of buybacks intact, completely unpersuaded by the arguments of the other. The reason, I believe is that our views on buybacks are a function of how we think companies act, what the motives of managers are and what it is that investors price into stocks.

      a. Buybacks are benign
      If companies are run sensibly, the cash that they return to shareholders should reflect a residual cash flow, making the cash return decision, in terms of sequence, the final step in the process. 

      If companies follow this process, buybacks are just another way of returning cash to stockholders, benign in their impact, because they are not coming at the expense of good investments, at least with good defined as investments that generate more than their hurdle rates. In fact, putting restrictions on how much cash companies can return, can harm not only stockholders (by depriving them of their claim on residual  cash flows) but also the economy, because capital will now be tied up in businesses that don't need them, rather than find its way to good ones.

      b. Buybacks are short term
      The benign view of stock buybacks is built on the presumption that managers make decisions at publicly traded companies with an eye on maximizing value, and since value is a function of expected cash flows over the life of the company, that they have a long term perspective. That view is at odds with evidence that managers often put short term gains ahead of long term value, and if investors are also short term, in pricing stocks, you can get a different picture of what drives buybacks and the consequences:

      In effect, managers buy back stock, often with borrowed money, because it reduces share count and increases earnings per shares, and markets reward the company with a higher stock price, because investors don't consider the impact of lost growth and/or the risk of more debt. The argument that buybacks are driven by short term interests is strengthened if management compensation takes the form of equity in the company (options or restricted stock), because managers will be personally rewarded then for buybacks that, while damaging to the company's value (which reflects the long term), push up stock prices in the short term. With this view of the world, buybacks can create damage, especially at companies with good long term projects, run by managers who feel the need to meet short term earnings per share targets.

      c. Buybacks are malignant
      There is a third view of buybacks, where buybacks are not just motivated by the desire to push up earnings per share and stock prices, but become the central purpose of the firm. With this view, companies try to do whatever they can to generate more cash for buybacks, including crimping on worker wages, turning away good investments and borrowing more, even if that borrowing can put their survival at risk.

      This picture captures almost all of the arguments that detractors of buybacks have used, including the ones that Senators Schumer and Sanders present in their article. If buybacks are the drivers of all other corporate actions, instead of being a residual cash flow, the “buyback binge” can be held responsible for a trifecta of America's most pressing economic problems: stagnant wages for workers, the drop in capital expenditures at US companies and the rise in debt on balance sheets. If this buyback shift is being driven by activist shareholders and a subset of "short term" institutional investors, as many argue that it is, you have a populist dream cast of good (workers, small stockholders, consumers) and evil (activists, wealthy shareholders and bankers). If you buy into this description of corporate and investor behavior, and it is not an implausible picture, it stands to reason that restricting or even stopping companies from buying back stock should alleviate and even solve the resulting problems. 

      Picking a perspective
      The reason debates about buybacks very quickly bog down is because proponents not only come in very different perspectives of corporate behavior, but they use anecdotal evidence, where they point to a specific company that behaves in a way that backs their perspective, and say "I told you so". The truth is that the real world is a messy place, with some companies buying back stocks for the right reasons (i.e., because they have no good investments and their stockholders prefer cash returns in this form), some companies buying back stock for short term price gains (to take advantage of markets which are myopic) and some companies focusing on buying back stock at the expense of their employees, lenders and own long term interests. 


      Moneyball with Buybacks

      The question of which side of this debate you will come down on, will depend on which of the perspectives outlined above comes closest to describing how companies and markets actually behave. Since that is an empirical question, not a political, idealogical or a theoretical one, I think it makes sense to look at the numbers on dividends and buybacks, not just in the US, but across the world, and I will do so with a series of data-driven statements.


      1. More companies are buying back stock, and more cash is being returned in buybacks

      Are US companies returning more and more cash in the form of buybacks? Yes, they are, and it represents a trend that saw its beginnings, not ten years ago, but in the 1980s. In the graph below, I look at the aggregate dividends and buybacks from firms in the S&P 500 since 1986, and also report on the percentage of cash returned that takes the form of buybacks, each year:

      Starting at a base in the early 1980s, where buybacks were uncommon and dividends represented almost all cash return, you can see buybacks climb through the 1980s and 1990s, both in dollar value terms and as a percentage of overall cash return. That trend has only accelerated in this century, with the 2008 crisis putting a brief crimp on it. In 2018, more than 60% of the cash returned by S&P 500 companies was in the form of buybacks, amounting to almost $700 billion.

      2. Cash Returns are rising as a percent of earnings, and it looks like companies are reinvesting less back into their own businesses
      If you look at the graph above, you can see that the rise in buybacks has been accompanied by a stagnation in dividends, with growth rates in dividends substantially falling short of growth in buybacks. This shift has had consequences for two widely used measures of cash return, dividend yield, which looks at dividends as a percent of market capitalization or stock prices and the dividend payout ratio, a measure of the proportion of earnings as dividends. The declining role of dividends, as a form of cash return, has meant that a more relevant measure of cash return has to incorporate stock buybacks, resulting in a broader definition of cash yield and cash payout ratio measures:
      • Cash Yield = (Dividends + Buybacks) / Market Capitalization
      • Cash Payout Ratio = (Dividends + Buybacks)/ Net Income
      The push back that you will get from dividend devotees that while dividends go to all shareholders, buybacks put cash only in the pockets of those stockholder who sell back, but that argument ignores the reality that the it is still shareholders who are getting the cash from buybacks. (As a thought experiment, imaging that you own all of the shares in a company and consider whether you notice a difference between dividends and buybacks, other than for tax purposes.) Calculating both dividend and cash measures of yield and payout over time, we observe the following for the companies in the S&P 500:
      S&P 500: Dividends, Buybacks, Mkt Cap and Net Income
      This table reinforces the message from the previous graph, which is that both dividends and buybacks have to be considered in any assessment of cash return. That is why I think that the handwringing over how low dividend yields have become over the last two decades misses the point. The cash yield for US companies, which includes both dividends and buybacks, is much more indicative of what companies are returning to shareholders and that  number has remained relatively stable over time. Using the same logic that I used to argue that cash yields were better indicators of cash returned to shareholders than dividend yields, I computed cash payout ratios, by adding buybacks to dividends, before dividing by net income in the table in the last section, and it does show a disquieting pattern. In fundamental analysis, analysts give weight to the payout ratio and its twin measure, the retention ratio (1- payout ratio) as a measure of how much a company is reinvesting into its own business, in order to grow.  The cash returned to shareholders exceeded net income in 2015 and 2016, and remains high, at 92.12% of net income, and that statistic seems to support the proposition that US companies are reinvesting less.

      3. The drop in reinvestment may be real, but it could also be a reflection of accounting inconsistencies and failure to see the full picture on cash return
      It is true that companies are returning more of their net income, as measured by accountants, to stockholders in dividends and buybacks, with the latter accounting for the lion's share of the return. Before we conclude that this is proof that companies are reinvesting less, there are two flaws in the numbers that need fixing:
      1. Stock Issuances: If we count stock buybacks as returning cash to shareholders, we should also be counting stock issuances as cash being invested by these same shareholders. Thus, the more relevant measure of cash return would net out stock issuances from stock buybacks, before adding dividends. While this is a lesser issue with the S&P 500 companies, which tend to be larger and more mature companies, less dependent of stock issuances, it can be a larger one for the entire market, where initial public offerings can augment seasoned equity issues, especially for smaller, higher growth companies.
      2. Accounting Inconsistencies: Over the last few decades, the percentage of S&P 500 companies that are in technology and health care has risen, and that rise has laid bare an accounting inconsistency on capital expenditures. If a key characteristic of capital expenditures is that money spent on them provide benefits for many years, accounting does a reasonable job in categorizing capital expenditures in manufacturing firms, where it takes the form of plant and equipment, but it does a woeful job of doing the same at firms that derive the bulk of their value from intangible assets. In particular, it treats R&D, the primary capital expenditure for technology and health care firms, brand name advertising, a key investment for the long term for consumer product companies, and customer acquisition costs, central for growth in subscriber/user driven companies as operating expenses, depressing earnings and rendering book value meaningless. In effect, companies on the S&P 500 are having their earnings measured using different rules, with the earnings for GM and 3M reflecting the correct recognition that money spent on investments designed to create benefits over many years should not be expensed, but the earnings for Microsoft and Apple being calculated after netting those same types of investments. As with the treatment of leases, I refuse to wait for accountants to come to their senses on this question, and I have been capitalizing R&D for all companies and adjusting their earnings accordingly. 
      In the table below, I bring in stock issues and R&D into the picture, looking across all US stocks, not just the S&P 500:
      All US publicly traded companies; S&P Capital IQ
      While the trend towards buybacks is still visible, bringing in new stock issuances tempers some of the most extreme findings. In 2018, for instance, the net cash return (with issuances netted out from dividends and buybacks) represented about 46% of adjusted net profit (with R&D added back), well below the gross cash return.  In fact, there is no discernible decline in reinvestment over time, barring 2008 and 2009, the years around the last crisis. Capital expenditures have grown slowly, but an increasing percentage of reinvestment, especially in the last 5 years, has taken the form of R&D and acquisitions. 


      4. Buybacks cut across sectors, size classes and growth categories, but the biggest cash returners are larger, more mature companies.

      Before we decide that buybacks are ravaging the economy and should be restricted or even banned, it is also worth taking a look at what types of companies are buying back the most stock.  Staying with US stocks, I looked at buybacks and dividends of companies, broken  down by industry grouping. The full table is at the end of this post, but based upon the dollar value of buybacks, the ten industries that bought back the least stock and the ten that bought back the most are highlighted below:
      Dividends and Buybacks: By Industry for US
      It should come as no surprise that the industries where you see buybacks used the least tend to be industries which have a history of large dividend payments, with utilities, metals and mining and real estate making the list. Looking at the industries that are the biggest buyers of their own stock, the list is dominated by companies that derive their value from intangible assets, with technology and pharmaceuticals accounting for seven of the ten top spots. While that may surprise some, since these are viewed as high growth businesses, some of the biggest players in both technology and pharmaceuticals are now middle aged or older, using my corporate life cycle structure.

      Given that there are often wide differences in size and growth, within each industry grouping, I also broke companies down by market cap size, to see if smaller companies behave differently than larger ones, when it comes to buybacks:
      Market capitalization, as of 12/31/18
      It is not surprising that the largest companies account for the bulk of buybacks, but you can also see that they return far more in buybacks, as a percent of their market capitalizations, then smaller firms do. 

      Finally, I categorized companies based upon expected growth in the future, to see if companies that expect high growth behave differently from ones that expect low growth.
      Expected revenue growth in the next two years
      While companies in every growth class have jumped on the buyback bandwagon, the biggest buybacks in absolute and relative terms are for companies that have the lowest expected growth in revenues, returning 4-5% of their market capitalization in buybacks each year. Companies in the highest growth class, in contrast, return only 0.95% of their buybacks. That said, there are companies in higher growth classes that are buying back stock, when they should not be, perhaps for short term pricing reasons, but they represent only a small portion of the market, accounting collectively for only 10.56% of overall market capitalization.

      I may be guilty of letting my priors guide my reading of these tables, but as I see it, the buyback boom in the United States is being driven by large non-manufacturing firms, with low growth prospects. If you restrict buybacks, expecting that this to unleash a new era of manufacturing growth and factory jobs, I am afraid that you will be disappointed. The workers at the firms that buy back the most stock, tend to be already among the better paid in the economy, and tying buybacks to higher wages for these workers will not help those who are at the bottom of the pay scale.

      5. Investing back into businesses is not always better than returning cash to shareholders, when it comes to jobs, economic growth and prosperity.
      Implicit in the Schumer-Sanders proposal to restrict buy backs is the belief that while shareholders may benefit from buybacks, the economy overall will be more prosperous, and workers will be better served, if the cash that is returned to shareholders is invested back in the businesses instead. Incidentally, this seems to be a shared delusion for both ends of the political spectrum, since one of the biggest sales pitches for the tax reform act, passed in 2017, was that the cash trapped overseas by bad US tax law, would, once released, be invested into new factories and manufacturing capacity in the US. I believe that both sides are operating from a false premise, since investing money back into bad businesses can make both economies and workers worse off. In a prior post, I defined a bad business as one where it is difficult to generate a return that is higher than the risk adjusted rate that you need to make to break even on your investment. 
      Data Update 6 on excess returns
      Using the return on capital, a flawed but still useful measure, as a measure of return and the cost of capital, with all of the caveats about measurement error, I found that approximately 60% of companies, both globally and in the US, earn less than their cost of capital. Forcing these companies to reinvest their earnings, rather than letting them pay it out, will only put more more money into bad businesses and create what I call "walking dead" companies, tying up capital that could be used more productively, if it were paid out to shareholders, who then can find better businesses to invest in. 

      6. Some companies may be funding buybacks with debt, but the bulk of buybacks are still funded with equity cash flows
      The narrative about stock buybacks that its detractors tell is that US companies have borrowed money and used that debt to fund buybacks, creating, at least in the narrative, sky-high debt ratios and  rising default risk. While there is certainly anecdotal evidence that you can offer for this proposition, there is evidence that we have looked at already that should lead you to question this narrative. Looking across sectors, we noted that the technology and pharmaceutical companies are on the list of biggest buyers of their own stock, and neither group is in the top ten or even twenty, when it comes to debt ratios.

      Taking the naysayers at their word, I broke US companies down, based upon their debt loads, using Debt/EBITDA as the measure, from lowest to highest, to see if there is a relationship between buybacks and debt loads:
      Debt to EBITDA at the end of 2018
      The bulk of the buybacks are coming from firms with low to moderate debt ratios, falling in the second and third quintiles of debt ratios.  It is true that the firms with the highest debt load, buy back the most stock, at least as a percent of their market capitalization. As with the growth data, you can view this as evidence of either short-term thinking or worse, but note that the second and third quintiles together account for 61% of overall market capitalization, suggesting that if buybacks are skewing debt upwards at some firms, it is more at the margins than at the center of the market. 

      7. Buybacks are now a global phenomenon
      It is true that stock buybacks, at least in the form that you see them today, as cash return to stockholders, had their origins in the United States in the 1980s and it is also true that for a long time after that, much of the rest of the world either stayed with dividends and many countries had severe constraints on the use of buybacks. In the last decade, though, the dam seems to have broken and stock buybacks can now be seen in every part of the world, as can be seen in the table below:

      US companies still lead the world in buybacks, but Canadian companies are playing catch up and you are seeing buybacks pick up in Europe. Asia, Eastern Europe and Latin America remain holdouts, though it is unclear how much of the reluctance to buy back stock is due to poor corporate governance. 


      The Follow Up

      I agree that wage stagnation and an unwillingness to invest into the industrial base are significant problems for US companies, but I think that buybacks are more a symptom of global economic changes, than a cause. In particular, globalization has made it more difficult for companies to generate sustained returns on investments,  and has made earnings more volatile for all businesses.  The lower returns on investments has led to more cash being returned, and the fear of earnings volatility has tilted companies away from dividends, which are viewed as more difficult to back out of, to buybacks. In conjunction, a shift from an Industrial Age economy to the economies of today has meant that our biggest businesses are less capital intensive and more dependent on investments in intangible assets, a trend that accounting has not been able to keep up with.  You can ban or restrict buybacks, but that will not make investment projects more lucrative and earnings more predictable, and it certainly is not going to create a new industrial age.

      If you came into this article with a strong bias against buybacks it is unlikely that I will be able to convince you that buybacks are benign, and it is very likely that you will be in favor, like Senators Schumer and Sanders, on restricting not just buybacks, but cash returns (including dividends), in general. Playing devil’s advocate, let’s assume that you succeed and play out what the effects of these restrictions will be on how much companies invest collectively and employee wages.
      • On the investment front, it is true that companies that used to buy back large numbers of their own shares will now have more cash to invest, but in what? It could be in more internal investments or projects, but given that many of these companies were buying back stock because they could not find good projects in the first place, it would have to be in projects that don’t earn a high enough returns to cover their hurdle rates. Perhaps, it will be in acquisitions, and while that will make M&A deal makers happy, the corporate track record is woeful. In either case, you will have more reinvestment in the wrong segments of the economy, at the expense of investments in the segments that need them more.
      • On the wage front, the consequences will be even messier. It is possible that tying buybacks to employee wages, as Senators Schumer and Sanders propose, will cause some companies to raise wages for existing employees, but with what consequences? Since they will now be paying much higher wages than their competitors, my guess is that these same companies will  be quicker to shift to automation and will have smaller workforces in the future, and that those at the low end of the pay scale will be most hurt by this substitution. 
      Illustrating my point about anecdotal evidence, the senators use Walmart and Harley Davidson to make their case, arguing that both companies should not have expended the money that they did on buybacks, and taken investments or raised wages instead. 
      • Assuming that Walmart had followed their advice and not bought back stock and invested instead, it is unlikely that Walmart would have opened more stores in the United States, a saturated market, but would have opened them instead in other countries, and I don’t believe that the senators would view more stores being built in Indonesia or India as the outcome they were hoping for. As for Harley Davidson, a company that serves a loyal, but niche market, building another factory may have created more jobs for the moment, but it is not at all clear that the demand exists for the bikes that would roll out.
      • Would Walmart have raised wages, if they had not bought back stock? In a retail landscape, where Amazon lays waste to any competitor with a higher cost structure, that would have been suicidal, and accelerated the flow of customers to Amazon, allowing that company to become even more dominant. In a world where people complain about how the FANG stocks are taking over the world, you would be playing into their hands, by handcuffing their brick and mortar competitors, with buyback legislation.
      In short, restricting buybacks may lead to more reinvestment, but much of it will be in bad businesses, acquisitions of existing entities and often in other countries. Tying buybacks to employee wage levels may boost the pay for existing employees, but will lead to fewer new hires, increasing automation and smaller workforces over time. In short, the ills that the Schumer-Sanders bill tries to cure will get worse, as a result of their efforts, rather than better.

      Conclusion
      I believe that the shift to buybacks reflects fundamental shifts in competition and earnings risk, but I don't wear rose colored glasses, when looking at the phenomenon. There are clearly some firms that are buying back stock, when they clearly should not be, paying out cash that could be better used on paying down debt, especially in the aftermath of the reduction of tax benefits of debt, or taking investments that can generate returns that exceed their hurdle rates. You may consider me naive, but I believe that the market, while it may be fooled for the moment, will catch on and punish these firms. Also, the data suggests that these bad players are more the exception than the rule, and banning all buybacks or writing in restrictions on buybacks for all companies strikes me as overkill, especially since the promised benefits of higher capital investment and wages are likely to be illusory or transitory. If you are tempted to back these restrictions, because you believe they are well intentioned, it is worth remembering that history is full of well intentioned legislation delivering perverse results. 

      YouTube Video

      Datasets



      January 2019 Data Update 7: Debt, neither poison nor nectar!

      Debt is a hot button issue, viewed as destructive to businesses by some at one end of the spectrum and an easy value creator by some at the other. The truth, as is usually the case, falls in the middle. In this post, I will look not only at how debt loads vary across companies, regions and industries, but also at how they have changed over the last year. That is because last year should have been a consequential one for financial leverage, especially for US companies, since the corporate tax rate was reduced from close to 40% to approximately 25%. I will also put leases under the microscope, converting lease commitments to debt, as I have been doing for close to two decades, and look at the effect on  profit margins and returns, offering a precursor to changes in 2019, when both IFRS and GAAP will finally do the right thing, and start treating leases as debt.

      The Debt Trade Off
      Debt is neither an unmixed good nor an unmitigated disaster. In fact, there are good and bad reasons for companies to borrow money, to fund operations, and in this section, I will look at the trade off, and look at the implications for what types of businesses should be the biggest users of debt, and which ones, the smallest.

      The Pluses and Minuses
      There are only two ways you can raise capital to fund a business. One is to use owner funds, which can of course range from personal savings in a small start up to issuing shares to the market, for a public company. The other is to borrow money, again ranging from a loan from a family member or friend to bank debt to corporate bonds. The debt equity trade off then boils down to what debt brings to the process, relative to equity, in both good and bad ways.

      The two big elements driving whether a company should borrow money are the tax code, and how heavily it is tilted towards debt, on the good side and the increased exposure to default and distress, that it also creates, on the bad side. Simply put, companies with stable and predictable earnings streams operating in countries, with high corporate tax rates should borrow more money than companies with unstable earnings or which operate in countries that either have low tax rates or do not allow for interest tax deductions. For financial service firms, the decision on debt is more complex, since debt is less source of capital and more raw material to a bank. As a consequence, I will look at only non-financial service firms in this post, but I plan to do a post dedicate to just financial service firms.

      US Tax Reform - Effect on Debt
      If one of the key drivers of how much you borrow is the corporate tax code, last year was an opportunity to see this force in action, at least in the US. At the start of 2018, the US tax code was changed in two ways that should have affected the tax benefits of debt:
      1. The federal corporate tax rate was lowered from 35% to 21%. Adding state and local taxes to this, the overall corporate tax rate dropped from close to 40% to about 25%.
      2. Restrictions were put on the deductibility of interest expenses, with amounts exceeding 30% of taxable income no longer receiving the tax benefit.
      Since there were no significant changes to bankruptcy laws or costs, these tax code changes make debt less attractive, relative to equity, for all US companies. In fact, as I argued in this post at the start of 2018, if US companies are weighing the pros and cons correctly, they should have reduced their debt exposure during the course of 2018.

      While I have data only through through the end of the third quarter of 2018, I look at the change in total debt, both gross and net, at non-financial service US companies, over the year (by comparing to the debt at the end of the third quarter of 2017).
      Download debt change, by industry
      In the aggregate, US non-financial service companies did not reduce debt, but instead added $434 billion to their debt load, increasing their total debt from $6,931 billion to $7,365 billion between September 2017 and September 2018. That represented only a 6.26% increase over the year, and was accompanied by a decline in debt as a percent of market capitalization, but that increase is still surprising, given the drop in the marginal tax rate and the ensuing loss of tax benefits from borrowing. There are three possible explanations:
      1. Inertia: One of the strongest forces in corporate finance is inertia, where companies continue to do what they have always done, even when the reasons for doing so have long since disappeared. It is possible that it will be years before companies wake up to the changed tax environment and start borrowing less.
      2. Uncertainty about future tax rates: It is also possible that companies view the current tax code as a temporary phase and that the drop in corporate tax rates will be reversed by future administrations.
      3. Illusory and Transient Benefits: Many companies perceive benefits in debt that I term illusory, because they create value, only if you ignore the full consequences of borrowing. I have captured these illusory benefits in the table below: Put simply, the notion that debt will lower your cost of capital, just because it is lower than your cost of equity, is widely held, but just not true, and while using debt will generally increase your return on equity, it will also proportionately increase your cost of equity.
      I will continue tracking debt levels through the coming years, and assuming no bounce back in corporate tax rates, we should get confirmation as to whether the tax hypothesis holds.

      Debt: Definition
      The tax law changed the dynamics of the debt/equity tradeoff, but there is an accounting change coming this year, which will have a significant impact on the debt that you see reported on corporate balance sheets around the world, and since this is the debt that most companies and data services use in measuring financial leverage. Specifically, accountants and their rule writers are finally going to come to their senses and plan to start treating lease commitments as debt, plugging what I have always believed is the biggest source of off balance sheet debt.

      Debt: Definition
      In my financing construct for a business, I argue that there are two ways that a business, debt (bank loans, corporate bonds) and equity (owner's funds), but to get a sense of how the two sources of capital vary, I looked at the differences:

      Specifically, there are two characteristics that set debt apart from equity. The first is that debt creates a contractual or fixed claim that the firm is obligated to meet, in good and bad times, whereas equity gives rise to a residual claim, where the firm has the flexibility not to make any payments, in bad times. The second is that with debt, a failure to meet a contractual commitment, will lead to a loss of control of the firm and perhaps default, whereas with equity, a failure to meet an expected commitment (like paying dividends) can lead to a drop in market value but not to distress. Finally, in liquidation, debt holders get first claim on the assets and equity gets whatever, if any, is left over. Using this definition of debt, we can navigate through a balance sheet and work out what should be included in debt and what should not. If the defining features for debt are contractual commitments, with a loss of control and default flowing from a failure to meet them, it follows that all interest bearing debt, short term as well as long term, bank loans and corporate bonds, are debt. Staying on the balance sheet, though, there are items that fall in a gray area:
      1. Accounts Payable and Supplier Credit:  There can be no denying that a company has to pay back supplier credit and honor its accounts payable, to be a continuing business, but these liabilities often have no explicit interest costs. That said, the notion that they are free is misplaced, since they come with an implicit cost. To make use of supplier credit, for instance, you have to give up discounts that you could have obtained if you paid on delivery. The bottom line in valuation and corporate finance is simple. If you can estimate these implicit expenses (discounts lost) and treat them as actual interest expenses, thus altering your operating income and net income, you can treat these items as debt. If you find that task impossible or onerous, since it is often difficult to back out of financial reports, you should not consider these items debt, but instead include them as working capital (which affects cash flows).
      2. Underfunded Pension and Health Care Obligations: Accounting rules around the world have moved towards requiring companies to report whether their defined-benefit pension plans or health care obligations are underfunded, and to show that underfunding as a liability on balance sheets. In some countries, this disclosure comes with legal consequences, where the company has to set aside funds to cover these obligations, akin to debt payments, and if this is the case, they should be treated as debt. In much of the world, including the United States, the disclosure is more for informational purposes and while companies are encouraged to cover them, there is no legal obligation that follows. In these cases, you should not consider these underfunded obligations to be debt, though you may still net them out of firm value to get to equity value.
      The table below provides the breakdown of debt for non-financial service companies around the world.
      Debt Details, by Industry (US)
      As you browse this table, please keep in mind that disclosure on the details of debt varies widely across companies, and this table cannot plug in holes created by non-disclosure. To the extent that company disclosures are complete, you can see that there are differences in debt type across regions, with a greater reliance on short term debt in Asia, a higher percent of unsecured and fixed rate debt in Japan and more variable rate, secured debt in Africa, India and Latin America than in Europe or the US. You can get the debt details, by industry, for regional breakdowns at the link at the end of this post.

      Debt Load: Balance Sheet Debt
      Using all interest bearing debt as debt in looking at companies, we can raise and answer fundamental questions about leverage at companies. Broadly speaking, the debt load at a company can be scaled to either the value of the company or to its earnings and cash flows. Both measures are useful, though they measure different aspects of debt load:

      a. Debt and Value
      Earlier, I noted that there are two ways you can fund a business, debt and equity, and a logical measure of financial leverage that follows is to look at how much debt a firm uses, relative to its equity. That said, there are two competing measures of value, and especially for equity, the divergence can be wide.
      • The first is the book value, which is the accountant's estimate of how much a business and its equity are worth. While value investors attach significant weight to this number, it reflects all of the weaknesses that accounting brings to the table, a failure to adjust for time value of money, an unwillingness to consider the value for current market conditions and an inability to deal with investments in intangible assets. 
      • The second is market value, which is the market's estimate, with all of the pluses and minuses that go with that value. It is updated constantly, with no artificial lines drawn between tangible and intangible assets, but it is also volatile, and reflects the pricing game that sometimes can lead prices away from intrinsic value.
      In the graph below, I look at debt as a percent of capital, first using book values for debt and equity, and next using market value.
      Debt ratios, by industry (US)
      In the table below, I break out debt as a percent of overall value (debt + equity) using both book value and market value numbers, and look at the distribution of these ratios globally:

      Embedded in the chart is a regional breakdown of debt ratios, and even with these simple measures of debt loads, you can see how someone with a strong  prior point of view on debt, pro or con, can find a number to back that view. Thus, if you want to argue as some have that the Fed (which is blamed for almost everything that happens under the sun), low interest rates and stock buybacks have led US companies to become over levered, you will undoubtedly point to book debt ratios to make your case. In contrast, if you have a more sanguine view of financial leverage in the US, you will point to market debt ratios and perhaps to the earnings and cash flow ratios that I will report in the next section. On this debate, at least, I think that those who use book value ratios to make their case hold a weak hand, since book values, at least in the US and for almost every sector other than financial, have lost relevance as measures of anything, other than accounting ineptitude.

      b. Debt and Earnings/Cashflows
      Debt creates contractual obligations in the form of interest and principal payments, and these payments have to be covered by earnings and cash flows. Thus, it is sensible to measure how much buffer, or how little, a firm has by scaling debt payments to earnings and cash flows, and here are two measures:
      • Debt to EBITDA: It is true that EBITDA is an intermediate cash flow, not a final one, since you still have to pay taxes and invest in growth, before you get a residual cash flow. That said, it is a proxy for how much cash flow is being generated by existing investments, and dividing the total debt by EBITDA is a measure of overall debt load, with lower numbers translating into less onerous loads.
      • Interest Coverage Ratio: Dividing the operating income (EBIT) by interest expenses, gives us a different measure of safety, one that is more immediately tied to default risk and cost of debt than debt to EBITDA. Firms that generate substantial operating income, relative to interest expenses, are safer, other things remaining equal, than firms that operate with lower interest coverage ratios. 
      In the table below, I look at the distributions of both these numbers, again broken down by region of the world:
      Debt ratios, by industry (US)
      Again, the story you tell can be very different, based upon which number you look at. Chinese companies have the most debt in the world, if you define debt as gross debt, but look close to average, when you look at net debt. Indian companies look lightly levered, if you look at Debt to EBITDA multiples, but have the most exposure to debt, if you use interest coverage ratios to measure debt load.

      Operating Leases: The Accounting Netherworld
      Going back to the definition of debt as financing that comes with contractually set obligations, where failure to meet these obligations can lead to loss of control and default, it is clear that focusing on only the balance sheet (as we have so far) is dangerous, since there are other claims that companies create that meet these conditions. Consider lease agreements, where a retailer or a restaurant business enters into a multi-year agreement to make lease payments, in return for using a store front or building. The lease payments are clearly set out by contract, and failing to make these payments will lead to loss of that site, and the income from it. You can argue that leases providing more flexibility that a bank loan and that defaulting on a lease is less onerous, because the claims are against a specific location and not the business, but those are arguments about whether leases are more like unsecured debt than secured debt, and not whether leases should be treated as debt. For much of accounting history, though, accountants have followed a different path, treating only a small subset of leases as debt and bringing them on to the balance sheet as capital leases, while allowing the bulk of lease expenses as operating expenses and ignoring future lease commitments on balance sheets. The only consolation prize is that both IFRS and GAAP have required companies to show these lease commitments as footnotes to balance sheets.

      In my experience, waiting for accountants to do the right thing will leave you twisting in the wind, since it seems to take decades for common sense to prevail. Consequently, I have been treating leases as debt for more than three decades in valuation, and the process for doing so is neither complicated nor novel. In fact, it is the same process that accountants use right now with capital leases and it involves the following steps:
      1. Estimate a current cost of borrowing or pre-tax cost of debt for the company today, given its default risk and current interest rates (and default spreads).
      2. Starting with the lease commitment table that is included in the footnotes today, discount each lease commitment back to today, using the pre-tax cost of debt as your discount rate (since the lease commitments are pre-tax). Most companies provide only a lump-sum value for commitments after year 5, and while you can act as if this entire amount will come due in year 6, it makes more sense to convert it into an annuity, before discounting.
      3. The sum total of the present value of lease commitments will be the lease debt that will now show up on your balance sheet, but to keep the balance sheet balanced, you will have to create a counter asset. 
      4. To the extent that the accounting has treated the current year's lease expense as an operating expense, you have to recompute the operating income, reflecting your treatment of leases as debt:
      Adjusted Operating Income = Stated Operating Income + Current year's lease expense - Depreciation on the leased asset

      Capitalizing leases will have large consequences for not just debt ratios at companies (pushing them for companies with significant lease commitments) but also for operating profitability measures (like operating margin) and returns on invested capital (since both operating income and invested capital will be changed). The effects on net margin and return on equity should either be much smaller or non-existent, because equity income is after both operating and capital expenses, and moving leases from one grouping to another has muted consequences. In the table below, I report on debt ratio, operating margin and return on capital. before and after the lease adjustment :
      Lease Effect, by Industry, for US
      You can download the effects, by industry, for different regions, by using the links at the bottom of this post.  Keep in mind, though, that there are parts of the world where lease commitments, though they exist, are not disclosed in financial statements, and as a consequence, I will understate the else effect, While the effect is modest across all companies, the lease effect is larger in sectors that use leases liberally in operations, and to see which sectors are most and least affected, I looked at the ten   sectors, among US companies, and not counting financial service firms, that saw the biggest percentage increases in debt ratios and the ten sectors that saw the smallest in the table below:
      Lease Effect, by Industry, for US
      Note that there are a large number of retail groupings that rank among the most affected sectors, though a few technology companies also make the cut. As I noted at the start of this post, this year will be a consequential one, since both GAAP and IFRS will start requiring companies to capitalize leases and showing them as debt. While I applaud the dawning of sanity, there are many investors (and equity research analysts) who are convinced that this step will be catastrophic for companies in lease-heavy sectors, since it will be uncover how levered they are. I am less concerned, because markets, unlike accountants, have not been in denial for decades and market prices, for the most part and for most companies, already reflect the reality that leases are debt. 

      Debt: Final Thoughts
      One of the biggest impediments to any rational discussion of debt's place in capital is the emotional baggage that we bring to that discussion. Debt is neither poison, as some detractors claim it to be, nor is a nectar, as its biggest promoters describe it. It is a source of capital that comes with fixed commitments and the risk of default, good for some companies and bad for others, and when it does create value, it is because the tax code it tilted towards it. It is true that some companies and investors, especially those playing the leverage game, over estimate its benefits and under estimate its side costs, but they will learn their lessons the hard way. It is also true that other companies and investors, in the name of prudence, think that less debt is always better than more debt, and no debt is optimal, and they too are leaving money on the table, by being too conservative.

      YouTube Video


      Datasets
      1. Debt Change, by Industry Group for US companies, in 2019
      2. Debt Details, by Industry Group in 2019 for US, Europe, Emerging Markets, Japan, Australia & Canada, India and China
      3. Debt Ratios, by Industry Group in 2019 for USEuropeEmerging MarketsJapanAustralia & CanadaIndia and China
      4. Lease Capitalization Effects, by Industry Group in 2019 for USEuropeEmerging MarketsJapanAustralia & CanadaIndia and China



      Lyft Off? The First Ride Sharing IPO!

      Last week, Lyft became the first of the ride sharing companies to announce plans for an initial public officering, filing its prospectus. It is definitely not going to be the last, but its fate in the market will not only determine when Uber, Didi, Ola and GrabTaxi will test public markets, but what prices they can hope to get. My fascination with ride sharing goes back to June 2014, when I tried to value Uber and failed spectacularly in forecasting how much and how quickly ride sharing would change the face of car service around the world. I have since returned multiple times to the scene of my crime, and while I am not sure that I have learned very much along the way, I have tried to right size my thinking on this business. You can be the judge as bring my experiences to play in my valuation of Lyft, ahead of its IPO pricing.

      The Rise of Ride Sharing
      The ride sharing business, as we know it, traces its roots back to the Bay Area, with the founding of Uber, Sidecar and Lyft providing the key impetus, and its impact on the car service business has been immense. In a post in 2015, I traced out the growth of ride sharing and the ripple effects it has had on the car service status quo, noting that revenues for ride sharing companies have climbed, the price of a taxi cab medallion in New York city has plummeted by 80-90%. The most impressive statistic, for ride sharing companies, is not just the growth in revenues, which has been explosive, but also how much it has become part of day-to-day life, not just for younger, more tech savvy individuals but for everyone.  While the growth was initially in the United States, ride sharing has taken off at an exponential rate in Asia, with India (Ola), China (Didi) and Malaysia (GrabTaxi) all developing home grown ride sharing companies. The regulatory push back has been strong in Europe, slowing growth, but there are signs that even there, ride sharing is acquiring a foothold.

      There are many factors that can explain how and why ride sharing so quickly and decisively disrupted the taxi cab business, but the latter was ripe for the taking for may reasons. First, the taxi business in the 2009 had changed little in decades, refusing to incorporate advance in technology and shifting tastes, secure that it did not have to adapt, because it had a captive market.  Second, in most cities, rules and regulations that were throwbacks in time or lobbied for by special interests handicapped taxi operators and gave ride sharing companies, not bound by the same rules, a decisive advantage. Third, automobiles are underutilized resources for the most part, since most cars sit idle for much of the day, and ride sharing companies took advantage of excess capacity, by letting car owners monetize it. Finally, individuals often under price their time and do not factor in long term costs in their decision making and the ride sharing companies have exploited that irrationality. I think that the MIT study in February 2018 that showed absurdly low hourly wages (less than $4/hour) for Uber and Lyft drivers was flawed, but I also don't buy into the rosy picture that the ride sharing companies paint about the income potential in driving. 

      It has not been all good news for ride sharing, as usage has increased. While revenues have come easily, the companies have struggled with profitability, reporting huge losses as they grow. Lyft reported losses of $911 million in 2018, in its prospectus, but Uber's loss was $1.8 billion during 2018, Didi almost matched that with a $1.6 billion loss and the only reason that Ola and GrabTaxi lost less was because they were smaller. Put simply, these company are money losing machines, at least at the moment, and if there are economies of scale kicking in, they are showing up awfully slowly. While some of this can be attributed to growing pains, that will ease as these companies age and grow bigger, a significant portion of the profitability shortfall can be attributed to how these businesses are designed. In my 2015 post, I argued that the low capital intensity (where ride sharing companies don't invest in cars) and the independent contractor model (where drivers are not employees), which made growth so easy, also conspired to make it difficult for these companies to gain economies of scale or stay away from cut throat competition. 

      The Playing Field
      In 2015, I argued, with tongue only half in cheek, that one possible model for the ride sharing companies to develop sustainable businesses was the Mafia's mostly successful attempt to stop intrafamily warfare in the 1930s by dividing up New York city among five families, giving each family its own fiefdom to exploit. (I prefer The Godfather version.). While that may have seemed like an outlandish comparison in 2015, it is interesting that in the years since, Uber has extricated itself from China, leaving that market to Didi, in return for a 20% stake in the company and then from South East Asia, in return for a share of GrabTaxi. In fact, the United States may be the most competitive ride sharing market in the world, with Uber and Lyft going head-to-head in most cities.

      While Uber and Lyft are ride sharing companies, their evolution over the last decade offers a fascinating contrast in business models, for young companies. In a post in 2015, I drew the contrast between the two companies, as a prelude to valuing them. Uber was the "big story" company, telling investors that it wanted to be in all things logistics, expanding into delivery and moving, and all over the world. Lyft was the "focused story" company, setting itself apart from Uber by keeping its business in the United States and staying with car service, as its primary business.  I argued in 2015, that given how the two companies were priced, I would rather be an investor in Lyft than Uber. 

      In the four years since the post, we have seen the consequences for both companies. While Uber's bigger story gained it a much higher pricing from investors, it has also brought the company a whole host of troubles, ranging from being a target for regulators to management over reach. Travis Kalanick, its high profile CEO, left the company in a messy and public divorce, and Dara Khosrowshahi, who replaced him, has scaled Uber's ambitions down, first globally by getting out of China and Southeast Asia, where it was burning through cash at an exponential rate, and then within the logistics business, by focusing on Uber Delivery as the key add on to car service. Lyft has stayed true to its US and car service focus, and it has paid off in a higher market share in the market. Both companies have jumped on the bike and scooter craze, with Uber buying Jump and Lime and Lyft acquiring Motivate. From the looks of it, neither company seems willing to concede to the other in the US market, and this fight will be fought on multiple fronts, in the years to come.

      The Lyft Valuation
      When valuing young companies, it is the story that drives your numbers and valuation, not historical data or current financials. I have stayed true to this perspective, in all of the valuations that I have done on ride sharing companies. In this section, I will lay out my story for Lyft, drawing on past behavior and the clues that are in their current plans, but it would be hubris to argue that I have a monopoly on the truth and a claim on the "right" story. So, feel free to disagree with me and you can use my valuation spreadsheet to reflect your disagreements.

      The Story
      Reviewing Lyft's (very long) prospectus, I was struck by the repetition of the mantra that it saw its future as a "US transportation" company, suggesting that the focus will remain primarily domestic and focused on transportation. While the cynical part of me argues that Lyft's use of the word "transportation" is intended to draw attention to the size of that market, which is $1.2 trillion, Lyft's history backs up their "focused" story. While I am normally leery of management stories for companies, I will adopt Lyft's story with a few changes:
      1. It will stay a US transportation services company: The total market that I assume for US transportation services is $120 billion at the moment, well over two and a half times larger than the taxi cab market was in 2009. That is, of course, well below the size of the transportation market, but the $1.2 trillion that Lyft provides for that market includes what people spend on acquiring cars and does not reflect that they would pay for just transportation services.
      2. In a growing transportation services market: One of the striking features of the ride sharing revolution is how much it has changed consumer behavior, drawing people who would normally never have used car service into its reach. I will assume that ride sharing will continue to draw new customers, from mass transit users to self-drivers, causing the transportations services market to double over the next ten years.
      3. With strong market-wide networking benefits: In 2014, when I first valued Uber, I argued that ride sharing companies would have local, but not market-wide, networking benefits. In effect, I saw a market where six, eight or even ten ride sharing companies could co-exist, each dominating different local markets. Observing how quickly the ride sharing companies have consolidated, over the last few years, I think that I was wrong and that the networking effects are likely to be market-wide. Ultimately, I see only two or three ride sharing companies dominating the US ride sharing market, in steady state. In my story, I see Lyft as one of the winners, with a 40% market share of the US transportation services market.
      4. A sustained share of Gross Billings: The concentration of the market among two or three ride sharing companies will also give them the power to hold the line on the percentage of gross billings. That percentage, which was (arbitrarily) set at 20% of gross billings, when the ride sharing companies came into being, has morphed and changed with the advent of pooled rides and how the gross billing number is computed. Lyft, for instance, in 2018, reported revenues of $2,156 million on gross billings of $8.054 million, working out to a 26.77% share. I will assume that as Lyft continues to grow and offers new services, this number will revert back to 20%.
      5. And a shift to drivers as employees: Since their inception, the ride sharing companies have been able to maintain the facade that their drivers are independent contractors, not employees, thus providing the company legal cover, when drivers were found to be at fault of everything from driving infractions to serious crimes, as well as shelter from the expenses that the would ensue if drivers were treated as employees. As the number who work for ride sharing companies rises into the millions, states are already starting to push back, and in my view, it is only a matter of time before ride sharing companies are forced to deal with drivers as employees, causing operating margins in steady state to drop to 15%.
      There are some aspects of this story that some of you may find too pessimistic, and other aspects that others may find too optimistic. You are welcome to download the spreadsheet and make the story your own,

      The Valuation
      The story that I have for Lyft already provides the bulk of the inputs that I need to value the company. To complete the valuation, I add four more inputs related to the company:
      1. Cost of capital: Rather than try to break down cost of capital into its constituent parts for a company that is transitioning to being a public company, I will take a short cut and give Lyft the cost of capital of 9.97%, at the 75th percentile of all US companies at the start of 2019, reflecting its status as a young, money-losing company. I will assume that this cost of capital will drift down towards the median of 8.24% for all US companies as Lyft becomes larger and profitable.
      2. Sales to capital: While Lyft will continue to operating with a low capital-intensity model, its need for reinvestment will increase, to build competitive barriers to entry and to preserve market dominance. If autonomous cars become part of the ride sharing landscape, these investment needs will become greater, I will assume revenues of $2.50 for every dollar of capital invested, in keeping with what you would expect from a technology company.
      3. Failure rate: Given that Lyft continues to lose money, with no clear pathway to generating profits, and that it will remain dependent on external capital providers to stay a going concern, I will assume that there is a 10% chance that Lyft will not survive as a going concern
      4. Share Count: Lyft posits that it will have 240.6 million shares outstanding, including both the class A shares that will be offered to the public and the class B shares, with higher voting rights, that will be held by the founders. It also discloses that it did not include in the share count two share overhangs: (1) 6.8 million shares that are subject to option exercise, with a strike price of $4.68, and (2) 31.6 million restricted shares that had already been issued to employees, but have not vested yet. I will include both of these in shares outstanding, the options because they are so deep in the money that they are effectively outstanding shares and the restricted stock because I assume that the employees that have large numbers of RSUs will stay until vesting, to arrive at a total share count is 279.03 million.
      Finally, the company has not made explicit how much cash it hopes to raise from the initial public offering, but I have used the rumored value of $2 billion in new proceeds, which will be kept in the firm to cover reinvestment and operating needs, according to the prospectus. With these assumptions in place, my valuation of Lyft is below:
      Download spreadsheet
      My story for Lyft leads to a value of equity of approximately $16 billion, with the $2 billion in proceeds includes, or $14 billion, prior to the IPO cash infusion. Dividing by the 279 million shares outstanding, computed by adding the restricted shares outstanding to the share count that the company anticipates after the IPO, yields a value per share of about $59. Any story about young companies comes with ifs, ands and buts, and the Lyft story is no exception. I remain troubled by the ride sharing business model and its lack of clear pathways to profitability, but I think Lyft has picked the right strategy of staying focused both geographically (in the US) and in the transportation services business. I also am leery of the special voting rights that the founders have carved out for themselves, but that seems to have now become par for the course, at least with young tech companies. Finally, the possibility that one of the big technology companies or even an automobile company may be tempted to enter the business remains a wild card that could change the business.

      The Lyft Pricing
      I am a realist and know that when the stock opens for trading on the offering day, it is not value that will determine the opening bid, but pricing. In the pricing game, investors look at what others are paying for similar companies, scaling to some common operating variable. With publicly traded companies in mature sectors, this takes the form of an earnings (PE), cash flow (EV/EBITDA) or book value (Price to Book) multiple that can then be compared across companies. With Lyft, investors will face two challenges.

      • The first is that it is the first ride sharing company to list, and the only pricing that we have for other ride sharing companies is from venture capital rounds that are sometimes dated (from the middle or early last year). 
      • The second is that every company in the ride sharing business is losing money and the book values have no substance (both because the companies are young and don't invest much in physical assets). 
      Notwithstanding these limitations, investors will still try, by scaling to any operating number that they can find that is positive, as I have tried to do in the table below:

      It is true that there is substantial noise in the VC pricing numbers and that the operating numbers  for some of these companies are rumored or unofficial estimates. That said, desperation will drive investors to scale the VC pricing to one of these numbers with the gross billings, revenues and number of riders being the most likely choices. Uber has the highest pricing/rider and that the metric is lowest for the Asian companies, which have far more riders than their US counterparts; the revenue per rider, though, is also far lower in Asia than in the US. The companies all trade at high multiples of revenues and more moderate multiples of gross billings. In the table below, I have priced Lyft, using Uber's most recent pricing metrics as well as global averages, both simple and weighted:

      To the extent that you accept these metrics, the pricing for Lyft can range from $5 billion to $22 billion, depending on your peer comparison (Uber, Global average, Global weighted average) and your scaling variable (Gross Billings, revenues or riders). In fact, if I bring in the rumored pricing of Uber ($120 billion) into the mix, defying circular logic, I can come up with pricing in excess of $30 billion for Lyft.  I think that they are all flawed, but you should not be surprised to see Lyft and its bankers to focus on the comparisons that yield the highest pricing.

      Given the way the pricing game is structured, the pricing of the Lyft IPO is going to be watched closely by the rest of the ride sharing companies, since there will be a feedback effect. In fact, I think of pricing as a ladder, where if you move one rung of the ladder, all of the other rungs have to move as well. For instance, if investors price Lyft at $25 billion, about 12 times its revenue in 2018, Uber will be quicker to go public and will expect markets to attach a pricing in excess of $130 billion to it, given that its revenues were more than $11 billion in 2018. The Asian ride sharing companies, where rider numbers are high, relative to revenues, will try to market themselves on rider numbers, though it is not clear that investors will buy that pitch. Conversely, if investors price Lyft at only $12 billion, Uber may be tempted to wait to go public, and continue to tap into private investors, with the caveat being that those investors will also lower their pricing estimates. The pricing ladder can lead prices up, but they can also lead prices down, and timing is the name of the game.

      The Waiting Game
      It is still early and there is much that we still do not know. While some of the uncertainties will not be resolved in the near future, we will learn more specifics about the offering itself, including the amount that Lyft plans to raise on the offering day, over the next few weeks. Sometime soon, we will also get the a pricing of the company from the bankers that have been given the task of taking the company public, and I use the word "pricing" rather than "valuation" deliberately. The bankers' job is to price the company for the IPO, not value it. Not only should any talk of value from them be discounted, but if you do see a discounted cash flow valuation from a bank for Lyft, you can almost bet that it will be a Kabuki valuation, where they will go through the motions of estimating valuation inputs, when the ending number has been pre-decided.

      YouTube Video


      Links
      1. Prospectus for Lyft
      2. Lyft Valuation
      3. Lyft Pricing
      Posts on Ride Sharing (from 2015)



      Uber's Coming out Party: Personal Mobility Pioneer or Car Service on Steroids?

      After Lyft’s IPO on March 29, 2019, it was only a matter of time before Uber threw its hat in the public market ring, and on Friday, April 12, 2019, the company filed its prospectus. It is the first time that this company, which has been in the news more frequently in the last few years than almost any publicly traded company, has opened its books for investors, journalists and curiosity seekers. As someone who has valued Uber with the tidbits of information that have hitherto been available about the company, mostly leaked and unofficial, I was interested in seeing how much my perspective would change, when confronted with a fuller accounting of its performance.

      Backing up!
      To get a sense of where Uber stands now, just ahead of its IPO, I started with the prospectus, which weighing in at 285 pages, not counting appendices, and filled with pages of details, can be daunting. It is a testimonial to how information disclosure requirements have had the perverse consequence of making the disclosures useless, by drowning investors in data and meaningless legalese. I know that there are many who have latched on to the statement that "we may not achieve profitability" that Uber makes in the prospectus (on page 27) as an indication of its worthlessness, but I view it more as evidence that lawyers should never be allowed to write about investing risk.

      Uber's Business
      Just as Lyft did everything it could, in its prospectus, to relabel itself as a transportation services (not just car services) company, Uber's catchword, repeatedly multiple times in its prospectus, is that it is a personal mobility business, with the tantalizing follow up that its total market could be as large as $2 trillion, if you count the cost of all money spent on transportation (cars, public transit etc.)
      Uber Prospectus: Page 11
      While the cynic in me pushes me back on this over reach (I am surprised that they did not include the calories burnt by the most common transportation mode on the face of the earth, which is walking from point A to point B, as part of the total market), I understand why both Lyft and Uber have to relabel themselves as more than car service companies. Big market stories generally yield higher valuation and pricing than small market stories!

      The Operating History
      Uber went through some major restructuring in the three years leading into the IPO, as it exited cash burning investments in China (settling for a 20% stake in Didi), South East Asia (receiving a 23.2% share of Grab) and Russia (with 38% of Yandex Taxi the prize received for that exit). It is thus not surprising that there are large distortions in the financial statements during the last three years, with losses in the billions flowing from these divestitures. In the last few weeks, Uber announced a major acquisition, spending $3.1 billion to acquire Careem, a Middle Eastern ride sharing firm. Taking the company at its word, i.e., that the large divestiture-related losses are truly divestiture-related, let’s start by tracing the growth of Uber in the parts of the world where it had continuing operations in 2016, 2017 and 2018:
      Uber Prospectus: Page 21
      The numbers in this table are the strongest backing for Uber’s growth story, with gross billings, net revenues, riders and rides all increasing strongly between 2016 and 2018. That good news on growing operations has to be tempered by the recognition that Uber has been unable to make money, as the table below indicates:
      Uber Prospectus: Pages 21 & 24
      The adjusted EBITDA column contains numbers estimated and reported for the company, with a list of adjustments they made to even bigger losses to arrive at the reported values. I convert this adjusted EBITDA to an operating income (loss) by first netting out depreciation and amortization (for obvious reasons) and then reversing the company’s attempt to add back stock based compensation. The company is clearly a money loser, but if there is anything positive that can be extracted from this table, it is that the losses are decreasing as a percent of sales, over time.

      The Rider Numbers
      One of Uber’s selling points lies in its non-accounting numbers, as the company reported having 91 million monthly riders (defined as riders who used either Uber or Uber delivery at least once in a month) and completing 5.2 billion rides. To break down those daunting numbers, I focus on the per rider statistics to see the engines driving Uber’s growth over time:
      Uber Prospectus: Page 21
      There is good and bad news in this table. The good news is that Uber’s annual gross billings per rider rose almost 28% over the three year period, but the sobering companion finding is that the billings/ride are decreasing. Boiled down to basics, it suggests that the growth in overall billings for the company is at least partially driven by existing riders using more of the service, albeit for shorter rides. It could also reflect the fact the new riders for the company are coming from parts of the world (Latin America, for instance), where rides are less expensive.  Finally, I took Uber’s expense breakdown in their income statement, and used it to extract information about what the company is spending money on, and how effectively:
      Uber Prospectus: F-4 (income statement in appendix)
      I make some assumptions here which will play out in the valuation that you will see below.
      1. User Acquisition costs: Using the assumption that user change over a year can be attributed to selling expenses during the year, I computed the user acquisition cost each year by dividing the selling expenses by the number of riders added during the year.
      2. Operating Expenses for Existing Rides: I have included the cost of revenues (not including depreciation) and operations and support as expenses associated with current riders. 
      3. Corporate Expenses; These are expenses that I assume are general expenses, not directly related to either servicing existing users or acquiring new ones and I include R&D, G&A and depreciation in this grouping.
      The good news is that the expenses associated with servicing existing users has been decreasing, as a percent of revenues, indicating that not all of these costs are variable or at least directly linked to more rider usage. Also, corporate expenses are showing evidence of economies of scale, decreasing as a percent of revenues. The bad new is that the cost of acquiring new users has been increasing, at least over this time period, suggesting that the ride sharing market is maturing or that competition is picking up for riders.

      More than ride sharing?
      Uber is a more complicated company to value than Lyft, for two reasons. The first is that Uber is not a pure ride sharing company, since it derives revenues from its food delivery service (Uber Eats) and an assortment of other smaller bets (like Uber Freight). In the graph below, you can see the evolution of these businesses:
      Uber Prospectus: Page 114

      It is worth noting this table while suggests that while some of Uber’s more ambitious reaches into logistics have not borne fruit, its foray into food delivery seems to be picking up steam. Uber Eats has expanded from 2.68% of Uber’s net revenues to 13.12%. There is some additional information in another portion of the prospectus, where Uber reports its "adjusted" net revenue and gross Billings by business, and it does look like Uber's net take from Uber Eats is lower than its take from ride sharing:
      Uber Prospectus: Pages 102 & 103
      While it is clear that Uber's ride sharing customers have been quick to adopt Uber Eats, there are subtle differences in the economics of the two businesses that will play out in future profitability, especially if Uber Eats continues to grow at a disproportionate rate.

      Unlike Lyft, which has kept its focus on the US and Canadian markets, Uber's ambitions have been more global, though reality has put a crimp on some of its expansion plans. While Uber's initial plans were to be everywhere in the world, large losses have led Uber to abandon much of Asia, leaving China to Didi and South East Asia to Grab, with India being the one big market where Uber has stayed, fighting Ola for market share and who can lose more money. The fastest growing overseas market for Uber has been Latin America, as you can see in the graph below:

      Uber does not provide a breakdown of profitability by geographical region, but the magnitude of the losses that they wrote off when they closed their Chinese and South East Asian operations suggests that the US remains their most lucrative ride sharing market, in terms of profitability. 

      The Road Ahead : Crafting a story and value for Uber
      1. A Top Down Valuation
      In valuing Lyft, I used a top-down approach, starting with US transportation services as my total accessible market and working down through market share, margins and reinvestment to derive a value of $13.9 billion for its operating assets and $16.4 billion with the IPO proceeds counted in. Using a similar approach is trickier for Uber, since its decision to be in multiple parts of the logistics business and its global ambitions require assessment of a global logistics market, a challenge. I did an initial assessment of Uber, using a much larger total market and arrived at a value of $44.4 billion for its operating assets, but adding the portions of Didi, Grab and Yandex Taxi pushed this number up to $55.3 billion. Adding the cash balance on hand as well as the IPO proceeds that will remain in the firm (rumored to be $9 billion), before subtracting out debt yields a value for equity of about $61.7 billion.
      The share count is still hazy (as the multiple blank areas in the prospectus indicate) but starting with the 903.6 million shares of common stock that will result from the conversion of redeemable convertible preferred shares at the time of the IPO, and adding in additional shares that will result from option exercises, RSUs (restricted stock units issued to employees) and new shares being issued to raise approximately $10 billion in proceeds, I arrive at a value per share of about $54/share, though  that the updated version of the prospectus, which should come out with the offering price, should allow for more precision on the share count. (Update: Based upon news stories today (4/26/19), it looks like the share count will be closer to 1.8 billion to 2 billion shares, which will result in a value per share closer to $31-$33/share).

      2. A Rider-based Valuation
      The uncertainty about the total accessible market, though, makes me uneasy with my top down valuation. So, I decided to try another route. In June 2017, I presented a different approach to valuing companies like Uber, that derive their value from users, subcribers or members. In that approach, I began by valuing an existing user (rider), by looking at the revenues and cash flows that Uber would generate over the user’s lifetime and then extended the approach to valuing a new user, where the cost of user acquisition has to be netted out against the user value. I completed the assessment by computing the value drag created by non-rider related costs (like G&A and R&D). In the June 2017 valuation, I had to make do with minimalist detail on expenses but the prospectus provides a much richer break down, allowing me to update my user-based valuation of Uber. The valuation picture is below:
      This approach yields a value for the equity of about $58.6 billion for Uber’s equity, which again depending on the share count would translate into a share price of $51/share. (Update: Based upon news stories today (4/26/19), it looks like the share count will be closer to 1.8 billion to 2 billion shares, which will result in a value per share closer to $30/share).

      Value Dynamics
      The benefits of the rider-based valuation is that it allows us to isolate the variables that will determine whether Uber turns the corner quickly and can make enough money to justify the rumored $100 billion value. The value of existing riders is determined by the growth rate in per-user revenues and the cost of servicing a user, with increases in the former and decreases in the latter driving up user value.  The value of new riders, in the aggregate, is determined by the increase in rider count and the cost of acquiring a new rider. One troubling aspect of the growth in users over the last three years has been the increase in user acquisition costs, perhaps reflecting a more saturated market. In the table below, I estimate the value of Uber's equity, using a range of assumptions for the growth rate in per user revenues and the cost of acquiring a new user:
      Download spreadsheet
      There are two ways that you can read this table. If you are a trader, deeply suspicious of intrinsic value, you may look at this table as confirmation that intrinsic value models can be used to deliver whatever value you want them to, and your suspicions would be well founded. I am a believer in value and I see this table in a different light.
      • First, I view it as a reminder that my estimate of value is just mine, based on my story and inputs, and that there are others with different stories for the company that may explain why they would pay much more or much less than I would for the company. 
      • Second, this table suggests to me that Uber is a company that is poised on a knife's edge. If it just continues to just add to its rider count, but pushes up its cost of acquiring riders as it goes along, and existing riders do not increase the usage of the service, its value implodes. If it can get riders to significantly increase usage (either in the form of more rides or other add on services), it can find a way to justify a value that exceeds $100 billion. 
      • Third, the table also indicates that if Uber has to pick between spending money on acquiring more riders or getting existing riders to buy more of its services, the latter provides a much bigger bang for the buck than the former. 
      Put simply, I hope Dara Khoshrowshahi means it when he says that Uber has to show a pathway to profitability, but I think that is what is more critical is that he acts on those words. In my view, this remains a business, whether you define it to be ride sharing, transportation services or personal mobility, without a business model that can generate sustained profits, precisely because the existing model was designed to deliver exponential growth and little else, and Uber, and the other players in this game), have only a limited window to fix it.


      Refreshing the Pricing
      Having spent all of this time on Uber's valuation, let me concede to the reality that Uber will be priced by the market, and it will be priced relative to Lyft. That is why Uber has probably been pulling harder than almost any one else in the market for the Lyft IPO to be well received and for its stock to continue to do well in the aftermarket. In the table below, I compare key operating numbers for Uber and Lyft, with Lyft's pricing in the market in place:

      In computing the metrics, it is worth remembering that Uber and Lyft use different definitions for basic metrics and I have tried to adjust. For instance, Uber defines riders as those who use the service at least once a month and the closest number that I can get for Lyft is their estimate that they had 18.6 million active quarterly riders. Uber is bigger on every single dimension, including losses, then Lyft. I convert Lyft's current market pricing (on April 12, 2019) into multiples, scaling them to different metrics and applying these metrics to Uber:
      Download pricing spreadsheet
      In computing Uber's equity value from its enterprise value, I have added the cash ($6.4 billion of cash on hand plus the $9 billion in expected IPO proceeds) $ and Uber's cross holdings ($8.7 billion) to the value and netted out debt ($6.5 billion). To get the value per share, I have used the estimated 1175 million shares that I believe will be outstanding, including options and RSUs, after the offering. Depending on the metric that I can scale it to, you can get values ranging from $47 billion to $124 billion for Uber's equity, though each comes with a catch. If you believe that there are no games that are played with pricing, you should think again! Also, as Lyft's price moves, so will Uber's, and I am sure that there are many at Uber (and its investment banks) who are hoping and praying that Lyft's stock does not have many more days like last Thursday, before the Uber IPO hits the market.

      Conclusion
      I am sure that there are many who understand the ride sharing business much better than I do, and see obvious limitations and pitfalls in my valuations of both Uber and Lyft.  In fact, I have been wrong before on Uber, as Bill Gurley (who knows more about Uber than I ever will) publicly pointed out,  and I am sure that I will be wrong again.  I hope that even if you disagree with me on my numbers, the spreadsheets that are linked are flexible enough for you to take your stories about these companies to arrive at your value judgments.

      YouTube Video


      Spreadsheets (for valuation)
      1. Uber Valuation - Top Down
      2. Uber Valuation - User-based
      3. Uber Pricing

      Other Links
      1. Uber Prospectus (April 2019)
      2. My first and fatally flawed valuation of Uber (June 2014)
      3. Bill Gurley's take down of my Uber valuation (July 2014)
      4. My post on the future of ride sharing (August 2016)
      5. My first user-based valuation of Uber (June 2017)



      Meatless Future or Vegan Delusions? The Beyond Meat Valuation

      In a big year for initial public offerings (IPOs), with Uber, Lyft, Pinterest and Zoom, to name just a few, already having gone public and more companies waiting in the wings, it is ironic that it is not a tech company, but a food company, Beyond Meat, that has managed to deliver the most dazzling post-IPO performance of any of the listings. As the stock increased seven-fold, investors who were able to get into the stock at the offering price have been enriched, but those who jumped on the bandwagon later have also reaped extraordinary returns. The speed and magnitude of the stock price rise has left many wondering whether investors have over reached and whether a correction is around the corner. 

      The Meatless Meat Company!
      The Company: Let's take a look at what Beyond Meat's products are and the market opening it is exploiting, before diving into a story and valuation for the company. The company, headquartered in Southern California, and founded in 2009, makes makes plant-based (pea protein) products that mimic burgers and ground meat  in taste, texture and aroma. In the prospectus that it filed leading up to its IPO, the company argues that its production process is revolutionary and new, and is responsible for its capacity to replicate animal-based meats. 

      The Competitors: While Beyond Meat is a leader right now in the specialized sub-category of meatless meats, it faces a formidable competitor in Impossible Foods, another young start-up producing its own plant-based versions of meat-like products. Since it is very likely, especially after Beyond Meat's explosive market debut, that Impossible Foods will be going public soon, it is inevitable that there will be comparisons between the two companies. While I have done my own taste test, taste is in the mouth of the beholder, and this article perhaps has the most even-handed comparison of the two companies' products. Both companies have also adopted similar strategies of enlisting fast-food companies as product adopters, with Impossible Foods showing up on Burger King (Impossible Whopper) and White Castle menus, and Beyond Meat countering with TGI Friday's, Carl's Jr. and Red Robin. Other companies are taking note, including companies like Amy's Kitchen, a long standing producer of organic and vegan offerings, and companies like Tyson Foods and Perdue that derive the bulk of their revenues from meat, but see opportunity in this new market.

      The Drivers: Both Beyond Meat and Impossible Foods have been helped by a shift away from meat to meatless alternatives, and that trend has been driven by three factors:
      1. Health: While the research on the health consequences of eating meat continues, it has become part of conventional wisdom that meat-based diets (and red meat in particular) are associated with a greater risk of cardiovascular disease and cancer. This link provides a fairly balanced account of whether this belief is true, but for better or worse, it has led some meat eaters to cut back and sometimes stop consuming meat. 
      2. Environment: As climate change and environmental concerns rise to the top of concerns for some, they are feeling the pressure to shift away from meat, in general, and beef, in particular, because of its environmental footprint. I am not  an environmental scold, but I don't think that there is any debate that meat-based diets puts a greater pressure on the environment 
      3. Taste: Until recently, shifting away from a meat-based diet also meant giving up the taste and texture of meat, since most meat substitutes did not come close. As companies like Beyond Meat and Impossible Foods are showing, plant-based alternatives are getting better at mimicking real meat, and for those who are attached to the texture and taste of meat, that is making a difference in their diet decisions.
      None of these three factors are likely to fade away. In fact, I think that we can safely assume that they will only get stronger over time, accelerating the shift from meat to meatless alternatives. 

      Market Sizing
      All of the talk about the shift to vegan and vegetarian diets can sometimes obscure two basic facts about this market and its underlying trends:
      1. The meatless meat market is still small, relative to the overall meat market: In 2018, the meatless meat market had sales of $1-$5 billion, depending on how broadly you define meatless markets and the geographies that you look at. Defined as meatless meats, i.e., the products that Beyond Meat and Impossible Foods offer, it is closer to the lower end of the range, but inclusive of other meat alternatives (tofu, tempeh etc.) is at the upper end. No matter which end of the range you go with, it is small relative to the overall meat market that is in excess of $250 billion, just in the US, and closer to a trillion, if you expand it globally, in 2018. In fact, while the meat market has seen slow growth in the US and Europe, with a shift from beef to chicken, the global meat market has been growing, as increasing affluence in Asia, in general, and China, in particular, has increased meat consumption,  Depending on your perspective on Beyond Meats, that can be bad news or good news, since it can be taken by detractors as a sign that the overall market for meatless meats is not very big and by optimists that there is plenty of room to grow.
      2. It is still a niche market: Meatless meat products have made their deepest inroads in urban and affluent populations and its allure is greatest with former meat-eaters rather than lifelong vegetarians, who don't crave either the taste or texture of meat. The plus is that this market has significant buying power, but the minus is that urban, well-to-do millennials can eat only so much. 
      The big question that we face is in estimating how much the shift towards vegan and vegetarian diets will continue, driven by health reasons or environmental concern (or guilt). There is also a question of whether some governments may accelerate the shift away from meat-based diets, with policies and subsidies. Given this uncertainty, it is not surprising that the forecasts for the size of the meatless meat market vary widely across forecasters. While they all agree that the market will grow, they disagree about the end number, with forecasts for 2023 ranging from $5 billion at the low end to $8 billion at the other extreme. Beyond Meat, in its prospectus, uses the expansion of non-dairy milk(soy, flax, almond mild) in the milk market as its basis, to estimate the market for meatless meat to be $35 billion in the long term. 

      Beyond Meat: Story and Valuation
      History: At the time of its public offering, Beyond Meat had all of the characteristics of a young company, not much separated from its start up days, with revenues of $87.9 million, operating losses of $26.5 million and a common equity of -$121.8 million. Its first earnings report, delivered to a rapturous market response, reported a tripling of revenues and a narrowing of operating losses, but even with it incorporated, the company remains a small, money losing company.

      The Story: To value young companies, I first have to put my optimist hat on, and with it firmly in place, my story for Beyond Meat is that it is catching the front end of a significant shift towards vegan and vegetarian-based diets. The key parts of my story are below:
      1. Total market for meatless meats will grow significantly: I see the total market for meatless meats growing from just over $1 billion in 2018 to $12 billion by 2028. While that is less than the $35 billion that Beyond Meat's back-of-the-envelope estimate delivers, it is closer to the upper end of the range of forecasts that you have for this market.
      2. With Beyond Meat capturing a significant market share: As the market grows, the number of players will increase, but I see Beyond Meats capturing a 25% market share of this market, building on its early entry into the market and brand name recognition, partly from its fast food connections.
      3. While delivering operating profits similar to the large US food processing companies: Over the next five years, I see pre-tax operating margins improving towards the 13.22% that US food processing business delivered in 2018, built largely on economies of scale and pricing power. 
      4. And reinvesting a lot less, in delivering that growth: While Beyond Meat generates about a dollar in revenue per dollar in invested capital right now, I will assume that it will be able to use technology as its ally to invest more efficiently in the future. Specifically, I will assume that the company will generate $3 in revenue for every dollar in invested capital, about double what the typical US food processing company is able to generate.
      Is there risk in this investment? Absolutely, and you may be surprised that my cost of capital is only 7.46%, but that reflects my assessment of risk in this investment, as a going concern and as part of a diversified portfolio. As a money-losing company that will require about $500 million in capital over the next four years to deliver on its potential, there remains a significant chance of failure, and I estimate the probability of failure to be 15%.

      The Valuation: With the story in place, the valuation follows and the picture below captures the ingredients of value:
      Download spreadsheet
      With my story, which I believe reflects an upbeat story for the company, the value that I obtain for its equity is $3.3 billion, yielding a value per share of about $47. At the end of June 10, when I completed my valuation, the stock price was close to $170, well above my estimated  value. What the stock dropped almost $41 on June 11 to $127/share, it still remained over valued.

      What if? As with any young company, the value of Beyond Meat is driven almost entirely by the story you tell about the company, and in this case, that story revolves around two key inputs. The first is the revenue that you believe the company can generate, once mature, and that reflects how big you think the market for meatless meats will get and Beyond Meat's market share of the market. The second   is its profitability at that point, which is a function of how much pricing power you believe the company will have. While I have assumed that Beyond Meat will deliver about $3 billion in revenues in 2028, with an operating  margin of 13.22%, your story for the company can lead you to very different estimates for one or both numbers:
      The shaded cells represent break even points, where you could justify buying Beyond Meat at the price ($127) it was trading at on June 11, 2019. Put differently, if your story for the meatless meat market and Beyond Meat's place in it leads you to revenues of $5 billion or higher with an operating margin of 20%, you should be a value investor in the company. 

      Macro Bets and Micro Value
      As you can see from the what-if analysis on Beyond Meat's value, the value that you obtain for Beyond Meat is determined mostly by how large you believe that market for meatless meats will end up being. In fact, there are some investors whose primary reason for investing in Beyond Meat is as a bet on a macro trend towards vegan and vegetarian diets. That said, it is worth remembering that investors don't get pay offs from making the right macro bets, but from the micro vehicles (individual investments) that they use as proxies for those bets. To get the pay off from a correct macro call, there are two additional assessments that investors have to make:
      1. Industry structure: A growing market may not translate into high value businesses, if it is crowded and intensely competitive. That market will deliver high revenue growth, but with low or no profitability, and no pathway to sustainable profits and value added. In contrast, a growing market where there are significant barriers to entry and a few big winners can result in high-value companies with large market share and unscalable moats. 
      2. Winners and Losers: Assuming that there is potential for value creation in a market, investors have to pick the companies that are most likely to win in that market. That is difficult to do, when you are looking at young companies in a young market, but there is no way around making that judgment. In a post from 2015, I argued that in big (or potentially big) markets, you can expect companies to be collectively over valued early in the game. 
      In my Beyond Meat valuation, I have implicitly made assumptions about both these components, by first allowing operating margins to converge on those of large food processing companies and then making Beyond Meat one of the winners in the meatless meat market, by giving it a 25% market share. My defense of these assumptions is simple. I believe that the meatless meat market will evolve like the broader food business, with a few big players dominating, with similar competitive advantages including brand name, economies of scale and access to distribution systems. I also believe that Beyond Meat and Impossible Foods, as front runners in this market, will use their access to capital to scale up quickly. Their use of fast food chains feeds into this strategy, with bulk sales increasing revenues quickly, allowing for economies of scale, and name-brand offerings (Impossible Whopper at Burger Kind, Beyond Famous Star burger at Carl's Jr.) helping improve brand name recognition. I will undoubtedly have to revisit these assumptions as the market evolves and some of you may disagree with me strongly on one or both assumptions. If so, please do download the spreadsheet and make your best judgments to derive your value for the company.

      A Trading Play
      Early in a company's life, it is the pricing game that dominates and it is futile to use fundamentals to try to explain a stock price or day-to-day changes. This table, from one of my presentations on corporate life cycles, illustrates how investors and trades view companies as they move through the life cycle.

      For a young company like Beyond Meat, making the transition from start-up to young growth, it is all pricing all the time, with stories about market size driving the pricing,. This trading phenomenon is exacerbated by the fact that it is one of the few pure plays on a macro trend, i.e., a shift in diets away from meat to plant-based options. That leads me to two conclusions. The first is an unexceptional one and it is that you will see wide swings in the stock price on a day to day basis, for little or no reason. That is a feature of priced stocks, not a bug, as mood and momentum shift for no perceptible reasons. The second is that selling short on a stock like this one (small, with a small float) is a dangerous game, since you are unlikely to have time as your ally, and while you may be right in the long term, you may bankrupt yourself before you are vindicated. 

      YouTube Video

      Links
      Past Posts






      Tesla's Travails: Curfew for a Corporate Teenager?

      It should come as no surprise to anyone that Tesla is back in the news, though it seems to be for all of the wrong reasons. From Musk's Twitter escapades with the SEC, to talk about electric lawn blowers to concerns about a debt death spiral, the company has managed, yet again, to get in its own way, and this time, it has paid a price in the market, as its stock price tests lows not seen in a couple of years. I would be lying if I said that I do not find the company fascinating, and as has been my pattern for the last six years, it is time for a Tesla valuation update.

      Looking Back: My Tesla Posts in 2018
      In my last valuation of Tesla, set in June 2018, I considered possible, plausible and probable valuations for the company. In my story, which I admitted was an optimistic one, I mapped out a pathway for the company to deliver $100 billion in revenues in 2028, while pushing pre-tax operating margins to 10% by 2023.  The value that I obtained for the stock was $170-$180 per share, depending on how the very generous option package (20.2 million options) granted to Musk were treated, and is in the picture below:
      In that post, I also listed possible, perhaps even plausible, scenarios where Tesla's value per share could be higher than $400/share, but argued that it would require the equivalent of a royal flush for the company to get there, a combination of a ten-fold increase in revenues, an operating margin of 12% and reinvesting more like a technology than an automotive company. Since the stock was trading at close $360 at the time of the valuation, I concluded that it was significantly over valued. True to form, Elon Musk roiled the waters in August 2018 with his now infamous tweet about funding being secured for a $420 buyout of the stock, causing a surge in the stock price, before questions arose about both how secured the funding actually was and whether the $420 price itself was fiction. In my post on the topic, I argued that if you were a private equity investor interested in taking a company private, Tesla would be a poor target, given its need for capital to keep growing, its heavy debt burden and the presence of Elon Musk as CEO. In the months after, both Musk and Tesla paid hefty prices for the indiscreet tweet, with the former in the SEC crosshairs for alleged stock price manipulation and the latter having to fight through the fog to get its story heard.

      Catching up with the news
      If you are wondering how much can happen in a year, you obviously don't follow Tesla, since the company is a magnet for newsworthy events. Borrowing a movie title to categorize what's happened to the company in the last year, I would break the news down into the good, the bad and what I can only term as gobsmacking, where you whack your head and say "what the heck was that?"

      1. The Good
      The market momentum has clearly shifted against Tesla, and all the news about the company seems to skew "bad", it is worth noting that there are good things that have happened at the company over the last year:
      1. Revenue Surge: In the drama around production targets and logistical misses, it is easy to lose sight of the fact that the Tesla 3 has caused the company to almost double revenues over the course of the last year, while easily winning the race for best selling electric car in the world. 
      2. Improving Profitability: While Musk's tweets about Tesla turning earnings positive may have been premature, the company has moved down the pathway to profitability, reducing operating losses and with R&D capitalized, perhaps even turning the corner on operating profitability. 
      In short, the operating base on which I will be building my Tesla valuation in June 2019 will be a more solid one than the one that I was using in 2018.

      2. The Bad
      With Tesla, good news is always bundled with bad, some of it caused by macro events but much of it the consequence of self inflicted wounds:
      1. Debt load and Distress: When Tesla chose to add to its debt burden by borrowing $5 billion in 2017, I argued that there was no good reason for Tesla to borrow money, since money losing companies gain no tax benefits and debt put growth potential at risk. Tesla has since added to that debt, using the false logic that it needed to borrow money to fund its growth; a much better option would have been to raise equity, the dilution bogeyman notwithstanding. In June 2019, that debt, now close to  $14 billion, is revealing its dark side, as a bond price plunge and ratings downgrades threaten to put Tesla's growth story at risk.
      2. Reinvestment Lags: Growth requires reinvestment, and especially so for automobile companies, where assembly lines and logistical infrastructure need to be put in place for cars to be delivered to customers. It is both frustrating and puzzling that Tesla, a company with a loyal customer base that is willing to wait, has been unwilling to make the investments that it needs to meet the demand. Instead, the company seems to lurch from one production crisis to another one (remember the tents that had to be put up to reach the 5,000 cars/week target) while its CEO muddies the water further by arguing that the company is not just earnings positive but cash flow positive. At the moment, the Fremont plant remains Tesla's major production facility, and while a plant in China is supposedly set for production late in 2019, the US/China trade war and Tesla's own tangled history on operating delays leads to skepticism.
      It is also worth noting that a significant part of Tesla's time has been spent extracting itself from another unforced error, its acquisition of Solar City in 2016, with cost cuts and employee layoffs that are incongruent with a company claiming to tell a great growth story.

      3. The Gobsmacking
      An investor in Tesla should earn a special premium for having to endure news stories about the company that are so unusual that they would be considered fiction at other companies. Just to give a sampling, here are the other items that added to the smoke around the stock:
      1. SEC Oversight: If there has been a recurring story over the past year, it has to do with the aftermath of Elon Musk's "funding secured" tweet, which led to a SEC investigation and a threat of sanctions on the company. While the company came to a settlement wit the SEC, that settlement requires restraint on the part of Musk on future disclosures to the market (especially in the form on tweets), and restrain is not a Musk strong point.
      2. Autonomous Cars: In April 2019, Musk unveiled a plan to roll out autonomous taxis, with Tesla owners being allowed to add to the network, in the near future, with the promise that Tesla's technology on auto driving was well ahead of the competition. There is a debate worth having about autonomous cars and how they will change the ride sharing business, but it is almost certain that this will not happen smoothly or soon.
      3. The Rest: This being Tesla, there were the weekly distractions as Musk muddied the waters with talk of electric leaf blowers and insurance products. 

      An Updated Tesla Valuation
      For the bulk of its existence, Tesla has been a story stock. That remains true, but as the company ages and acquires substance, you can argue that the story is getting more bounded. In this section, I will update my Tesla story and valuation first, then look at the uncertainty around the valuation and close with a comment on a "valuation" by ARK Invest, one of Tesla's biggest institutional cheerleaders.

      1. The Story: Tesla, Corporate Teenager?
      Bringing together everything that has happened at Tesla over the last year, I find myself telling the same story that I told about Tesla a year ago, of a company that would find a pathway to revenues of $100 billion in 2028, with strong operating margins, remains intact, with one notable change. The company's debt overhang, already a concern a year ago, has become a clear and present danger to the company. In effect, on an operating basis, the company is in better shape than it was a year ago but on a financial leverage basis, it faces more truncation risk (a chance of failure of 20%). The value per share that I get with both effects built in is about $190/share:
      Download spreadsheet
      If there is a modification to my story, it would be this. As I watched Musk repeatedly put Tesla's story and value at risk with his distractions, I was reminded of teenagers around the world, with immense potential and intelligence, who risk it all for momentary and often meaningless rushes. In fact, I am tempted to add a corporate teenage phase in my corporate life cycle framework and put Tesla in it, a corporate teenager with immense potential, who repeated puts it all at risk for distractions. 

      To provide perspective on why the value per share today is higher, even with a much greater chance of failure, I compared the numbers that I used in my valuation in June 2018 to June 2019:

      Note that while my end game on revenues ($100 billion by 2028) and operating margins (10% in 5 years) has not changed, the base numbers make both easier reaches. The rise in failure risk (from 5% in 2018 to 20% in 2019) is at least partially offset by a lower risk free rate and a cost of capital. In truth, the value per share is close enough that I would argue that there really has been little change, but the price per share has dropped by almost 50%, making the stock go from being significantly over valued to close to fairly valued now.

      2.  Facing up to Uncertainty
      As with every Tesla valuation that I have done over the last six years, this one comes with caveats and uncertainties, and the contrasting views that bulls and bears have about the company are captured in the table below:
      As you can see, I borrow from both sides of this debate, and I am sure that Tesla bulls will be disappointed that I don't have higher revenues for the company and Tesla bears will take issue with my reinvestment assumptions and expectations that the company will eventually deliver solid margins. Using a technique that I find useful, when confronted with divergent views, to deal with uncertainties, I computed Tesla's values in a simulation, with the results below:


      in summary, the median value across the 100,000 simulations is $180/share, the 10th percentile delivering a $52 value/share and the 90th yielding $380/share. In this simulation, I have assumed that Tesla will remain a stand alone, going concern, and that the equity value could drop to zero, if there is a shock to the value of operating assets, given the debt load. There is talk, however, that Tesla could become an acquisition target, to an automobile company or a tech company (see this rumor about Apple being interested in 2014). While there are some entanglements (such as the one with Panasonic in the battery factories) that will have to be worked out, there have generally been two impediments on this path. One is that Tesla has been an expensive target, especially when its market capitalization exceeded $50 billion. That will become less of a barrier, as the stock price drops, and at a market cap of less than $15 billion, it could be much more affordable. The other is a bigger and more intractable problem. With Elon Musk as part of the package, Tesla has a poison pill that few companies will want to imbibe, and it is likely that the relationship will have to be severed or at least significantly weakened for an acquisition to occur. I remain skeptical on the odds of an acquisition, precisely because I don't see Musk going quietly into the night, but adding an acquisition floor at a $15 billion value for equity (about $60/share) increases the simulated value for the stock by about $10/share.

      3. The ARK Tesla Pricing
      It is not my role to be an arbiter of other people's valuations, and I generally avoid commenting on them unless they are in the public domain, as was the case with the Tesla/Solar City fairness opinions, or seek public comment. I will make an exception with the ARK "valuation" of Tesla, partly because they are among the stock's strongest boosters and partly because they put their model up for public comments, for which I commend them. In summary, here are the ARK numbers:
      Download ARK pricing from Github

      1. This is a pricing, not a valuation: I know that this will strike some as nitpicking but what ARK has produced is a forward pricing for Tesla, not a valuation. An intrinsic valuation requires forecasting cash flows over time, after taxes and reinvestment, and then discounting those cash flows back at a rate that reflects the risk in the investment. A pricing usually involves picking a metric (revenues, earnings, EBITDA), picking a forecast year for the metric and applying a multiple based upon what other companies in the peer group trade at. ARK's basic model forecasts revenues, earnings and other metrics in 2023, and applies a multiple to estimated EBITDAR&D in 2023, making it a forward pricing.
      2. The ARK bear is bullish:  The ARK bear case requires that Tesla will sell 1.7 million cars in 2023, at an average price of $50,000/car and generate an operating margin of 6.1% on those revenues. Each of these assumptions is plausible, and the combination is possible, though to call a seven fold increase in revenues over five years, with a concurrent improvement to industry average profitability, a bear case seems to be stretching the definition of bear.
      3. The weakest link: The model's weakest link is on cash flows, since to sell 1.7 million cars, you have to make them first, and Tesla's production capacity, even if you count the China plant as functional and about the same capacity as the Fremont plant, brings you only about half way to the goal. It will be magical, if adding another $3.7 billion to net PP&E (as ARK seems to be assuming) and $1.2 billion to working capital will allow you to increase revenues by $63.5 billion, but it gets even more stretched, when you assume that Tesla also pays off $14 billion in debt (as ARK seems to) over the five years. In sum, the bear case will require at the very least $25 to $30 billion in cash flows, even with ARK's own assumptions, over the next five years, and since the operating cash flows at the company are still a trickle, this will require equity issuances in massive proportions fairly soon. ARK does allow for an equity capital raise of $10.6 billion which strikes me as too little to fill the gap, but in the absence of a balance sheet or statements of cash flows, I may be missing something (and it has to be very big).
      4. Share count issue: Even for the equity capital raise of $10.6 billion, ARK reduces the impact on share count by assuming a stock price of $360/share (market cap will be $70 billion) at the time of the raise. Since this capital will have to be raised soon, there is an element of wishful thinking here, i.e., that stock prices will double in short order and the capital raise will follow. In addition, if stock prices do climb, as ARK assumes, there will there is an overhang of 20 million options that have been granted to Musk by the board of directors that will become actual shares. In short, for the ARK bear case to unfold, the share count will have to double over the next five years.
      5. There is a time value question: Applying a multiple to EBITDAR&D in 2023 gives you a value in 2023, and to make it comparable to today's stock price, you will have to discount it back to today, at a risk adjusted rate. In fact, if you bring in the probability of failure embedded in Tesla bonds, there will an additional discounting on value.


      Even if you take the ARK bear case as realistic, with Tesla projected to sell 1.7 million cars in 2023 and earn operating margins close to the auto sector, the pricing per share that you get will be closer to $250/share, with a more realistic share count and time value adjustments, not the $560 that you see on the ARK spreadsheet. As for the bull case, I will leave it untouched, since it strikes me as more fairy tale than valuation, a world where there will be 7.2 autonomous cars on the road in 2023, with Tesla controlling a 70% market share, and generating $52 billion in annual cash flows. I am willing to accept the argument that Tesla is closer to mastering the autonomous car technology than its competitors, but I see a business that is further in the future than 2023, less dominated by Tesla and much less profitable than ARK is assuming it to be. In short, right now, it is more option than conventional going concern value, and even if I believed it, I would make more money selling short on Uber and Lyft, than buying Tesla.

      Bottom Line
      I did my first valuation of Tesla in 2013, and undershot the mark, partly because I saw its potential market as luxury cars (smaller), and partly because I under estimated how much it would be able to extract in production from the Fremont plant. Over time, I have compensated for both mistakes, giving Tesla access to a bigger (albeit, still upscale) market and more growth, while reinvesting less than the typical auto company. In spite of these adjustments, I have consistently come up with valuations well below the price, finding the stock to be valued at about half its price only a year ago. This year marks a turning point, as I find Tesla to be under valued, albeit by only a small fraction. Even in the midst of my most negative posts on Tesla, I confessed that I like the company (though not  Elon Musk's antics as CEO and financial choices) and that I would one day own the stock. That day may be here, as I put in a limit buy order at $180/share, knowing fully well that, if I do end up as a shareholder, this company will test my patience and sanity. (Update: My limit buy just executed. As a shareholder my risks would be much lower, if Musk was banned from tweeting...) 

      YouTube Video

      Spreadsheet links



      From Shareholder wealth to Stakeholder interests: CEO Capitulation or Empty Doublespeak?

      Last week. the Business Roundtable, composed of the CEOs of some of America’s largest companies, put out a press release that hinted at a fundamental, perhaps revolutionary, shift in corporate focus. In the statement, the CEOs seemed to be saying that corporations should be run to protect all corporate stakeholders, defined to include customers, society and employees, rather than hew to its conventional objective of maximizing shareholder wealth. The reason that I say “seemed to” is because the document was written in CEO-speak, full of platitudes and open to interpretation. I will confess that I have a personal interest in this debate since I teach and write about corporate finance, a discipline built around shareholder wealth maximization, and valuation, which is about measuring it.

      The Business Roundtable Speaks: A flawed message from a flawed messenger
      The Business Roundtable, tracing it history back to 1972, and restricting its membership to CEOs of major corporations, lobbies for business-friendly legislation and has a history of making statements about corporate purpose that are usually completely predictable and not very newsworthy. This year’s statement, at least on the surface, breaks with this past with its talk of stakeholder interests and rather than give you my interpretation of the statement, I will quote directly from it:
      While each of our individual companies serves its own corporate purpose, we share a fundamental commitment to all of our stakeholders. We commit to:
      • Delivering value to our customers. We will further the tradition of American companies leading the way in meeting or exceeding customer expectations.
      • Investing in our employees. This starts with compensating them fairly and providing important benefits. It also includes supporting them through training and education that help develop new skills for a rapidly changing world. We foster diversity and inclusion, dignity and respect.
      • Dealing fairly and ethically with our suppliers. We are dedicated to serving as good partners to the other companies, large and small, that help us meet our missions.
      • Supporting the communities in which we work. We respect the people in our communities and protect the environment by embracing sustainable practices across our businesses.
      • Generating long-term value for shareholders, who provide the capital that allows companies to invest, grow and innovate. We are committed to transparency and effective engagement with shareholders.
      The use of the word “stakeholders: and an explicit listing of how corporations should act in each of their interests has drawn extensive attention from a diverse group of individuals, each drawing its own conclusions and making its own criticisms. Critics of shareholder wealth maximization viewed this statement as vindication, an acceptance of their long-term tenet that focusing on shareholder wealth has given rise to income inequality, loss of good manufacturing jobs and societal costs. Supporters of shareholder wealth maximization considered the statement to be not only ill-advised but also a craven concession to populist forces. Cynics argued that it was more political document than restatement of purpose, smoke and noise that signified nothing. Journalists have concluded that this statement is, in fact, a fundamental restatement of corporate purpose, driven by political pressures. 

      While the statement was signed by 181 CEOs, including Bezos (Amazon), Tim Cook (Apple), Brian Moynihan (B of A) and Mary Barra (GM), I found it odd that Jamie Dimon, the CEO of JP Morgan Chase, was the person who was chosen to deliver the message. To give Mr. Dimon his due, he is a very good banker and has excellent political skills, a plus at the top of a money center bank, but he is definitely not someone that I would view as putting shareholder interests first. Over the last decade, Jamie Dimon has repeatedly clashed with his own stockholders, first over his decision to chair the board of directors that is supposed to oversee him and multiple times about his compensation. He has technically won these fights at annual meetings, but with some of the highest opposition among large, widely held public companies, and he has been well protected by his ineffectual and mostly rubber stamp board of directors. Jamie Dimon talking about shareholder wealth is about as believable as Madonna singing “like a virgin” or Kim Kardashian speaking about the importance of privacy.

      The Stakeholders in a Corporation
      To most laymen, the debate about whether to focus on shareholders or stakeholders may seem like an obscure one that has few consequences for their lives, but it is of huge import and the best way to get perspective is to see who these stakeholders in the modern corporation are and what their relationship is with public companies:

      Stakeholders therefore have different legal relationships with the company and divergent interests, implying that actions that make one stakeholder group better off may make other stakeholder groups worse. It is this conflict that makes the discussion of which group has primacy in decision making so heated and political. 

      Versions of Corporatism
      In the section below, I will present five different perspectives on how corporations are run, and I will let you draw your own conclusions on which one best describes current corporate behavior and argue that your that choice will determine, in large part, what you think should be the norm.

      1. Cutthroat Corporatism
      The most extreme view of corporations is what describe as cutthroat capitalism, where the strong companies drive out the weak and the end game is stockholder wealth maximization (often with a founder/family being the prime beneficiary) at almost any cost:

      In the late nineteenth century, the robber barons of the age (Andrew Carnegie, John D. Rockefeller and others) hewed to this template to build some of the greatest companies of the time, some of which survive to this day. They were ruthless in their march towards domination, crushing competitors through fair means or foul, bending society to their will and exploiting customers and employees. Their overreach led to Teddy Roosevelt’s election and the subsequent passage of antitrust laws, but much as we tend to view these corporate chieftains as villains, they played a major role in making the US a global economic power. In the century since, there are other companies that have aspired for dominance, using what many critics have viewed as ruthless and perhaps even illegal ways to exercise market dominance. Lest you view this model of corporate behavior as a historical artifact, many of today's companies have, at least in some aspects of their behavior, have been accused of following this model.

      2. Crony Corporatism
      A variant of this win-at-all-costs corporatism is crony corporatism, where the end game is still market dominance but the base is built less on economies of scale, efficient operations and product differentiation, and more on connections to government and rule writers, with the objective being tilting the scales of competition in the company’s favor:
      While the end result of cutthroat and crony capitalism is the same, i.e., large market-dominating companies that give short shrift to employees and customers, it can be argued that since the winners are the most connected, not the most efficient, crony capitalism offers all of the costs of cutthroat capitalism, with none of the benefits. While family group companies in some emerging markets obviously fit this mould, I think that an argument can be made that there is an element of cronyism in many developed markets.

      3. Managerial Corporatism
      There is a third version of corporatism that comes to the forefront, especially as public companies age, founders/families are replaced with professional managers and shareholdings get dispersed among lots of shareholders with small (percent) stakes. In this version, it is the professional managers whose interests drive decision making in the company, with other stakeholders viewed as side players.

      Note that the managers who make corporate decisions often own little equity in the company, or if they do, get it as part of compensation packages, often determined by boards of directors that operate less as checks and more as rubber stamps. The question of how well other stakeholders do in this version depends in large part on whether their interests converge on those of managers; if there is convergence, their interests will be advanced, but only because it happens to advance managerial interests as well, and if not, they will find themselves paying the price to make managers better off. This was the default for US companies in the decades after the second world war, with long tenures for CEOs and little or no shareholder activism, and overall economic prosperity allowing for a coopting of other stakeholder: solid wage gains for employees, corporate charity and restrained competition.

      4. Constrained Corporatism
      I suspect that there are very few people, even among true believers in free markets and capitalism, who will defend cutthroat or crony capitalism. There are some who are nostalgic for managerial corporatism, pointing to the solid stock returns, well-paying jobs and societal side benefits that came with it, not seeing that these stakeholder benefits were made possible by US economic dominance during the period, and the ease with US companies could make money. It is no coincidence that shareholder activism rose to the surface in the 1980s, as US economic power slipped and managerial interests were served at the expense of not just shareholders, but other stakeholders. While this activism resulted in leveraged buyouts in some companies, it also gave rise to a version of shareholder wealth maximization that I center my corporate finance decision making, that I call constrained corporatism, where companies preserve the primacy of shareholders, while constraining how they interact with other stakeholder groups:
      The efficacy of this version of corporatism depends largely on how well the constraints protect other stakeholders and what drives companies to adopt the constraints in the first place, with three possible drivers for the latter:
      • Government-imposed constraints: Governments can write laws or draw up rules that constrain how corporations treat stakeholders, with labor laws determining not only how much workers get paid but also conditions under which they can be hired or fired, product laws capping prices on some products and protecting customer interests in others and anti-trust laws determining whether product markets stay competitive. European governments have been far more aggressive with this approach than the US, but the globalization of businesses has not only weakened the protections offered by these laws, but also put companies covered by them at a competitive disadvantage, relative to companies that operate in countries without these laws and restrictions.
      • Self-imposed constraints: In this variant, companies voluntarily adopt constraints on their interactions with other stakeholder groups, often choosing to pay higher wages (than they could get away paying) to their employees, charging customers less for products/services than they could have, given their pricing power, and turning away investments that they could pursue legally, for profits, because of the costs that it will create for society. In effect, the essence of these constraints is that the profit settles for less profit than it could have made if it have as an unconstrained player. The problem with self-imposed constraints is that your capacity to adopt them will be correlated with how profitable you are to begin with, with companies with more slack built into their business models being in a better position than companies facing profit pressures in an intensely competitive market. 
      • Market-driven constraints: In this final variation, companies adopt constraints on how they treat stakeholders because it makes them more valuable companies, even as they settle for less profits, at least in the near term. That seeming contradiction can be explained by two factors. The first is that whatever costs the company faces in the short term from imposing the constraints may be overwhelmed by benefits in the long term; paying employees more may yield more loyal and better employees, offering customers better deals may lead to more repeat business and being a good corporate citizen may operate as advertising, attracting more customers to the company. To top it all off, investors who care about any or all of these behaviors may be more inclined to invest in your shares, pushing up stock prices. The second is that companies that exploit customers and employees or acquire a reputation for being bad corporate citizens will have few defenders when it does make a mistake or have a problem, inevitable in the long term, leading to potentially catastrophic costs.
      As an advocate for shareholder wealth maximization, I would love to live in a world where the market rewarded companies that try to do the right thing, since it would make good behavior entirely consistent with value maximization. That said, I am a realist and accept that some constraints have to be imposed by governments, regulators and rule writers, and that some companies, especially ones with strong profitability and substantial slack in their business models, may accept self constraints.

      5. Confused Corporatism
      In some sectors and in some markets and during some time periods, markets will not do the job, leaving us as the mercy of bad behavior by some or many corporate players. It is therefore not surprising that stakeholder wealth maximization is seen as an alternative corporate model:

      It is quite clear that the corporate mission in this version of corporatism has been enlarged to cover all stakeholders, often with very different interests at heart. On the surface, it may look like constrained capitalism, but unlike it, in this version, you have multiple objectives, with no clear sense of which one dominates. Your job as a top manager or CEO is to pay not just a fair, but a living wage, even if you cannot afford it as a company, but also deliver maximum value to your customer, preserve society’s best interests and ensure that your business stays competitive, while also making sure that you deliver the returns your stockholders and lenders desire. In my view, it is destined to fail for three reasons:
      • Conflicting interests: By treating the interests of all stakeholders as equivalent, it ignores the reality that decisions in companies, almost by definition, will make stakeholders better off and others worse off. Since some of these costs and benefits will be not easily translated into numbers, it is not clear how managers will be able to decide what investments to take, what businesses to enter and exit, how to finance these businesses and when and how much cash to return to shareholders. 
      • No accountability: The fact that there are multiple stakeholders with conflicting interests also leaves CEOs and top managers accountable to none of them, with the excuse with any group that was ill-served during a period being that other group’s interests had to be met. 
      • Decision paralysis: If one of the problems at large companies has been the time it takes to make decisions, I will predict that expanding decision making to take into account the interests of all stakeholders will create decision paralysis, as the “on the one hand, and on the other” arguments will multiply, often with no way to resolve them, since some stakeholder interests will remain fuzzy and non-measurable.
      To those who believe that stakeholder wealth maximization will usher in a period of common good, with society, customers and employees benefiting from more compassionate corporatism, I offer you two cautionary counter examples. First, you may want to take a look at government-owned and run companies not just in the socialist economies but in many capitalist ones. The managers of these companies were given a laundry list of objectives, resembling in large part the listing of stakeholder objectives, and told to deliver on them all. The end results were some of the most inefficient companies on the face of the earth, with every stakeholder group feeling ill-served in the process. Second, let me use a second illustration not from the corporate sector, but s setting that I am intimately familiar with, because I have spent almost four decades of my life in it. Research universities in the United States are entities built without a central focus, where the stakeholder group being served and the objective is different, depending on who in the university administration you talk to, and when. The end result is not just economically inefficient operations, capable of running a deficit no matter how much tuition is collection, but one where every stakeholder group feels aggrieved; students feel that they pay too much in tuition and have too little say in their education, faculty believe that their rights are being chipped away by no-nothing administrators and the communities feel disrespected and cheated. If you want publicly traded companies to look like research universities in terms of economic efficiency or taking care of stakeholder group interests, confused capitalism is your answer.

      Revisiting the Message
      To be fair to the CEOs, there is enough ambiguity in the Business Roundtable statement for readers to read into it whatever they want it to mean, but there are three possible interpretations:
      1. A Public Relations Move: It is undeniable that the public perception of corporations has become more negative over the last few decades, and politicians have noticed. Populists on both sides of the political divide have found that the public buys into their framing as corporations as self-interested entities that don’t care about employees, customers or society, with their focus on shareholders being the reason. CEOs have noticed, and the Business Roundtable’s statement may be just a restatement of constrained corporatism.
      2. A Return to the Past: Since the business roundtable is composed of CEOs, many of whom have felt the heat of activist investors and pushy shareholders, the cynic in you may lead you to conclude that what the CEOs in the Roundtable would like to see is a return to the good old days of managerial corporatism, where they could rule their companies with little push back, and that this push for stakeholder interests is a diversionary tactic.
      3. The Conspiratorial Twist: There is a third twist, and it does require a conspiratorial mindset. Note that the CEOs who are in the Roundtable represent the status quo, large and established companies, many of which find their business models being disrupted by young, start-ups. One way to preempt disruption is to increase the costs of doing business and having to take care of all stakeholders does that, but it is a cost that established companies may be able to bear better right now than their disruptive competitors. ( If you are skeptical, remember I said that you need a conspiratorial mindset.
      Conclusion
      I know that this is a trying time to be a corporate CEO, with people demanding that you cure society’s ills and the economy’s problems, with the threat of punitive actions, if you don’t change. That said, I don’t believe that you can win this battle or even recoup some of your lost standing by giving up on the focus on shareholder wealth and replacing it with an ill-thought through and potentially destructive objective of advancing stakeholder interests. In my view, a much healthier discussion would be centered on creating more transparency about how corporations treat different stakeholder groups and linking that information with how they get valued in the market. I think that we are making strides on the first, with better information disclosure from companies and CSR measures, and I hope to help on the second front by connecting these disclosures to intrinsic value. As I noted earlier, if we want companies to behave better in their interactions with society, customers and employees, we have to make it in their financial best interests to do so, buying products and services from companies that treat other stakeholders better and paying higher prices for their shares.

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      Country Risk: A Mid-year 2019 Update

      One of the consequences of globalization is that investors, analysts and companies can no longer stay focused on just their domestic markets, but have to also understand the risks and opportunities elsewhere in the world. When developed market companies first embarked on the journey of expanding into emerging market growth economies, investors pushed up their stock prices, primarily because of the potential that they saw in these markets for expansion. Over time, though, we have learned that, as with much else in business, this strategy comes with additional risk, not just from changing exchange rates, but from unstable economic and political forces. This growth/risk trade off explains why some companies have gained from value from globalizing and others have lost. In this post, I look at country risk through many lens, but with the end game of being able to incorporate it into decision making both for investors and businesses.

      The Sources of Country Risk
      When companies invest outside their domestic markets, the most immediate risk that they are exposed to is exchange rate risk, since revenues, profits and cash flows are affected by changing exchange rates. That risk, though, is but a piece of the puzzle, a symptom of economic fundamentals and affected by political crises. Digging deeper, the factors that make some countries riskier than others can be broadly classified into the following groups:

      1. Life Cycle: I have used the construct of a corporate life cycle to talk about companies at different stages in the life cycle, and how they differ on cash flow generation and growth potential. It is also generally true that younger companies, deriving more or most of their value from future growth, are riskier than more mature companies, where the bulk of their value coming from investments already made. The same construct can be applied to countries, with emerging economies that are growing rapidly being more exposed to global shocks than mature countries. It should come as no surprise, therefore, that in almost every market crisis over the last decade, emerging markets have paid a much large price in terms of lost economic growth and lower market value than developed markets.

      2. Political RiskIf the last few years have taught us a lesson, it is that politics can affect economic and market risk, not just in emerging markets, but also in developed ones. While there are many forms of political risk, ranging from abrupt changes in fiscal and monetary policy to regime change, there are at least two measurable manifestations of this risk in the form of corruption risk and exposure to violence.
      • Corruption Risk: There are parts of the world where the costs of doing business include greasing palms and paying off intermediaries, and the roots lie deep, resisting feel-good quick fixes. While anecdotal stories of corruption and its consequences are plentiful, there are services to try to measure corruption levels across countries. Transparency International, for instance, derives a corruption score, by country, and in its 2019 report, provides a listing of the ten least and most corrupt countries in the world in the figure below, with higher scores indicating less corruption) for 2018.
        Source: Transparency International
        The effect of corruption upon business is insidious, making winners of those most willing to play the bribery game and losers of those who resist. In an earlier post, I argued that corruption creates the equivalent of an informal tax, pushing down after-tax income to companies.
      • Physical Violence: When talking about risk in investing or business, we tend to focus on financial risk, but it is undeniable that adding the threat of physical violence, from war, terrorism or crime, makes it more difficult to operate a business. There are services again that measure exposure to violence in different countries, and while each brings its own biases, the Institute of Economics and Peace has created and reports on a Global Peace Index, measuring exposure to violence, by country.
        Source: Institute of Economics and Peace
        The map summarizes their findings from the most recent year. I must confess that I am surprised to see Botswana at the top of the list, but having never been there, that may be a reflection of my regional biases.
      3. Legal Risk: A business derives its value from the assets it owns, physical ord intangible, and to continue to derive value, it has to not only preserve its ownership but have a legal system that enforces it’s rights. The quality of this protection varies across countries, either because property rights have fewer protections in some countries or because those rights are not enforced in a timely manner in others. A group of non-government organizations has created an international property rights index, measuring the protection provided for property rights in different countries. The results in 2018, by region, are provided in the table below:

      4. Economic Structure: Just as diversification helps investors spread their bets and reduce risk exposure, countries with more diversified economies are less exposed to global macroeconomic shocks than countries that derive their value from one or two industries, or as is often the case from one or two commodities. In a comprehensive study of commodity dependent countries, the United National Conference on Trade and Development (UNCTAD) measures the degree of dependence upon commodities across emerging markets and the figure reports the results.  
      Source: UNCTAD
      Note the disproportional dependence on commodity exports that countries in Africa and Latin America have, making their economies and markets very sensitive to changes in commodity prices.

      Measures of Country Risk
      To the extent that country risk comes from different sources, you need composite measures of risk to help in decision making. This section begins with a look at country risk scores, where services, using proprietary factors, measure country risk with a number, followed with financial measures of country risk, primarily designed to measure default risk.

      Country Risk Scores
      There are services, ranging from the World Bank to the Economist that measure country risk with scores, though each one uses different criteria and scalars. The PRS Group provides numerical measures of country risk for more than a hundred countries, using twenty variables on three dimensions: political, financial and economic. The scores range from zero to one hundred, with high scores (80-100) indicating low risk and low scores indicating high risk. The figure below captures the June 2019 update, as well as the 10 countries that emerged as safest and riskiest in that update.
      Source: Political Risk Services (PRS)

      Default Risk Measures
      Country risk scores have the benefit of being comprehensive, but they are also difficult to translate into business-friendly metrics. There are country risk measures in markets, albeit focused primarily on default risk, and the most public of these are sovereign ratings, there are now also market based measures, sovereign CDS spreads.

      Sovereign Ratings
      Moody’s, S&P and Fitch all estimate and publish ratings for countries, ranging from Aaa (AAA) for countries they view has having no default risk to D for countries already in default. The figure below provides a map of sovereign ratings across the world in July 2019, using Moody’s ratings where available and S&P to fill in some gaps. While the sovereign ratings themselves are alphabetical (and thus are difficult to incorporate into financial analysis), they can be converted to default spreads by looking at traded bonds in the market.
      Source: Moody's Sovereign Ratings
      Note that while the Aaa rated countries (in dark green) are predominantly in North America and Northern Europe, there are shades of green in Asia, reflecting the region's improvement on risk and that much of Africa remains unrated.

      Sovereign CDS Spreads
      Ratings agencies have come under fire, especially since the 2008 crisis, with one of the primary critiques being their perceived bias. I am not being dismissive of that critique, but I believe that their bigger sin is that they are slow to respond to changing fundamentals, causing rating changes to lag real changes on the ground. In the last two decades, a market has risen to fill in the gap, where investors can buy protection against default risk by buying sovereign credit default swaps (CDS). If the insurance against default is complete, the price of a sovereign CDS can be viewed as a default spread for the country. On July 23, 2019, the map below summarizes the sovereign CDS spreads for the 81 countries that they were available for. 
      Source: Bloomberg (10-year $ Sovereign Spreads)
      While these market-set default spreads provide more timely readings of sovereign default risk than the sovereign ratings, they suffer from the standard problems that all market-set numbers are exposed to. They are volatile, affected by momentum and mood and can give misguiding signals on risk.

      Equity Risk
      While default spreads may represent adequate measures of country risk if you intend to lend to a sovereign or buy bonds issued by it, you are exposed to more and sometimes different risks, if you plan to expand your business into a country, or invest in equities in that country, and you need equity risk premiums that capture that risk. It is true that many practitioners use default spreads as proxies of additional country equity risk and add it to a mature market premium (often a historical US premium) to arrive at country-specific equity risk premiums. As readers of this blog know, I use a mild variation on this approach, replacing the historical equity risk premium with an implied premium for the US and augmenting the default spread by a scaling factor, to reflect the higher risk of equity:


      The equity risk premiums that result from this process in July 2019 are reported in the picture below, with the implied equity risk premium of 5.67% for the S&P 500 on July 1, 2019, representing the base number. 
      Source: Damodaran Online (Current Data)
      The picture continues a story that has been building over the last decade. While Africa and Latin America remain hotbeds of country risk, Asia has become safer over time and parts of Southern Europe have regressed. 

      If you are a developed market company or investor, and believe that risk in Africa, Latin America or parts of Asia don’t apply to you, you may want to think again. The risk exposure of a company does not come from where it is incorporated but from where it does business. Thus, Coca Cola and Royal Dutch may be US and UK-listed companies respectively, but their business models expose them to risk around the world. With Coca Cola, that risk comes primarily from where it sells its products. With Royal Dutch, the risk is derived from where it extracts its oil and gas, making it more exposed to emerging markets than many emerging market companies. By the same token, Vale and Infosys may be Brazil and India-based companies, but there are both global companies that are exposed to risk in the rest of the globe. In addition, when multinationals try to estimate hurdle rates for projects, it should reflect not just the currency you do the analysis in but also the country in which the project will be located. A Royal Dutch refinery investment in Nigeria will have a higher hurdle rate than an otherwise similar refinery investment in the United States. If you find these concepts intriguing, I have my annual update on country risk available for download at this link. Be warned! It may operate as a narcoleptic to those who are sleep deprived.


      Conclusion
      There was a time a few decades ago when the line between developed and emerging markets was a clear one. On one side were developed markets, with independent central banks, rule-following governments and stable fiscal policies, and on the other side were emerging markets, with unstable and unpredictable political leadership and central banks that did their bidding. The last decade has seen a blurring of lines, as some “developed markets” mimic emerging market behavior and some emerging markets mature. There are some (companies and investors) who have decided that this convergence is a reason to ignore country risk, but I think that they do so at their own peril. Notwithstanding globalization and convergence on some dimensions of risk, we face wide variations in risk across the world, and prudence and good sense demand that we incorporate these differences into our decisions.
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      Insights on VC Pricing: Lessons from Uber, WeWork and Peloton!

      As a confession, I started this post intending to write about Peloton, the next big new offering hitting markets, but I got distracted along the way. As I read the Peloton prospectus, with the descriptions of its business, its measure of total market size and its success at scaling up revenues accompanied by large losses, I had a feeling of déjà vu, since other prospectuses that I had read this year from Lyft, Uber, Slack, Pinterest and, most recently, WeWorks, not only shared many of the same characteristics, but also used much of the same language. I briefly considered the possibility that these companies were using a common prospectus app, where given a bare bones description, a 250-page prospectus would be generated, complete with the requisite buzz words and corporate governance details. Setting aside that cynical thought, I think it is far more likely that these companies are emphasizing those features that allowed them to get to where they are today, and that examining these shared features should give us insight into how venture capitalists price companies, and the dangers of basing what you  pay on VC pricing. To keep my write up from becoming too long (and I don't think I succeeded), I will use only Uber, WeWork and Peloton to illustrate what I see as the commonalities in their investment pitches, when I could have spread my net wider to include all IPOs this year.

      1. Unbounded Potential Markets
      It is natural that companies, especially early in their lives, puff up their business descriptions and inflate their potential markets, but the companies that have gone public this year seem to have taken it to an art form. Lyft, which went public before Uber, described themselves as a transportation company, a little over-the-top for a car service company, but Uber topped this easily, with their identification as a personal mobility company. WeWork, in its prospectus, steers clear of ever describing itself as being in real estate, framing itself instead as a community company, whatever that means. Peloton, in perhaps the widest stretch of all, calls itself a technology, media, software, product, experience, fitness, design, retail, apparel and logistics company, and names itself Peloton Interactive for emphasis.   In conjunction with these grandiose business descriptions, each of the company's IPOs also lists a total addressable or accessible market (TAM) that it is targeting. While this is a measure, initiated with good sense , it has become a buzzword that means close to nothing for these young companies. In the picture below, I have taken the total market descriptions given in the Uber, WeWork and Peloton prospectuses:

      If you believe these companies, Uber's TAM is $5.71 trillion spread across 175 countries, and obtained by adding together all passenger vehicle and public transport spending, WeWork is looking at $3 trillion in office space opportunities and Peloton believes that it can sell its expensive exercise bikes and subscriptions to 45 million people in the US and 67 million globally.  

      It is no secret that my initial valuation of Uber used far too cramped a definition of its total market, and Bill Gurley rightly pointed to the potential that these companies have to expand markets, but defining the market as broadly as these companies makes a mockery of the concept. In fact, I will draw on a 3P test that I developed in the context of converting stories to numbers, to put these TAM claims to the test;
      With Uber, for instance, my initial estimate of the car service market in June 2014, while defining the magnitude of the car services market then, was a constrained TAM and, in hindsight, it proved far too limited, as Uber's pricing and convenience drew new customers into the market, expanding the market significantly. It is a lesson that I have taken to heart, and I do try to give disruptive companies the benefit of the doubt in estimating TAM, erring more towards the expanded TAM definition.  That said, the total market claims that I see outlined in the prospectuses of the companies that have gone public this year, while perhaps meeting the possible test, fail the plausible and probable tests. That TAM overreach makes the cases for these companies weaker, rather than stronger, by making them less credible.

      2. All about Scaling (in dollars and units)
      All of the companies that have gone, or are planning to go, public this year are telling scaling up stories, with explosive growth in revenues and talk of acceleration in that growth. On this count, the companies are entitled to crow, since they have grown revenues at unprecedented rates coming into their public offerings. 
      In short periods, these companies have grown from nothing to becoming among the largest players in their markets, at least in terms of revenues. While this focus on revenue growth is not surprising, since it is at the heart of their stories, it is revealing that all of the companies spend as much, if not, more time talking about growth in their revenue units (Uber riders, WeWork members and Peloton subscribers). 
      In fact, each of these companies, in addition to providing user/subscriber members, also provide other eye-popping numbers on relevant units, Uber on drivers and rides taken, WeWork on cities and locations and Peloton on bikes sold. I understand the allure of user numbers, since the platform that they inhabit can be used to generate more revenues. That is implicitly the message that all these companies are sending, and I did estimate a lifetime value of an Uber rider at close to $500 and I could use the model (described in this paper) to derive values for a WeWork member or a  Peloton subscriber. After all, the most successful user-based companies, such as Facebook and Amazon Prime, have shown how having a large user base can provide a foundation for new products and profits. However, there are companies that focus just on adding users, using badly constructed business models and pricing products/services much too cheaply, hoping to raise prices once the users are acquired. MoviePass is an extreme example of user pursuit gone berserk, but it  had no trouble attracting venture capital money, and I fear that there are far more young user-based companies following the MoviePass script than the Facebook one.

      3. Blurry Business Models and Flaky Earnings Measures
      Most of the companies that have gone public this year have entered the public markets with large losses, even after you correct for what they spend to acquire new users or subscribers. For some investors, this, by itself, is sufficient to turn away from these companies, but since these are young companies, pursuing ambitious growth targets, neither the negative earnings, nor the negative cash flows, is enough to scare me away. However, there are two characteristics that these companies share that I find off putting:
      • Pathways to Profitability: As money losing companies, I had hoped that Uber, WeWork and Peloton would all spend more time talking, in their investor pitches, about their existing business models, current weaknesses in these models and how they planned to reduce their vulnerabilities. With Uber and Lyft, the question of how the companies planned to deal with the transition of drivers from independent contractors to employees should have been dealt with front and center (in their prospectuses), rather than be viewed as a surprise that no one saw coming, a few months later. With WeWork, their vulnerability, stemming from a duration mismatch, begged for a response, and plan, from the company in its prospectus, but none was provided. In fact, Peloton may have done the best job, of the three companies, of positioning themselves on this front, with an (implicit) argument that as subscriptions rise, with higher contribution margins, profits would show up.
      • Earnings Adjustments: As has become standard practice across many publicly traded companies, these IPOs do the adjusted EBITDA dance, adding back stock-based compensation and a variety of other expenses. I have made my case against adding back stock-based compensation here and here, but I would state a more general proposition that adding back any expense that will persist as part of regular operations is bad practice. That is why WeWork's attempt to add back most of its operating expenses, arguing that they were community related, to get to community EBITDA did not pass the smell test.
      In summary, it is not the losses that these companies made in the most recent year that are the primary concern, it is that there seems to be no tangible plan, other than growth and hand waving on economies of scale, to put these companies into the plus column on profits.

      4. Founder Worship and Corporate Dictatorships
      Some time in the last two decades, newly public companies and many of their institutional investors seem to have lost faith in the quid quo pro that has characterized public companies over much of their history, where in return for providing capital, public market investors are at least given the semblance of a say in how the company is run, voting at annual meetings for board directors and substantive changes to the corporate charter. The most charitable characterization of the corporate governance arrangement at most newly minted public companies is that they are benevolent dictatorships, with a founder/CEO at the helm, controlling their destiny, and with no threat of loss of power, largely through super-voting right shares. In fact, most of the IPO companies this year have had:
      • Shares with different voting classes: With the exception of Uber, every high profile IPO that has hit the market has had multiple classes of shares, with the low-voting right shares being the ones offered to the market in the public offering and the high voting right shares held by insiders and the founder/CEO. It is also revealing that Uber was also one of the few companies in the mix where the founder was not the CEO at the time of the IPO, after the board, pressured by large VC investors, removed Travis Kalanick from atop the company in June 2017, in the aftermath of personal and corporate scandals. 
      • Captive boards of directors: I am sure that the directors on the boards of newly public companies are there to represent the interests of  investors in the company and and that many are well qualified, but they seem to do the bidding of the founder/CEO. The WeWork board seems to have been particularly lacking in its oversight of Adam Neumann, especially leading up to the IPO, but it is probably not an outlier.
      • Complex ownership and corporate structures: When private companies go public, there is a transition period where shares of one class are being converted to another, some options have forced exercises and there are restricted share offerings that ripen, all of which make it difficult to estimate value per share. It does not help when the company going public takes this confusion and adds to it, as WeWork did, with additional layers of complex organizational structure.
      In many of the companies that have gone public this year, it is quite clear that the company's current owners (founder and VCs) view the public equity market as a place to raise capital but not one to defend or debate how their companies should be run. Put simply, if you are public market investor, these companies want your money but they don't want your input. When faced with that choice with Alibaba, I characterized this as Jack Ma charging me five-star hotel prices, when I check in as an investor in his company, but then directing me to stay in the outhouse,  because I was not one of the insiders.

      Reverse Engineering the VC Game
      Every company that has come down the IPO pipeline this year has been able to raise ample capital from venture capitalists on its journey, with contributions coming from some public investor names (Fidelity and T.Rowe Price, to name just two). The fact that almost every company that went public this year framed its total market as implausibly big, emphasized how quickly it has scaled itself up, both in terms of revenues and users/subscribers, glossed over the flaws and weaknesses in its business model, and had shares with different voting rights suggests to me that this is behavior that was learned,  because venture capitalists encouraged and rewarded it. Bluntly put, the pricing offered by venture capitalists for private companies must place scaling success over sound business models, over-the-top total addressable markets over plausible ones and founder entrenchment over good corporate governance.

      In almost every IPO this year, the basis for at least the initial estimate of what the company would get from the market was the pricing at the most recent VC round, about $66 billion for Uber, $47 billion for WeWorks on the Softbank investment and about $4.2 billion at Peloton. The strongest sales pitch that the company and its bankers seem to be making is that venture capitalists are smart people who know a great deal about the company, and that you should be willing to base your pricing on theirs. This is not very persuasive, because, as I noted in this post, VCs price companies, they don't value them, and the pricing ladder, while it can lead price up, up and away, can also bring price down, when the momentum shifts.  

      This is not meant to be a broadside against all of venture capital. As with other investor groups, I am sure that there are venture capitalists who are sensible and unwilling to go along with these bad practices. Unfortunately, though, they risk being priced out of this market, as a version of Gresham's law kicks in, where bad players drive out good ones. In fact, since VC pricing takes its cues from public markets, it will interesting to see if the WeWork fiasco works its way through the VC price chain, leading to a repricing of companies that emphasize revenue scaling over all else. 

      A Peloton Valuation
      Since I started this post intending to value Peloton, I might as sell include my valuation of the company, especially since the company has released an updated prospectus with an estimated offering price of $26 to $30 per share. The company posits that there will 277.76 million shares outstanding (across voting share classes), but it also very clearly states that this does not include the 64.6 million options outstanding.

      Business Model and Accessible Market
      The Peloton product offerings started with an upscale exercise bike, but has since expanded to include an even more expensive treadmill; the bike currently sells for about $2,250 and the treadmill for more than $4,000. In fact, if that is all that the company sold, it would have been competing in  a constrained fitness product market with other exercise equipment manufacturers (Nautilus, Bowflex, NordicTrack, Life, Precor etc.). The company's innovation is two fold, first focusing on the upper end of the market with a very limited product offering and then offering a monthly subscription to those who bought, where you can take online classes and access other fitness-related services, with a monthly subscription fee of $40/month. In 2018, Peloton expanded its subscription service to non-Peloton fitness product owners, charging about $20 a month, with a membership count of 100,000 in 2018. The growth in the subscription portion of the business can be seen in the graphs below:

      The fitness market that Peloton is going after is large, but splintered, currently with gyms, both local and franchised, and fitness product companies all competing for the pie. In 2019, it was estimated that the total market for fitness products was $30 billion in the United States and close to $90 billion globally.  That said, harking back to our discussion of probable and plausible markets, Peloton is trying to draw people into this market who may otherwise have stayed away and getting existing customers to pay more, hoping to expand the market further. 

      Valuation Story and Numbers
      I am way too cheap to own a Peloton, but my conversations with Peloton owners/subscribers suggests to me that they have created a loyal customer base, perhaps unfairly likened to a cult. They rave about the online classes and how they keep them motivated to exercise, and while I take their praise with a grain of salt, it is quite clear that the company's online presence is not only polished but looks amazing on the high resolution TV screens that are built into their bikes and treadmills. In my story, I assume that the total accessible market will grow as Peloton and other new entrants into the subscription model draw in new customers, and that Peloton's allure will last, allowing it to grow its revenues over time to make it one of the bigger players in the fitness game. In my base case valuation, I see Peloton's subscription model as their ticket for future growth, pushing revenues by year 10 for the company to just above $10 billion, a lofty goal, given that the largest US fitness companies (gyms and equipment makers) have revenues of $2-$3 billion. I also believe that the shift towards subscriptions will continue, allowing for higher margins and lower capital investment than at the typical fitness company. My valuation is pictured below:
      Download spreadsheet
      My equity value is $6.65 billion, but in computing value per share, I have to consider the overhang of past option issuances at the company; there are 64.6 million options, with an average strike price of $6.71, outstanding in addition to the 277.76 million shares that the company puts forward as its share count. Valuing the options and netting them out yields a value per share of $19.35, about 20% below the low end of the IPO offering. That does bring me closer to the initial offering price than I got with either my Uber or WeWork valuations, though that is damning Peloton with faint praise. The magnitude of options outstanding at Peloton make it an outlier, even among the IPO companies, and I would caution investors to take these options into account, when computing market capitalizations or per share numbers. For instance, this Wall Street Journal report this morning, after the offering price was set at $26-$29/share, used the actual share count of 277.76 million shares to extrapolate to a market capitalization of $8 billion, at the upper end of the pricing range. That is not true. In fact, if you pay $29/share, you are valuing the equity in this company at more $9.5-$10 billion, with the options counted in.

      Is there a great deal of uncertainty embedded in this valuation? Of course! While some argue that this is reason enough to either not invest in the company, or to not do a discounted cash flow valuation, I disagree. 
      • First, at the right price, you should be willing to expose yourself to uncertainty, and while I would not buy Peloton at $26/share, I certainly would be interested at a price lower than $19.35. 
      • Second, the notion that the value of a business is a function of its capacity to generate cash flows is not repealed, just because you have a young, high growth company. If your critique is that my assumptions could be very wrong, I completely agree, but I can still estimate value, facing up to that uncertainty. In fact, that is what I have done in the simulation below:

      In terms of base numbers, the simulation does not change my view of Peloton. My median value is $18.30, with the tenth percentile at close to zero and the ninetieth percentile at $38.42, making it still over valued, if it is priced at $26/share. The long tail on the positive end of the distribution implies that I would buy Peloton with a smaller margin of safety than a more mature company, because of the potential of significant upside. (I have a limit buy, at $15/share. Given the offering price of $26-$29, there is little chance that it will execute soon, but I can play the long game).

      A Requiem
      The flood of companies going public, and their diverse businesses, has made for interesting valuations, but there are also more general lessons to be learned, even for those not interested in investing in these companies. First, our experiences with these IPOs should make it clear that it is the pricing game that dominates how numbers get attached to companies, and that is especially true for IPOs, not just on the offering day, but in the VC rounds leading up to the offering, and in the post-offering trading. Second, to the extent that the pricing game becomes centered on intermediate metrics, say revenue growth or on users or subscribers, it can lead companies astray, as they strive to deliver on those metrics, often at the expense of creating viable business models, and the pricing players (VCs and public investors) can get blindsided when the game changes. As I noted in my long-ago post on Twitter, these companies will face their bar mitzvah moments, when markets shift, often abruptly, from the intermediate users to the end game of profits, and many of these companies will be found wanting.

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      Links
      1. Valuation of Peloton (September 16, 2019)
      Posts on IPOs this year
      Posts on Venture Capital

      1. Venture Capital: It is a pricing, not a value, game!



      Runaway Story or Meltdown in Motion? The Unraveling of the WeWork IPO

      In a year full of high-profile IPOs, WeWork takes center stage as it moves towards its offering date, offering a fascinating insight into corporate narratives, how and why they acquire credibility (and value) and how quickly they can lose them, if markets lose faith. When the WeWork IPO was first rumored, there was talk of the company being priced at $60 billion or more, but the longer investors have had a chance to look at the prospectus, the less enthusiastic they seem to have become about the company, with a news story today reporting that the company was looking at a drastically discounted value of $20 billion, which would make Softbank, the biggest (and most recent) VC investor in WeWork, a big loser on the IPO. Before I set my thoughts down on WeWork, I will confess that I have never liked the company, partly because I don't trust CEOs who seem more intent on delivering life lessons for the rest of us, than on talking about the businesses they run, and partly because of the trail it has left of obfuscation and opaqueness. That said, I don't believe in writing hit pieces on companies and I will bend over backwards to give WeWork the benefit of the doubt, as I wrestle not only with its basic business model but also with converting that model into a story and numbers.

      The WeWork Business Model: A Leveraged Bet on Flexibility
      The WeWork business model is neither new, nor particularly unique in its basic form, though access to capital and scaling ambitions have put that model on steroids. That said, most traditional real estate companies that have tried the WeWork business model historically have abandoned it, for micro and macro reasons, and the test of the WeWork model is whether the advantages it brings to the table, and it does bring some, can help it succeed, where others have not.

      The Business Model
      Most businesses need office space and the way in which that office space is created and provided has followed a standard script for decades. The owner of an office building, who has generally acquired the building with significant debt, rents the building to businesses that need office space, and uses the rent payments received to cover interest expenses on the debt, as well as the expenses of operating the building. As economies weaken, the demand for office space contracts, and the resulting drop in occupancy rates in office buildings exposes the owner to risk. Prudent real estate operators try to buy buildings when real estate prices are low, and sign up credit worthy tenants with long term leases when rental rates are high, thus building a profitability buffer to protect themselves against downturns, when they do come. Even with added prudence, commercial real estate has always been a boom and bust business and even the most successful real estate developers have been both billionaires and bankrupt (at least on paper), at different points of their lives.

      The WeWork business model puts a twist on traditional real estate. Like the conventional model, it starts by identifying an attractive office property, usually in a city where office space is tight and young businesses are plentiful. Rather than buying the building, WeWork leases the building with a long term lease, and having leased it, it spends significant amounts upgrading the building to make it a desirable office space for the Gen-X and Gen-Y workers, brought up to believe in the tech company prototype of a cool office space. Having renovated the building, WeWork then offers office space in small units (you can rent just one desk or a few) and on short term contracts (as short as a month). For a given property, if things go according to plan, as the building gets occupied, the excess of rental income (over the lease payment) is used to cover the renovation costs, and once those costs get covered, the economies of scale kick in, generating profits for the company. The steps in the WeWork business model are captured in the picture below:
      If you buy into the company’s spin, as presented in its prospectus, the strengths it brings to each stage in the process are what sets it apart, allowing it to win, where others have failed before. In fact, the company is explicitly laying the foundations for this argument with two graphs in its prospectus, one of which maps out its time frame from signing to filling a location and the other which presents a picture, albeit a little skewed, of the profitability of each location, once stable.
      Prospectus: Pages 
      Note that all we have is the company's word on the timing and its definition of contribution margin plays fast and loose with operating expenses. To illustrate how the WeWorks model works, consider 600 B Street in San Diego, which is an office building that WeWork acquired, renovated and opened in 2017:


      In 2019, WeWork claimed that the building was mostly occupied, which should mean that the renovation costs are being recouped, but since the company does not reveal per-building numbers, it is impossible to tell what the company's financials are just on this building. 

      The Model Trade off
      The model's allure is built on three factors. The first is the WeWork look, with open work spaces, cool lighting and lots of extras, that the company has worked on building over its lifetime and presumably is able to duplicate in a new building, with cost savings and quickly. The second is the WeWork community, where the company supplements its cosmetic features with add-on services that range from business networking to consulting services and seminars. The third is its offer of flexibility to businesses, especially valuable at young companies that face uncertain futures but increasing becoming so even at established companies that are experimenting with alternate work structures. Presumably, these businesses will be willing to pay extra for the flexibility and WeWork can capture the surplus. The model's weakness lies in a mismatch that is at the heart of the business model, where WeWork has locked itself into making the renovation costs up front and the lease payments for many years into the future, but its rental revenues will ebb and flow, depending upon the state of the economy. In fact, the numbers in WeWork’s own prospectus give away the extent of this mismatch, with lease commitments showing an average duration in excess of 10 years, whereas its renters are locked into contracts that average about a year in duration, which I obtained by dividing the revenue backlog by the revenue run rate. This mismatch is not unique to WeWork. You can argue that hotels have always faced this problem, as do the owners of apartment buildings, but WeWork is particularly exposed for four reasons:
      1. Own versus lease: There is an argument to be made that owning a property and leasing it is less risky than leasing the property and then sub-leasing it, and it is not because buying a property does not give rise to fixed costs. It does, in the form of the debt that you take on, when you buy the property, but borrowing & buying comes with two advantages over leasing. First, when buying a property, you can decide the proportion of value that comes from equity, allowing you to reduce your financial leverage, if you feel over exposed. Second, if the property value of a building rises after you have bought it, the equity component of value builds up implicitly, reducing effective leverage, though if property values drop, the reverse will occur.
      2. Explosive growth: As we will see in the next section, WeWork does not just have a mismatched model, it is one that has scaled up at a rate that has never been seen in the real estate business, going from one property in 2010 to more than 500 locations in 2019, adding more than 100,000 square feet of office space each month. This global growth has given rise to gigantic lease commitments, which combined with its operating losses in 2018, make it particularly exposed.
      3. Tenant Self-selection: By specifically targeting young companies and businesses that value flexibility, the company has created a selection bias, where its customers are the ones most likely to pull back on their office rentals, if there is a downturn.
      4. Lack of cost discipline: Companies that have historically been exposed to the mismatch problem have learned that, to survive, they need to have cost discipline, keeping fixed cost commitments low and adjusting quickly to changes in the environment. While it is possible that WeWork is secretly following these practices, their prospectus seems to suggest that they are oblivious to their risk exposure.
      It is worth noting that the WeWork business model has been tried in real estate before, with calamitous results. As Sam Zell, a billionaire with deep roots in real estate, noted on CNBC, on September 4, 2019, not only did he lose money investing in a business model like this one in 1956, but every company in the office space subletting space that existed then went out of business.

      The Back Story
      To understand where WeWork stands today, I started with the prospectus that the company filed on August 14. While this filing may be updated, it provides a basis for any story telling or valuation of the company.

      1. Operations
      The financials reported in a company clearly paint a picture of growth in the company, as can be seen on almost every operating dimension (cities, locations, tenants, revenues).

      While the growth represents the good news part of the story, there is bad news. Accompanying the growth in locations and revenues are losses that have grown to staggeringly large amounts by 2018.
      EBITR= EBIT + Lease Expense, EBITR&PO = EBITR + Non-lease pre-opening expenses
      One argument that the company may make for its losses is that they are after operating lease expenses (which are financial expenses, i.e., debt) and pre-opening location expenses (which are capital expenses). Adjusting for these expenses make the losses smaller, but they still remain daunting.

      2. Leverage: The Leasing Machine
      The WeWork business model is built on leasing properties, often for large amounts, with a long-period commitment, and not surprisingly, the results are manifested in lease commitments that represent a mountain of claims that the company has to cover before it can generate income for equity investors. The graph below captures the lease commitments that WeWork has contractually committed itself to for future years, and how much these commitments represent in equivalent debt:
      Prospectus
      Brought down to basics, WeWork is a company that had $2.6 billion in revenues in the twelve months ending in June 2019, with an operating loss of more than $2 billion during the period, and debt outstanding, if you include the conventional debt, of close to $24 billion. Note that this leverage is built into the business model and will only grow, as the company grows. The hope is that as the company matures, and its leaseholds age, they will turn profitable, but this is a model built on a knife’s edge that, by design, will be sensitive to the smallest economic perturbations.

      3. Issuance Details
      To value an initial public offering, you need three additional details and at the moment, information on at least two of the three details is not fully disclosed, though it will be made public before the offering.
      • Magnitude of Proceeds: While the company has not been explicit about how much cash it plans to raise in the IPO, rumors as recently as last week suggested that it was planning to raise about $3.5 billion from the offering. Of course, that was premised on a belief that the market would price their equity at about $45-$50 billion and that may change, now that there are indications that it may have to settle for a lower pricing.
      • Use of Proceeds: In the prospectus (page 56), the company says that it intends to use the net proceeds for general corporate purposes, including working capital and capital expenditures. In effect, there seem to be no plans, at least currently, for any of the existing equity owners of the firm to cash out of the firm, using the proceeds. 
      • Dilution: There will be additional shares issued to raise the planned proceeds, and the offering price will determine the share count. There will be circularity involved, because the proceeds, since they will stay in the firm, will increase the value of the firm (and equity) by roughly the amount raised, and thus the value per share, but the value per share itself will determine how many additional shares will be issued and thus the share count.
      I will do my initial valuation with the rumored $3.5 billion proceeds amount and use the estimated value per share to adjust share count, but these numbers will need to be revisited, once there is more concrete information.

      4. Corporate Governance: Founder Worship and Complexity
      In keeping with what has become almost standard practice for companies going public in the last decade, WeWork has muddied the corporate governance waters by creating both a complex holding structure and share classes with different voting rights. Let's start with the holding structure for the company:
      Prospectus: Page
      In particular, note the carve out of a separate company (ARK) which will presumably buy real estate and lease it back to We and the region-specific joint ventures, where the company collects management fees. I am not quite sure what to make of the partnership triangle at the center, where it looks like the company will be partnering with it's own managers (with the founder/CEO presumably leading the way) to run WeWork Company. I have to compliment the company's owners and bankers, and it is a back-handed compliment, for managing to create more complexity in a couple of years than most companies can create in decades. Some of this complexity is probably due to tax reasons, in which case the company is behaving like other real estate ventures in putting tax considerations high up on its list of decision-drivers. Some of the complexity is to protect itself from the downside of its own lease-fueled growth, where the company can maintain the argument that since its leases are at the property-level, and the properties are structured as nominally stand-alone subsidiaries, it is less exposed to distress. That is fiction because a global economic showdown will lead to failures on dozens, perhaps hundreds, of lease commitments at the same time, and there is no protective cloak for the company against that contingency. A great deal of the complexity, though, has to do with the founder(s) desire for control and potential conflicts of interests, and investors will have to take that into account when valuing/pricing the company.

      On the governance front, the company’s voting structure continues the deplorable practice of entrenching founders, by creating three classes of shares, with the class A shares that will be offering in the IPO having one twentieth the voting rights of the class B and class C shares, leaving control of the company in the hands of Adam Neumann. In fact, the prospectus is brutally direct on this front, stating that “Adam’s voting control will limit the ability of other stockholders to influence corporate activities and, as a result, we may take actions that stockholders other than Adam do not view as beneficial” and that his ownership stake will result in WeWork being categorized as a controlled company, relieving it of the requirement to have independent directors on its compensation and nominating committees.

      Valuing WeWork
      As I mentioned at the top of this post, I fundamentally mistrust the company, but I am not willing to dismiss its potential, without giving it a shot at delivering. In creating this narrative, I am buying into parts of the company’s own narrative and here are the components of my story:
      • WeWork meets an unmet and large need for flexible office space: The demand comes both younger, smaller companies, still unsure about their future needs, and established companies, experimenting with new work arrangements. There is a big market, potentially close to the $900 billion that the company estimates.
      • With a branded product & economies of scale: The WeWork Office is differentiated enough to allow them to have pricing power, and higher margins.
      • And continued access to capital, allowing the company to both fund growth and potentially live through mild economic shocks. That access, though, will be insufficient to tide them through deeper recessions, where their debt load will leave them exposed to distress.
      This story translates into three key operating inputs:
      1. Revenue Growth: I will assume that revenues will grow at 60% a year, for the next five years, scaling down to stable growth (set equal to the riskfree rate of 1.6%) after year 10. If this seems conservative, given their triple digit growth in the most recent year, using this growth rate results in revenues of approximately $80 billion in 2029.
      2. Target Operating Margin: Over the next decade, I expect the company’s operating margins to improve to 12.50% by year 10. That is much higher than the average operating margin for real estate operating companies and higher than 11.04%, the average operating margin from 2014-2018 earned by IWG, the company considered to be closest to WeWork in terms of operating model. For those of you persuaded by the company’s argument that its locations make a 25% contribution margin, note that that measure of profitability is before corporate expenses, stock-based compensation and capital maintenance expenditures.
      3. Reinvestment Needs: The business will stay capital intensive, economies of scale notwithstanding, requiring significant investments in new properties and substantial ones in aging properties to preserve their earning power. I will assume that each dollar of additional capital invested into the business will generate $1.68 in additional revenues, again drawing on industry averages. (Currently, WeWork generates only 11 cents in revenues for every dollar invested, but in its defense, many of its locations are either just starting to fill or are not occupied yet.)
      From my perspective, this seems like an optimistic story, where WeWork generates pre-tax operating income of 10.07 billion on revenues of $80.5 billion in 2029, generating a 26.61% return on capital on intermediate capital investments. Allowing for a starting cost of capital of about 8%, the resulting value for the operating assets is about $29.5 billion, but before you decide to put all your money in WeWork, there are two barriers to overcome:
      1. Possibility of failure: The debt load that WeWork carries makes its susceptible to economic downturns and shocks in the real estate market, and the cost of capital, a going concern measure of risk, is incapable of capturing the risk of failure embedded in the business model. I will assume a 20% chance of failure in my valuation, and if it does occur, that the firm will have to sell its holdings for 60% of fair value.
      2. Debt load: As I noted in the last section, the company has accumulated a debt load, including lease commitments, of $23.8 billion. 
      Adjusting for these, the resulting value of equity is $13.75 billion, and with my preliminary assessment of shares outstanding, translates into a value per share of about $26/share.
      Download spreadsheet
      I am sure that I will get pushback from both directions, with optimists arguing that the unmet demand for flexible office space in conjunction with the WeWork brand will lead to higher revenue growth and margins, and pessimists positing that both numbers are overstated. In response, here is what I can offer:
      If you are puzzled as to why the equity value changes so much, as growth and margins change, the answer lies in the super-charged leverage model that WeWork has created. To the question of whether WeWork could be worth $40 billion, $50 billion or more, the answer is that it is possible but only if the company can deliver well-above average margins, while maintaining sky-high growth. That would make those values improbable, but what should terrify investors is that even the $15 or $20 billion equity values require stretching the assumptions to breaking point, and that there are a whole host of plausible scenarios where the equity is worth nothing. In fact, there is an argument to be made that if you invest in WeWork equity, you are investing less in an ongoing business, and more in an out-of-the-money option, with plausible pathways to a boom but just as many or even more pathways to a bust.

      Storytelling's Dark Side: The Meltdown of Runaway Stories
      Valuation is a bridge between stories and numbers, and for young companies, it is the story that drives the numbers, rather than the other way around. This is neither good nor bad, but a reflection of a reality which is that bulk of value at these companies comes from what they will do in the future, rather than what they have done in the past. That said, there is a danger when stories rule, and especially so if the numbers become props or are ignored, that the pricing that is attached to a company can lose its tether to value. In 2015, I used the notion of a runaway story to explain why VC investors pushed up the price of Theranos to $9 billion, without any tangible evidence that the revolutionary blood testing, that was at the basis of that value, actually worked. In particular, I suggested that there are three ingredients to a runaway story:
      With Theranos, Elizabeth Holmes was the story teller, arguing that her nanotainers would upend the (big) blood testing business and in the process, make it accessible to people around the world who could not afford it. Investors, Walgreens and the Cleveland Clinic all swooned, and no one asked questions about the blood tests themselves, afraid, perhaps, of being viewed as being against making the world a healthier place. For much of its life, WeWork has had many of the same ingredients, a visionary founder, Adam Neumann, who seems to view the company less as a business and more as a mission to make the business world a little more equal by giving the underdogs (young start-ups, entrepreneurs and small companies) a base, at least in terms of office space and community support, to fend off bigger competitors. It is no surprise, therefore, that the company describes its clients as community and members and that the word "We" carries significance beyond the company name. Along the way, the company was able to get venture capitalists to buy in, and the pricing of the company reflects its rise:
      Add caption
      The list of investors includes some big names in the VC and money management space, indicating that the runaway story’s allure is not restricted to the naïve and the uninitiated. Note also that one of the last entrants into the capital game was Softbank, providing a capital infusion of $2 billion in January 2019, translating into a pricing of $47 billion for the company's equity. In sum, Softbank’s holdings give it 29% of the equity in the company, larger even than Adam Neumann’s share.

      As we saw with Theranos, in its rapid fall from grace, there is a dark side to story companies and it stems from the fact that value is built on a personality, rather than a business, and when the personality stumbles or acts in a way viewed as untrustworthy, the runaway story can quickly morph into a meltdown story, where the ingredients curdle:
      Once investors lose faith in the narrator, the same story that evoked awe and sky-high pricing in the runaway model starts to come apart, as the flaws in the model and its disconnect with the numbers take center stage. With WeWork, the shift seems to have occurred in record time, partly because of bad market timing, with the macro indicators indicating that a global economic showdown may be coming sooner rather than later, and partly because of its own arrogance. In fact, if you were mapping out a plan for self-destruction, the company has delivered in spades with:
      1. CEO arrogance: For someone who is likely to be a multi-billionaire in a few weeks, Adam Neumann has been remarkably short sighted, starting with his sale of almost $800 million in shares leading into the IPO, continuing with his receipt (which he reversed, by only after significant blowback) of $6 million for giving the company the right to use the name “We”, and the conflicts of interest that he seems to have sowed all over the corporate structure. 
      2. Accounting Game playing: WeWork’s continued description, with more than a 100 mentions in its prospectus, of itself as a tech company is at odds with its real estate business model, but investors would perhaps have been willing to overlook that if the company had not also indulged in accounting game playing in the past. This is after all the company that coined Community EBITDA (https://www.bloomberg.com/opinion/articles/2018-04-27/wework-accounts-for-consciousness), an almost comically bad measure of earnings, where almost all expenses are added back to derive arrive at earnings. 
      3. Denial: Since even a casual observer can see the mismatch that lies at the heart of the WeWork business model, it behooves the company to confront that problem directly. Instead, through 220 pages of a prospectus, the company bobs and weaves, leaving the question unanswered.
      While these are all long standing features of the company, I think that if pricing is a game of mood and momentum, the mood has darkened during this period, and it came as no surprise when rumors started a couple of days ago that the company was considering slashing its pricing to $20 billion a lower. That is an astounding mark down from the initial pricing estimate, but it suggests that the company and its bankers are running into investor resistance.

      What is the end game?
      As WeWork stumbles its way to an IPO, with the very real chance that it could be pulled by its biggest stockholders (Neumann and Softbank) from a public offering, the question of what to do next depends upon whose perspective you tak.
      1. If you are a VC/equity owner in WeWorks, your choice is a tough one. On the one hand, you may want to pull the IPO and wait for a better moment. On the other, your moment may have passed and to survive as a private company, WeWork will need more capital (from you).
      2. As an investor, whether you invest or not will depend on what you think is a plausible/probable narrative for the company, and the resulting value. I would not invest in the company, even at the more modest pricing levels ($15-$20 billion), but if the price collapsed to the single digits, I would buy it for its optionality.
      3. If you are a trader, this stock, if it goes public, will be a pure pricing game, going up and down based upon momentum. If you are good at sending momentum shifts, you could take advantage. 
      4. If you are a founder/CEO of a company, the lesson to be learned from this IPO is that no matter how disruptive you may perceive your company to be, in a business, there are lessons to be learned from looking at how that business has been run in the past. 
      The saying that those who do not know their history are destined to repeat it seems apt not just in politics and public policy, but also in markets, as companies rediscover old ways to make money, and then find anew the flaws that put an end to those ways.

      YouTube Video

      Data/Spreadsheets



      Disrupting the IPO Process: Challenging the Banker-run Going-Public Model!

      In the age of disruption, where young companies are challenging the status quo and upending conventional businesses, it was only a matter of time before they turned their attention to the process by which they are taken public. For decades, the standard operating procedure for a company going public has been to use a banker or a banking syndicate to market itself to public investors at a “guaranteed” price, in return for a sizeable fee. That process has developed warts along the way but it has remained surprisingly stable even as the investing world has changed. In the aftermath of some heavily publicized let downs in the IPO market this year, with the WeWork fiasco topping off the bad news, there is now an active and healthy discussion about how companies should make the transition to being public. Change may finally be coming to the going-public game and it is long overdue.

      Going Public? The Choices
      When a private company chooses to go public, there are two possible routes that it can take in making this transition. The more common one is built around a banker or bankers who manage the private to public transition:

      There is an alternative, though it seems to be seldom used, which is to do a direct listing. In this process, a private company lets the markets set the price on the offering date, skipping the typical IPO dance of setting an offer price, which in retrospect is set too low or too high. 

      The company still has to file a prospectus, but the biggest difference is that it cannot raise fresh capital on the offering date, though existing owners can cash out by selling their shares. That is not as much of a problem as it sounds, since the company can choose to raise cash in a pre-listing round from interested investors, or to make a secondary offering, in the months after it has gone public. In fact, one advantage that direct listing have is that there is no lock-up period, as there is with conventional IPOs, where private investors cannot sell their shares for six months after the listing. If you are interested in the details of a direct listing, this write-up by Andreesen Horowitz sums it up well. Let’s be clear. If this were a contest, the status quo is winning, hands down. While there have been a couple of high-profile direct listings in Spotify and Slack, the overwhelming majority of companies have chosen the status quo. Furthermore, the status quo seems to be global, indicating either that the benefits that issuing companies see in the banker-based model apply across markets or that the US-model has been adopted without questions in other markets.

      The IPO Status Quo: The Pros and Cons
      To understand how the status quo got to be the standard, it makes sense to look at what issuing companies perceive to be the benefits of having banking guidance, and weigh them off against the costs. In the process, we will also lay the foundations for examining how the world has changed, and why the status quo may be under threat.

      The Banker's case
      Looking at the status quo picture that I showed in the last section, I listed the services that bankers offer to issuing companies, starting with the timing and details of the offering, all the way through the after-market support. At the risk of sounding like a salesperson for bankers, let’s see what bankers bring, or claim to bring, to the table on each of the services:
      1. Timing: Bankers would argue that their experience in financial markets and their relationship with institutional investors give them the insights to determine the optimal timing window for a public offering, where the investment stars are aligned to deliver the highest possible price and the smoothest post-market experience.
      2. Filing/Offering Details: A prospectus is as much legal document as it is information disclosure, and past experience with other initial public offerings may allow bankers to guide companies in what information to include in the prospectus and the language to use to in providing that information, as well as provide help in navigating the regulatory rules and requirements for public offerings.
      3. Pricing: It is on this front where bankers can claim to offer the most value added for three reasons. First, their knowledge of public market pricing can help them bridge the gap with the private market pricing preceding the offering, and in some cases, reduce unrealistic expectations on the part of VCs and founders. Second, they can help frame the offer pricing by finding the best metric to scale the pricing to and identifying the peer group that investors will use in public markets. Third, by reaching out to investors, bankers can not only gauge demand and fine tune the pricing but also isolate concerns that investors may have about the company. 
      4. Selling/Marketing: To the extent that multiple banks form the selling syndicate, and each can reach out to their investor clientele, bankers can expand the investor base for an issuing company. In addition, the marketing that accompanies the road shows can market the company to the larger market, attracting buzz and excitement ahead of the offer date. 
      5. Underwriting Guarantee: At first sight, the underwriting guarantee that bankers offer seems like one of the bigger benefits of using the banking-run IPO model, but I am afraid that there is less there than meets the eye, since the guarantee is set first and the price is not set until just before the offering, and it can be set below what you believe investors would pay for the stock. In fact, if you believe the graph on offer day price performance that I will present in the next section, the typical IPO is priced about 10-15% below fair price, making the guarantee much less valuable.
      6. After-market Support: Bankers make the case that they can provide price support for IPOs in the after-market, using their trading arms, sometimes with proprietary capital. In addition, researchers have documented that the equity research arms of banks that are parts of IPO teams are far more likely to issue positive recommendations and downplay the negatives.
      At least on paper, bankers offer services to issuing companies, though the value of these services can vary across companies and across time.

      The Bankers’ Costs
      The banking services that are listed above come at a cost, and that cost takes two forms. The first and more obvious one is the banker’s fees for the issuance and these costs are usually scaled to the issuance proceeds. They can range from 3% to more than 8% of the proceeds, with the percentage costs increasing for smaller issuers:
      While issuance costs do decrease for larger issuers, it is surprising that the drop off is not more drastic, suggesting either that costs are more variable than fixed or that there is not much negotiating room on these costs. To provide an example of the magnitude of these costs, the banking fees for Uber’s IPO amounted to $105 million, with Morgan Stanley, the lead banker, claiming about 70% of the fees.

      There is a second cost and it arises because of the way the typical IPO is structured. Since investment banks guarantee an offering price, they are more inclined to underprice an offering than over price it, and not surprisingly, the typical IPO sees a jump in the price from offer to opening trade on the first day of trading:
      Source: Jay Ritter, University of Florida
      Thus, the median IPO sees its stock price jump about 15% on the offering date, though there are some companies where the stock price jump is much greater. To provide specific examples, Beyond Meat saw a jump of 84% on the offering date, from its offer price, and Zoom’s stock price at the end of its first trading day was 72% higher than the offering price. Note that this underpricing is money left on the table by issuing company’s owners for the investors who were able to get shares at the offering price, many preferred clients for the banks in the syndicate. In defense of banks, it is worth noting that many issuing company shareholders seem to not just view this “lost value” as part of the IPO game, but also as a basis for subsequent price momentum. That argument, though, is becoming increasingly tenuous since if it were true, IPOs, on average, should deliver above-average returns in the weeks and months after the offering date, and they do not. If momentum is the rationale, it should also follow that newly listed stocks that do well on the offering date should deliver higher returns than newly listed stocks that do badly and there is no evidence of that either. 

      Revisiting the IPO Process
      Given the costs of using banks to manage the going-public process, it is surprising that there have not been more rumblings from private market investors and companies planning to go public about the process. After the WeWork and Endeavor IPO debacles, the gloves seem to have come off and the battle has been joined.

      The Bill Gurley Case for Direct Listings
      Bill Gurley has often been an atypical venture capitalist, willing to challenge the status quo on many aspects of the VC business. For many years now, he has sounded the alarm on how private market investors have paid too much for scaling models and not paid enough attention to building sound businesses. In the last few months, he has been aggressively pushing young companies to consider the direct listing option more seriously. His primary argument has been focused on the underpricing on the offering date, which as he rightly points out, transfers money from private market investors to investment bankers' favored clientele. In fact, he has pointed to absurdity of paying for an underwriting pricing guarantee, where the guarantors get to set the price much later, and are open about the fact that they plan to under price the offering. I don’t disagree with Bill, but I think that he is framing the question too narrowly. In fact, the danger with focusing on the offer day pricing jump runs two risks.
      • The first is that many issuing companies not only don’t seem to mind leaving money on the table, but some actively seem to view this under pricing as good for their stock, in the long term. After all, Zoom's CFO, Kelly Steckelberg seemed not only seems untroubled by the fact that Zoom stock jumped more than 70% on the offering date (costing its owners closer to $250-$300 million on the offered shares), but argued that that Zoom “got the most added attention in the financial community,” and even picked up business from several of its IPO banks who she said are “trialing or have standardized on Zoom now.” 
      • The second is that Gurley's critique seems to suggest that if bankers did a better job in terms of pricing, where the stock price on the offer date is close to the offer price, that the banker-run IPO model would be okay. I think that a far stronger and persuasive argument would be to show that the problem with the banking IPO model is that changes in the world have diluted and perhaps even eliminated that value of the services that bankers offer in IPOs, requiring that we rethink this process.
      The Dilution of Banking Services
      In the last section, in the process of defending the banker presence in the IPO process, I listed a series of services that bankers offer. Given how much the investing world, both private and public, has changed in the last few decades, I will revisit those services and look at how they have changed as well:
      1. No timing skills: To be honest, no one can really time the market, though some bankers have been able to smooth talk issuing companies into believing that they can. For the most part, bankers have been able to get away with the timing claims, but when momentum shifts, as it seems to have abruptly in the last few months in the IPO market, it is quite clear that none of the bankers saw this coming earlier in the year.
      2. Boilerplate prospectuses: When I wrote my post on the IPO lessons from WeWork, Uber and Peloton, I noted that these three very different companies seem to have the same prospectus writers, with much of the same language being used in the risk sections and business sections. While the reasons for following a standardized prospectus model might be legal, the need for banking help goes away if the process is mechanical.
      3. Mangled Pricing: This should be the strong point for bankers, since their capacity to gauge demand (by talking to investors) and influence supply (by guiding companies on offering size) should give them a leg up on the market, when pricing companies. Unfortunately, this is where banking skills seem to be have deteriorated the most. The most devastating aspect of the WeWork IPO was how out of touch the bankers for the company were in their pricing:
        Source: Financial Times
        I would explain this pricing disconnect with three reasons. The first is that bankers are mispricing these companies, using the wrong metrics and a peer group that does not quite fit, not surprising given how unique each of these companies claims to be. The second is that the bankers are testing out prices with a very biased subset of investors, who may confirm the mistaken pricing. The third and perhaps most likely explanation is that the desire to keep issuing companies happy and deals flowing is leading bankers to set prices first and then seek out investors at those prices, a dangerous abdication of pricing responsibility.
      4. Ineffective Selling/Marketing: When issuing companies were unknown to the market and bankers were viewed as market experts, the fact that a Goldman Sachs or a JP Morgan Chase was backing a public offering was viewed as a sign that the company had been vetted and had passed the test, the equivalent of a Good Housekeeping seal of approval for the company, from investors' perspective. In today’s markets, there have been two big changes. The first is that issuing companies, through their product or service offerings, often have a higher profile than many of the investment banks taking them public. I am sure that more people had heard about and used Uber, at the time of its public offering, than were aware of what Morgan Stanley, its lead banke, does.  The second is that the 2008 banking crisis has damaged the reputation of bankers as arbiters of investment truths, and investors have become more skeptical about their stock pitches. All in all, it is likely that fewer and fewer investors are basing their investment decision on banking road shows and marketing.
      5. Empty guarantee: Going back to Bill Gurley’s point about IPOs being under priced, my concern with the banking IPO model is that the under pricing essentially dilutes the underwriting guarantee. Using an analogy, how much would you be willing to pay a realtor to sell a house at a guaranteed price, if that price is set 20% below what other houses in the neighborhood have been selling for?  
      6. What after-market support? In the earlier section, I noted that banks can provide after-issuance support for the stocks of companies going public, both explicitly and implicitly. On both counts, bankers are on weaker ground with the companies going public today, as opposed to two decades ago. First, buying shares in the after-market to keep the stock price from falling may be a plausible, perhaps even probable, if the issuing company is priced at $500 million, but becomes more difficult to do for a $20 billion company, because banks don’t have the  capital to be able to pull it off. Second, the same loss of faith that has corroded the trust in bank selling has also undercut the effectiveness of investment banks in hyping IPOs with glowing equity research reports. 
      Summing up, even if you believed that bankers provided services that justified the payment of sizable issuance costs in the past, I think that you would also agree that these services have become less valuable over time, and the prices paid for these services have to shrink and be renegotiated, and in some cases, entirely dispensed with.

      Why change has been slow
      Many of the changes that I highlighted in the last section have been years in the making, and the question then becomes why so few companies have chosen to go the direct listing route. There are, I believe, three reasons why the status quo has held on and that direct listings have no become more common.
      1. Inertia: The strongest force in explaining much of what we see companies do in terms of investment, dividend and financing is inertia, where firms stick with what's been done in the past, partly because of laziness and partly because it is the safest path to take.
      2. Fear: Unfounded or not, there is the fear that shunning bankers may lead to consequences, ranging from negative recommendations from equity research analysts to bankers actively talking investors out of buying the stock, that can affect stock prices in the offering and in the periods after.
      3. The Blame Game: One of the reasons that companies are so quick to use bankers and consultants to answer questions or take actions that they should be ready to do on their own is that it allows managers and decisions makers to pass the buck, if something goes wrong. Thus, when an IPO does not go well, and Uber and Peloton are examples, managers can always blame the banks for the problems, rather than take responsibility.
      I do think that at least for the moment, there is an opening for change, but that opening can close very quickly if a direct listing goes bad and a CFO gets fired for mismanaging it.

      The End Game

      As the process of going public changes, everyone involved in this process from issuing companies to public market investors to bankers will have to rethink how they behave, since the old ways will no longer work.

      Issuing companies (going public) 
      1. Choose the IPO path that is right for you: Given your characteristics as a company, you have to choose the pathway, i.e., banker-led or direct listing that is right for you. Specifically, if you are a company with a higher pricing (in the billions rather than the millions), with a public profile (investors already know what you do) and no instantaneous need for cash, you should do a direct listing. If you are a smaller company and feel that you can still benefit from even the diminished services that bankers offer, you should stay with the conventional IPO listing route.
      2. If you choose a banker, remember that your interests will not align with those of the bankers, be real about what bankers can do for you and negotiate for the best possible fee, and try to tie that feee to the quality of pricing. If I were Zoom's CFO, I would have demanded that the banks that underpriced my company by 80% return their fees to me, not celebrated their role in the IPO process.
      3. If you choose the direct listing path, recognize that the public market may not agree with you on what you think your company is worth, and not only should you accept that difference and move on, you should recognize that this disagreement will be part of your public market existence for your listing life. 
      4. In either case, you should work on a narrative for your company that meets the 3P test, i.e., is it possible? plausible? probable? You are selling a story, but you will also have to deliver on that story, and overreaching on your initial public offering story will only make it more difficult for you to match expectations in the future.
      Investors
      1. Choose your game: In my last post, I noted that there are two games that you can play, the value game, where you value companies and trade on the difference, waiting for the price to converge on value and the pricing game, where you buy at a low price and hope to sell at a higher one. There is nothing inherently more noble about either game, but you should decide what game you came to play and be consistent with that choice. In short, if you are a trader, stop pondering the fundamentals and using discounted cash flow models, since they will be of little help in winning, and if you are an investor, don't let momentum become a key ingredient of your value estimate.
      2. Keep the feedback loop open: Both investors and traders often get locked into positions on IPOs and are loath to revisit their original theses, mostly because they do not want to admit mistakes. With IPOs, where change is the only constant, you have to be willing to listen to people who disagree with you and change your views, if the facts merit that change.
      3. Spread your bets: The old value investing advice of finding a few good investments and concentrating your portfolio in them can be catastrophic with IPOs. No matter how carefully you do your homework, some of the investments that you make in young companies will blow up, and if your portfolio succeeds, it will be because a few big winners carried it. 
      4. Stop whining about bankers, VCs and founders: Many public market investors seem to believe that there is a conspiracy afoot to defraud them, and that bankers, founders and VCs are all part of that conspiracy. If you lose money on an IPO, the truth is that it may not be your or their faults, but the consequence of circumstances out of anyone's control. In the same vein, when you make money on an IPO, recognize that it has much to do with luck as with your stock picking skills.
      Bankers
      1. Get real about what you bring to the IPO table: As I noted before, public and private market changes have put a dent on the edge that bankers had in the IPO game. It behooves bankers then to understand which of the many services that they used to charge for in the old days still provide added value today and to set fees that reflect that value added. This will require revisiting practices that are taken as given, including the 6-7% underwriting fee and the notion that the offer price should be set about 15% below what you think the fair prices should be.
      2. Speak your mind: If one of the reasons that the IPOs this year have struggled has been a widening gap between the private and public markets, bankers can play a useful role in private companies by not only pointing to and explaining the gap, but also in pushing back against private company proposals that they believe will make the divergence worse. 
      3. Get out of the echo chamber: An increasing number of banks have conceded the IPO market to their West Coast teams, often based in Silicon Valley or San Francisco. These teams are staffed with members who are bankers in name, but entirely Silicon Valley in spirit. It is natural that if you rub shoulders with venture capitalists and founders all day that you relate more to them than to public market investors. I am not suggesting that banks close their West Coast offices, but they need to start putting some distance between their employees and the tech world, partly to regain some of their objectivity. 
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      IPO Lessons for Public Market Investors

      This year, I have found myself returning repeatedly to the IPO well, as high profile companies have chosen to go public, and like a moth to a flame, I have been drawn to value them. There was much enthusiasm at the start of 2019 that this would be a blockbuster year for IPOs, not just for the companies going public, but also for public market investors who would now get a chance to own pieces of companies which had made venture capitalists and private market investors rich, at least on paper. While many of these companies, with the exception of WeWork, have gone public and raised large amounts of capital, many of the new listings have disappointed in the after market. The WeWork fiasco, while creating vast collateral damage, has also created healthy discussions about how venture capitalists price private companies and whether public market investors should base their pricing of the latest VC rounds, whether the IPO process itself is in need of a change, what the share count that we should be using in computing market capitalization at these young companies and whether investors should even enter this space, where uncertainty abounds and cash burn is more the rule than the exception.

      An 2019 IPO Pricing Retrospective
      It is estimated that nearly 200 companies will go public this year, an increase of about 5% over last year's 190 IPOs, but still well below the 547 companies that went public in 1999. The first half of the year was a good one for investors in these IPOs, but investors have soured on these companies in the last few months. One way to measure the performance of these young companies in the after market is to look at how the Renaissance IPO ETF, a fund that tracks larger initial public offerings and weights them based upon free float, has done over the course of the year:

      Since the fund tracks IPOs for 500 trading days after the listing date, it is not quite a clean measure of this year's IPOs, but it is a good proxy. Notwithstanding all of the negative press you may have read about IPOs in the last few weeks, and third quarter damage, the Renaissance ETF IPO has outperformed the market over the course of this year.

      To take a closer look at a subset of these IPOs, I focused on seven of the offerings this year - Uber, Lyft, Pinterest, Slack, Levi Strauss, Peloton and Beyond Meat - and looked the performance of each of these stocks since the opening trade on the offering date:

      To compare the performance of these offerings, I standardized performance by looking at how much $100 invested in each stock at the open price on the first trading day would have done, in periods ranging from a day to the year to date:

      I have tracked the returns that investors would have earned if they had invested at the offer price and at the open price on the first trading day. Note first that five of the seven stocks registered a jump in excess of 20%, comparing the open price to the offer price, when they started trading. Looking at the returns in the year to date, the outlier is Beyond Meat, on an almost unbelievable run from its offer price, but of the remaining six stocks, only Pinterest has gone up, relative to it first trade price. Uber, Lyft and Slack have been awful investments, though if you had received Slack shares at the offer price, the pain would be more bearable. Even Levi Strauss, not a young or a tech company, has seen rough going in the months since its initial public offering. Peloton has been listed only ten trading days, but it has to hope that the worst is behind it.  What does this all mean? First, in spite of recent setbacks, investors in IPOs collectively have done reasonably well over the course of the year, but only if they spread their bets. Second, in the midst of this good news, some of the most hyped IPOs have had difficulty gaining traction, and since these companies attract the most attention from investors and the financial press, they are contributing to the perception that investing in IPOs has been a loser's game this year.
         IPO Lessons for Public Market Investors
      In my post on the Peloton IPO, I opined on how venture capitalists price companies and how the pressures that they have put on companies to scale up quickly, often without paying heed to building good business models, is playing out. In this one, I would like to look at the public market side of the IPO process, again looking for common threads.

      1. It stays a pricing game
      At the risk of repeating myself, the price of an asset and its value are determined by different forces and estimated using different tools. and while they may be good estimates of each other in an efficient market, they can diverge, creating both opportunities and dangers for investors:

      It is not just venture capitalists that play the pricing game. Most public market investors do as well, and this is particularly true when companies first go public for three reasons:
      1. The IPO process: The IPO process is one of gauging demand and supply and setting a price based on that assessment, not estimating the value of businesses. It is the job of the bankers managing the process is to make this judgment, usually based upon the responses they get from their investor clientele. Thus, it should be not surprising that the bulk of the backing for an offering price comes from finding a pricing metric (revenue multiple, user value etc.) and relevant comparable firms (a subjectively judgment). 
      2. Self Selection: The players who get drawn into the IPO game tend to be those with shorter time horizons who feel that their strength is in riding momentum, when it exists, and detecting shifts, before the rest of the market does. In short, the IPO market is built for traders, not investors.
      3. Type of companies: Most initial public offerings tend to be of firms that are younger and often  less formed than their more seasoned public counterparts. Consequently, more of their value lies in the future and there is more uncertainty in assessing numbers, leading investors to abandon these stocks, claiming that there is too much uncertainty, giving pricing almost all of the stage.
      So what if the IPO market is a pricing game? First, trying to use value tools (like DCF) or fundamentals to explain IPO pricing, and what causes these prices to move on a day-to-day basis in the after market is a recipe for frustration. The nature of the pricing game is that mood and momentum can not only cause these companies to be priced at numbers very different from value, but also cause price movements on trivial, perhaps even irrelevant, news stories. Second, playing the momentum game is akin to riding on the back of a tiger, with the danger being that you will be consumed, if the game shifts. Take a look at Beyond Meat's price movements over the course of this year, since its IPO, and you can see how quickly momentum can shift in a stock, and the decisive effects it has on pricing.

      2. On a shaky base
      In the pricing game, you estimate how much to pay for a company by looking at how similar companies are being priced by the market, usually scaling price to a common metric like earnings, book value or revenues, as well as its own pricing history. With initial public offerings, this process gets more difficult for two reasons:
      1. Peer Group Framing: With most public companies, a combination of the company's operating history and market learning leads to a consensus on what its peer group should be, for pricing purposes. Thus, when pricing Coca Cola or Adobe, investors tend to agree more than they disagree about what companies to put into the peer group for comparison. For many IPOs, especially built around new business models and practices, there is much more confusion about what grouping to put the company into. Not surprisingly, the IPOs try to influence this choice by framing themselves as being in businesses that will deliver a higher pricing, explaining why almost every one of them likes to use the word "tech" in its description.
      2. Past Pricing History: Unlike publicly traded companies, where there is a market price history, the only price history that you have with IPOs is from prior VC rounds. To understand this may be problematic, let me focus on the seven IPOs I highlighted in the last section and provide information on the private investor funding of each, leading into the IPO:
        Note three problems with using this information as a basis for public market pricing. First, in most cases, the pricing for the company is extrapolated from a small VC investment. With Lyft, for instance, the estimated pricing of $14.5 billion from the most recent round was extrapolated from an investment of $600 million for the company for a 4.1% share of the company. Second, this problem is worsened by the fact that VC investors can and usually do negotiate for post-investment protections, when they invest. For instance, ratchets allow VCs to adjust their ownership stake in a company upwards, if a subsequent funding round is based upon a lower pricing for the company. In effect, VCs are being provided with options, and as I noted in this post on unicorns, the presence of these additional features makes simplistic extrapolation to pricing from a VC investment almost impossible to do. Third, even if the pricing is correctly extrapolated from the last VC investment, all you need is one over optimistic venture capitalist to push the pricing beyond reasonable bounds. In the case of WeWork, it can be argued that much of the surge in pricing in the company came from Softbank's continued investments in the company and not a reflection of consensus among venture capitalists.
      In the traditional IPO model, where investment bankers form a syndicate to sell the shares at a pre-set offer price, it can be argued that the primary service that bankers provide, if they do their job well, is to use their access to public investors to fine tune the pricing. This year's experiences with Peloton and Uber, where the stock price dropped on the offer day, and with WeWork, where the pricing estimates imploded to the point of imperiling the public offering, has led some founders and venture capitalists to question whether it is worth hiring bankers in the first place. 

      3. With an unstable share count
      We all know the process for estimating market capitalization for a firm, and it involves taking the stock price and multiplying by the number of shares outstanding. For most publicly listed firms, that calculation should yield a value fairly close to the truth, but IPOs are different for two reasons. First, an overwhelming number in recent years have had two classes of shares (sometimes three) with different voting rights and being sloppy and missing an entire share class will cause devastating errors in computation. Second, most of these companies are young and cash-poor, and they have chosen to compensate employees with equity, either in the form of restricted shares and options. The way in which investors and analysts deal with these employee equity claims ranges from the abysmal to the barely acceptable, again with significant consequences. Let's take the Peloton case, where the company in its final prospectus listed itself as having 41.8 million class A shares, with lower voting rights, and 235.9 million class B shares, with higher voting rights, after its IPO, yielding a total share count of 277.7 million shares. That is the share count that has been used by journalists in writing about the offering and by most of the data services since, in estimating the implied pricing of $8.1 billion for the company, at the offer price of $29. That is patently untrue, and the reason is in the same prospectus, where Peloton states that "the number of shares..... does not include:
      • 64,602,124 shares of our Class B common stock issuable upon the exercise of options to purchase shares of our Class B common stock  outstanding as of June 30, 2019, with a weighted-average exercise price of $6.71 per share; 
      • 883,550 shares of our Class B common stock issuable upon the exercise of options to purchase shares of our Class B common stock  granted between June 30, 2019 and September 10, 2019 with a weighted-average exercise price of $23.40 per share; 
      • 240,000 shares of our Class B common stock issuable upon the exercise of a warrant to purchase Class B common stock outstanding as  of June 30, 2019, with an exercise price of $0.19 per share;"
      Focus on just the first bullet, where Peloton admits that there 64.6 million options, with an exercise price of $6.71. Given that the offer price was $29/share and the open price was $27, is there any doubt that at some point in time, sooner rather than later, these options will get exercised and become shares? In fact, in what universe can you ignore these options in estimating market capitalization? The reason this practice can lead to dangerous mis-pricing is simple. Let's assume that the Peloton bankers came to the conclusion that $8.1 billion was a reasonable value to attach to its equity, based upon past VC rounds and peer group pricing. To get to an offer price, they cannot divide that number by just the shares outstanding (277.7 million), since that will treat the options as worthless. In my valuation of Peloton, I did what I think should always be done, which is to value the options as options, which allows me to include at-the-money and out-of-the-money options, as well as time value, net that option value from my equity value and then divide by the 277.7 million shares.  If you find option pricing models too opaque, here is a simpler way to get to value per share from the estimated equity value:
      Thus, if the Reuters story quoted above is correct in its judgment that the bankers wanted to price Peloton at $8.1 billion, the estimated offer price per share, counting only the 64.6 million additional options would have been:
      Alternatively, it is possible that this was a journalistic error in extrapolation and that the bankers took options into account and meant to price it at $29/share, in which case the implied market capitalization for Peloton at the $29 offer price, using the exercise proceeds short cut, would have been:
      Implied Market Cap at $29/share = 277.7 * $29 + 64.6* ($29 - 6.71) = $9.5 billion
      To see why this matters, any enterprise value or pricing multiple that you compute for Peloton should be based upon the $9.5 billion estimate, not the $8.1 billion, if the stock was trading at $29. I think that we are generally sloppy in market capitalization calculations, but that sloppiness has much bigger consequences with IPOs. So, as investors, we should follow the Russian adage of "trust, but verify", when it comes to share count.

      4. And a Bar Mitzvah Moment waiting!
      At this stage, I don't blame you if you are puzzled by how I approach IPOs. As soon as an IPO is announced, I use the prospectus to value the company, but I just confessed earlier that the IPO market, at listing and in the periods afterwards, is a pricing game, not a value game. So, why bother with a DCF in the first place?
      • If your intent is to trade IPOs, you should not care about value, but mine is different. I consider myself an investor, not a trader, not because it is a more noble calling but because I am a terrible trader. 
      • As an investor, I have faith that when investing in equity in a business, there will eventually a reckoning, where price converges on value. I use the word "faith" because there is no mechanism that guarantees this convergence.
      Young companies that go public are often adept at playing the pricing game, delivering more users, subscribers or revenues, if that is what the pricing gods want, and their stock prices often continue to rise, even though their fundamentals don't merit it. It is my belief that each of these companies will face what I call a "Bar Mitzvah" moment, where the market, hitherto focused on magical metrics, asks the company about its pathway to profitability. As I look back over time, the very best of these companies, and I would include Facebook, Google and Amazon in this grouping, are ready for this moment, since they have been building viable business models, even as they delivered on market metrics. Many of these young companies, though, seem unready for this question, and the market punishes them, as was the case with Twitter in 2014.

      Go where it is darkest!
      Even if you accept my proposition that price eventually converges to value, if you subscribe to old time value investing, you are probably wondering why I would want to try to put my money at risk, investing in these young companies, when it is so much easier to value mature companies like Philip Morris and Coca Cola. I don't disagree with you on your premise that there is a great deal more uncertainty in valuing Uber than in valuing Coca Cola, but I believe that the payoff to imprecisely valuing Uber is greater than the payoff to precisely valuing Coca Cola. After all, what made Coca Cola easy for you to value also makes it easy for other investors to do as well, and the uncertainty that scares you with Uber is scaring most investors away from even trying. It is for that reason that I value companies at the time of their public offerings, and repeatedly thereafter, hoping that I am able to get in at the right price. Here are my estimates of value for the companies on my list at the time of the IPO, with updates on both value and price as trading has continued:



      Levi StraussLyftPinterestBeyond MeatUberSlackPeloton
      IPO Value $24.23 $58.78 $25.08 $46.88 $32.91 $20.59 $19.35
      IPO Offer Price$17.00 $72.00 $19.00 $25.00 $45.00 $26.00 $29.00
      IPO Open Price$22.22 $87.33 $23.75 $46.00 $42.00 $38.50 $27.17
      % Difference-8.30%48.57%-5.30%-1.88%27.62%86.98%40.41%

      Updated Value$26.59 $54.38 $26.17 $47.41 $35.42 $23.95$19.35
      Price on 8/10/19$18.96 $38.66 $25.63 $142.73 $29.28 $25.70 $23.21
      % Difference-28.69%-28.91%-2.06%201.05%-17.33%5.59%19.95%
      SpreadsheetDownload Download Download Download Download Download Download 

      At the time of the offering, relative to the open price, only Levi Strauss looked mildly under valued, Beyond Meat was at close to fair value and the other companies all looked over valued. Since the offering, each of these companies has released earnings reports and I updated the treasury bond rates and equity risk premiums in all of the valuations. With Uber and Lyft, the added perturbation comes from legislation passed by the state of California, requiring that drivers be treated as employees, an assumption that I had already built into my valuation, but one that seemed to catch the market by surprise. Incorporating the price changes at all of the companies, and reflecting my updated valuation stories for the companies, Levi Strauss has become more under valued, Uber and Lyft have moved from being over to under valued, Slack and Peloton have converged on value and Beyond Meat has become significantly overvalued. 
      1. Levi Strauss's most recent earnings report was not well received by the market, with the stock dropping 1.1% to $18.96. I see its fundamentals justifying a higher value and I bought shares at $18.96.
      2. I have gone back and forth on whether to buy Uber, Lyft or both. Lyft looks more under valued, but Uber offers more upside, given its global ambitions. In addition, I prefer Uber's single class of shares to Lyft's multiple voting right classes, and these factors tilted me to buying the latter at $30/share. 
      3. Slack and Pinterest are getting close to fair value as their prices have drifted down and Peloton has become less over valued but still has room to fall. For the moment, I will add these companies to my watch list, and track their pricing.
      4. With my story for Beyond Meat, I find the price almost unreachable with any story that I craft, and while this was the same conclusion that I drew a few months ago, this time, I tried shorting the stock at $142, but was unable to get my trade through. I fell back on buying put options at a 120 strike price, expiring on December 20, 2019, paying a mind-bending time premium for a two-month option. While the stock has been resistant to the laws of gravity (or value) for must of its listed life, I believe that there are two things that have changed that make this a good time to make this short term intrinsic value bet. One is the listing of Impossible Foods gives investors not just another way of making a macro bet on veganism, but also an easy comparison on pricing. The other is the decision by Beyond Meat to issue 3.25 million shares a few weeks ago, with 3 million shares coming from insiders, suggests that the firm itself may think its stock is over priced.
      Some of my bets will go wrong, and if they do, I am also sure that some of you will point them out to me, and I am okay with that. That said, I hope that you make your own judgments on these companies, and you are welcome to use my spreadsheets (linked both above and below) and change the inputs that you disagree with, if that helps.

      YouTube Video


      Valuation Spreadsheets

      1. Levi Strauss (October 8, 2019)
      2. Lyft (October 8, 2019)
      3. Pinterest (October 8, 2019)
      4. Beyond Meat (October 8, 2019)
      5. Uber (October 8, 2019)
      6. Slack (October 8, 2019)
      7. Peloton (September 28, 2019)
      Links



      US Equities: Resilient Force or Case Study in Denial?

      As readers of this blog know, I don't write much about whether stocks collectively are over or under priced, other than my usual start of the year posts about markets or in response to market crisis. There are two reasons. The first is that there is nothing new or insightful that I can bring to overall market analysis, and I generally find most market punditry, including my own, to be more a hindrance than a help, when it comes to investing. The second is that I am a terrible market timer, and having learned that lesson, try as best as I can to steer away from prognosticating about future market direction. That said, as markets test their highs, talk of market bubbles has moved back to the front pages, and I think it is time that we have this debate again, though I have a sense that we are revisiting old arguments.

      Who are you going to believe?
      One reason that investors are conflicted and confused about what is coming next is because there is are clearly political and economic storms that are on the horizon, and there seems to be no consensus on what those storms will mean for markets. The US equity market itself has been resilient, taking bad macroeconomic and political news in stride, and a bad day, week or month seems to be followed by a strong one, often leaving the market unchanged but investors wrung out. Investors themselves seem to be split down the middle, with the optimists winning out in one period and the pessimists in the next one. One measure of investor skittishness is stock price variability, most easily measured with the VIX, a forward-looking estimate of market volatility:

      Here again, the market's message seems to be at odds with the stories that we read about investor uncertainty, with the VIX levels, at least on average, unchanged from prior years. If you follow the market and macroeconomic experts either in print or on the screen, they seem for the most part either terrified or befuddled, with many seeing darkness wherever they look. As in the Christmas Carol, the ghosts of market gurus from past crises have risen, convinced that their skill in calling the last correction provides special insight on this market. In the process, many of them are showing that their success in  market timing was more luck than skill, often revealing astonishing levels of ignorance about instruments and markets. (At the risk of upsetting those of you who believe these gurus, GE is not Enron and index funds are not responsible for creating market bubbles...)

      Stock Market - Bubble or not a bubble? Point and Counter Point!
      Why do so many people, some of whom have solid market pedigrees and even Nobel prizes, believe that markets are in a bubble? The two most common explanations, in my view, reflect a trust in mean reversion, i.e., that markets revert back to historic norms. The third one is a more subtle one about winners and losers in today's economy, and requires a more serious debate about how economies and markets are evolving. The final argument requires that you believe that powerful rate-setting central bankers and market co-conspirators have artificially propped up stock and bond prices. With each argument, though, there are solid counter arguments and in presenting both sides, I am not trying to dodge the question, but I am interested in looking at the facts.

      Bubble argument 1: Markets have gone up too much, in too short a period, and a correction is due
      The simplest argument for a correction is that US equity markets have been going up for so long and have gone up so much that it seems inevitable that a correction has to be near. It is true that the last decade has been a very good one for stocks, as the S&P 500 has more than tripled from its lows after the 2008 crisis. While there have been setbacks and a bad period or two in the midst, staying fully invested in stocks would have outperformed any market timing strategy over this period.

      Is it true that over long time periods, stocks tend to reverse themselves? Yes, but when and by how much is not just debatable, but the answers could have a very large impact on anyone who decides to cash out prematurely. The easy push back on this strategy is that without considering what happens to earnings or dividends over the period, no matter what stock prices have done, you cannot make a judgment on markets being over or under priced.

      Counter Argument 1: It is not just stock prices that have gone up...
      If stock prices had jumped 230% over a period, as they did over the last decade, and nothing else had changed, it would be easy to make the case that stocks are over priced, but that is not the case. The same crisis that decimated stock prices in 2008 also demolished earnings and investor cash flows, and as prices have recovered, so have earnings and cash flows:

      Notice that while stocks have climbed 230% in the ten-year period since January 1, 2009, earnings have risen 212% over the same period, and cash flows have almost kept track, rising 188%. Since September 2014, cash flows have risen faster than earnings or stock prices. It is possible that earnings and cash flows are due for a fall, and that this will bring stock prices down, but it requires far more ammunition to be credible.

      Bubble Argument 2: Stocks are over priced, relative to history, and mean reversion works
      The second argument that the market is in a bubble is more sophisticated and data-based, at least on the surface. In short, it accepts the argument that stocks should increase as earnings go up, and that looking at the multiple of earnings that stocks trade at is a better indicator of market timing. In the graph below, I graph the PE ratio for the S&P 500 going back to 1969, in conjunction with two alternative estimates, one of which divides the index level by the average earnings over the prior ten years (to normalize earnings across cycles) and the other of which divides the index level by the inflation-adjusted earnings over the prior ten years.
      Download raw data on PE ratios
      Note that on October 1, 2019, all three measures of the PE ratios for the S&P 500 are higher than they have been historically, if you compare them to the median levels, with the PE at the 75th percentile of values over the 50-year period, and normalized PE and CAPE above the 75th percentile. Proponents then complete the story using one of two follow up arguments. One is that mean reversion in markets is strong and that the values should converge towards the median, which if it occurs quickly, would translate into a significant drop in stock prices (35%-40% decline). The other is to correlate the l PE ratio (in any form) with stock returns in subsequent periods, and show that higher PE ratios are followed by weaker market returns in subsequent periods. 

      Counter Argument 2: Stocks are richly priced, relative to history, but not relative to alternative investments today
      If you are convinced by one of the arguments above that stocks are over priced and choose to sell, you face a question of where to invest that cash. After all, within the financial market, if you don't own stocks, you have to own bonds, and this is where the ground has shifted the most against those using the mean reversion argument with PE ratios. Specifically, if you consider bonds to be your alternative to stocks, the drop in treasury rates over the last decade has made the bond alternative less attractive. In the graph below, I compare earnings yields on US stocks to T.Bond rates, and include dividend and cash yields in my comparison:

      Download raw data on yields and interest rates
      In short, if your complaint is that earnings yields are low, relative to their historic norms, you are right, but they are high relative to treasury rates today. To those who would look to real estate, a reality check is that securitization of real estate has made its behavior much closer to financial markets than has been historically true, as can be seen when you graph capitalization rates (a measure of required return for real estate equity) against equity and bond rates. 

      Bubble Argument 3: The market is up, but the gains have come from a few big companies
      In a version of the glass half-empty argument, there are some who argue that while US stock market indices have been up strongly over the last decade, the gains have not been evenly spread. Specifically, a few companies, primarily in the technology space, have accounted for a big chunk of the gain in market capitalization over the period. There is some truth to this argument, as can be seen in the graph below, where I look at the FAANG (Facebook, Apple, Amazon, Netflix and Google/Alphabet) stocks and the S&P 500, in terms of total market capitalization:
      As you can see, the last decade has seen a phenomenal surge in the market capitalizations of the FAANG stocks, with the $3.15 trillion increase in their market capitalizations alone explaining more than one-sixth of the increase in market capitalization of the S&P 500. In the eyes of pessimists, that gives rise to two concerns, one relating to the past and one to the future. Looking back, they argue that many investors have been largely left out of the market rally, especially if their portfolios did not include any of the FAANG stocks. Looking forward, they posit that any weakness in the FAANG stocks, which they argue is largely overdue, as they face pressure on legal and regulatory fronts, will translate into weakness in the market.

      Counter Argument 3: The market reflects changes in how markets and economies work 
      The concentration of market gains in the hands of a few companies, at least at first sight, is troublesome but it is not new. There have been very few bull markets, where companies have shared equally in the gains, and it is more common than not for market gains to be concentrated in a small percentage of companies. That said, the degree of concentration is perhaps greater in this last bull run (from 2009 to 2019), but that concentration represents forces that are reshaping economies and markets. Each of the companies in the FAANG has disrupted existing businesses and grabbed market share from long-standing players in these businesses, and the nature of their offerings has given them networking benefits, i.e., the capacity to use their rising market share to grow even faster, rather than slower. It is this trend that has drawn the attention of regulators and governments, and it is possible, maybe even likely, that we will see anti-trust laws rewritten to restrain these companies from growing more or even breaking them up. While that would be bad news for investors in these companies, those rules are also likely to enrich some of the competition and push up their earnings and value. In short, a pullback in the FAANG stocks, driven by regulatory restrictions, is likely to have unpredictable effects on overall stock prices.

      Bubble Argument 4: Central banks, around the world, have conspired to keep interest rates low and push up the price of financial assets (artificially) 
      As you can see in the earlier graph comparing earnings to price rates to treasury bond rates, interest rates on government bonds have dropped to historic lows in the last decade. That is true not just in the US, but across developed markets, with 10-year Euro, Swiss franc and Japanese Yen bond rates crossing the zero threshold to become negative.
      If you buy into the proposition that central banks set these rates, it is easy to then continue down this road and argue that what we have seen in the last decade is a central banking conspiracy to keep rates low, partly to bring moribund economies back to life, but more to prop up stock and bond prices. The end game in this story is that central banks eventually will be forced to face reality, interest rates will rise to normal levels and stock prices will collapse. 

      Counter Argument 4: Interest rates are low, but central bankers have had only a secondary role
      Conspiracy theories are always difficult to confront, but at the heart of this one is the belief that central banks set interest rates, not just influence them at the margin. But is that true? To answer that question, I will fall back on a simple measure of what I call an intrinsic risk free rate, constructed by adding the inflation rate to the real growth rate, drawing on the belief that interest rates should reflect expected inflation (rising with inflation) and real interest rates (related directly to real growth).
      Download raw data on interest rates, inflation and growth
      Looking back over the last decade, it is low inflation and anemic economic growth that have been driving interest rates lower, not a central banking cabal. It is true that at the start of October 2019, the gap between the ten-year treasury bond rate and the intrinsic risk free rate is higher than it has been in a long time, suggesting that either Jerome Powell is a more powerful central banker than his predecessors or, more likely, that the bond market is building in expectations of lower inflation and growth.

      Implied Equity Risk Premiums: A Composite Indicator
      Did you think I would have an entire post on stock markets, without taking a dive into implied equity risk premiums? Unlike PE ratios that focus just on stock prices or treasury bond rates that focus just on the alternative to stocks, the implied equity risk premium is a composite number that is a function of how stocks are priced, given cash flows and expected growth in earnings, as well as treasury bond rates. In my monthly updates for the S&P 500, I compute and report this number and as of October 1, 2019, here is what it looked like:
      Download spreadsheet

      The equity risk premium for the S&P 500 on October 1, 2019, was 5.55%, and by itself, you may not know what to do with this number, but the graph below shows how this number has changed between 2009 and 2019:
      Download historical ERP
      There are two uses for this number. First, it becomes the price of equity risk in my company valuations, allowing me to maintain market neutrality when valuing WeWork, Tesla or Kraft-Heinz. In fact, the valuations that I will do in October 2019 will use an equity risk premium of 5.55% (the implied premium on October 1, 2019, for the S&P 500) as my mature market premium. Second, though I have confessed to being a terrible market timer, the implied ERP has become my divining rod for overall market pricing. An unduly low number, like the 2% that I computed at the end of 1999 for the S&P 500, would represent market over-pricing and a really high number, such as the 6.5% that you saw at the start of 2009, would be a sign of market under-pricing. At 5.55%, I am at the high end of the range, not the low end, and that backs up the case that given treasury rates, earnings and cash flows today, stock prices are not unduly high.

      My Market View (or non-view)
      I am neither bullish nor bearish, just market-neutral. In other words, my investment philosophy is built on valuing individual companies, not taking a view on the market, and I will take the market as a given in my valuation.  Does this mean that I am sanguine about the future prospects of equities? Not in the least! With equities, it is worth remembering that the coast is never clear, and that the reason we get the equity risk premiums that I estimated in the last section is because the future can deliver unpleasant surprises. I can see at least two ways in which a large market correction an unfold.

      An Implosion in Fundamentals
      Note that my comfort with equities stems from the equity risk premium being 5.55%, but that number is built on solid cash flows, a very low but still positive growth in earnings and low interest rates. While the number is robust enough to withstand a shock to one of these inputs, a combination that puts all three inputs at risk would cause the implied ERP to collapse and stock pricing red flags to show up. In this scenario, you would need all of the following to fall into place:
      1. Slow or negative global economic growth: The global economic slowdown picks up speed, spreads to the US and become a full-fledged recession.
      2. Cash flow pullback: This recession in conjunction causes earnings at companies to drop and companies to drastically reduce stock buybacks, as their confidence about the future is shaken.
      3. T. Bond rates start to move back up towards normal levels: Higher inflation and less credible central banks cause rates to move back up from historic lows to more "normal" levels.
      I can make an argument for one, perhaps even two of these developments, occurring together, but a scenario where all three things happen is implausible. In short, if economic growth collapses, I see it as unlikely that interest rates will rise.

      A Global Crisis with systemic after shocks
      There is no denying that there are multiple potential crises unfolding around the world, and one of these crises may be large enough, in terms of global and cross sector consequences, to cause a major market pull back. It is unclear what exactly equity markets are pricing in right now, but the triggering mechanism for the meltdown will be an "unexpected" crisis development, leading equity risk premiums to jump to higher levels, as investors reassess market-wide risk. For the crisis to have sustained consequences, it has to then feed into economic growth, perhaps through a drop in consumer and business confidence, and also into earnings and cash flows. After a decade of false alarms, investors are jaded, but the crisis calendar is full for the next two months, as Brexit, impeachment, Middle East turmoil and the trade war will all play out, almost on a daily basis.

      Bottom Line
      I am not a macroeconomic forecaster, and I am going to pass on market timing, accept the fact that the markets of today are globally interconnected and more volatile than the markets of the last century, and stick to picking stocks. I hope that my choice of companies will provide at least partial protection in a market correction, but I know that if the market is down strongly, my stocks will be, as well. I know that some of you will disagree strongly with my market views, and I will not try to talk you out of them, since it is your money that you are investing, not mine, and your skills at market/macro forecasting may be much stronger than mine. If you are a master macroeconomic forecaster who believes that a perfect storm is coming where there is a global recession with a drop in earnings and a loss or corporate confidence (leading to a pull back on buybacks), perhaps accompanied by high inflation and high interest rates, you definitely should cash out, though I cannot think of a place for that cash to go, right now.

      YouTube Video

      Linked Datasets
      1. PE ratios for the S&P 500
      2. Stock Yields and Interest Rates: US
      3. Intrinsic Riskfree versus 10-year T.Bond Rate 
      4. Historical Implied Equity Risk Premiums: US



      Regime Change and Value: A Follow up Post on Aramco

      In my post from a couple of days ago, I valued Aramco at about $1.65 trillion, but I qualified that valuation by noting that this was the value before adjusting for regime change concerns. That comment seems to have been lost in the reading, and it is perhaps because (a) I made it at the end of the valuation and (b) because the adjustment I made for it seemed completely arbitrary, knocking off about 10% off the value. Since this is a issue that is increasingly relevant in a world, where political disruptions seem to be the order of the day in many parts of the world, I thought that a post dedicated to just regime changes and how they affect value might be in order, and Aramco would offer an exceptionally good lab experiment.

      Going Concern and Truncation Risks
      Risk is part and parcel of investing. That said, risk came come from many sources and not all risk is created equal, to investors. In fact, modern finance was born from the insight that for a diversified investor, it is only risk that you cannot diversify away, i.e., macroeconomic risk exposure, that affects value. In this section, I want to examine another stratification of risk into going concern and truncation risk that is talked about much less, but could matter even more to value.

      DCF Valuation: A Going Concern Judgment
      The intrinsic value of a company has always been a function of its expected cash flows, its growth and how risky the cash flows are, but in recent decades a combination of access to data and baby steps in bringing economic models into valuation has resulted in the development of discounted cashflow valuation as a tool to estimate intrinsic value. Put simply, the discounted cash flow value of an asset is:

      Extended to a publicly traded company, with a potential life in perpetuity, this value can be written as:

      If you are a reader of my posts, it should come as no mystery to you that I not only use DCF models to value companies, but that I believe that people under estimate how adaptable it is, usable in valuing everything from start ups to infrastructure projects.  There is, however, one significant limitation with DCF models that neither its proponents nor its critics seem be aware of, and it needs to be addressed. Specifically, a DCF is an approach for valuing going concerns, and every aspect of it is built around that presumption. Thus, you estimate expected cash flows each year for the firm, as a going concern, and your discount rate reflects the risk that you see in the company as a going concern. In fact, it is this going concern assumption that allows us to assume that cash flows continue for the long term, sometimes forever, and attach a terminal value to these cash flows.

      Truncation Risks
      If you accept the premise that a DCF is a going concern value, you are probably wondering what other risks there may be in investing that are being missed in a DCF valuation. The risks that I believe are either ignored or incorrectly incorporated into value are truncation risks. The simplest way of illustrating the difference between going concern and truncation risks is by picking a year in your cash flow estimation, say year 3. With going concern risk, you are worried about the actual cash flows in year 3 being different from your expectations, but with truncation risk, you are worried about whether there will be a year 3 for your company. 

      So, what types of risk will fall into the truncation risk category? Looking at the corporate life cycle, you will see truncation risk become not just significant, but is perhaps the dominant risk that you worry about, age both ends of the life cycle. With start ups and young companies, it is survival risk that is front and center, given that approximately two thirds of start ups never make it to becoming viable businesses. With declining and aging companies, especially laden with debt, it is distress risk, where the company unable to meet its contractual obligations, shutters its doors and liquidates it assets. Looking at political risk, truncation risk can come in many forms, starting with nationalization risk, where a government takes over your business and pays you nothing in some cases and less than fair value in the rest, but extending to other expropriation risks, where you still are allowed to hold equity, but in a much less valuable concern.

      Since truncation risk is more the rule than the exception, and it is the dominant risk in some companies, you would think that investors and analysts valuing these companies will have devised sensible ways of incorporating the risk, but you would be wrong.
      • The most common approach to dealing with truncation risk is for analysts to hike up the discount rate, using the alluring argument that if there is more risk, you would demand a higher return. The problem, though, is that this higher discount rate still goes into a DCF where expected cash flows continue in perpetuity, creating an internal contradiction, where you increase the discount rate for truncation risk but you do nothing to the cash flows. In addition, the discount rate that these analysts use are made up, higher just for the sake of being higher, with no rationale for the adjustment. With venture capitalists, this shows up as absurdly high target rates of 40%, 50% or 60%, fiction in a world where these VCs actually deliver returns closer to 15-20%. Discount rates are blunt instruments and are incapable of carrying the burden of truncation risk, and should not be made to do so.
      • Some analysts take the more sensible approach of scenario analysis, allowing for good and bad scenarios (including failure or nationalization) but never close the loop by attaching probabilities to the scenarios. Instead, they leave behind ranges for the value that are so wide as to be useless for decision making purposes. 
      My suggestion is that you use a decision tree approach, where you not only allow for different scenarios, but you make these scenarios cover all possibilities and then attach a probability to each one. In the case of a start up, then, your two possible outcomes will be that the company will make it as a going concern and that it will not, and you will follow through with a DCF, with a going concern discount rate, yielding the value for the going concern outcome, and a liquidation providing your judgment for what the company will be worth, in the failure scenario:

      Since you have probabilities for each outcome, you can compute an expected value. If you do this, you should expect to see discount rates for companies prone to failure (young start ups and declining firms) be drawn from the same distribution as that for healthy companies, but the adjustment for failure will be in the post-DCF adjustments. Put more simply, you should see 12-15% as costs of capital for even the riskiest start-ups, in a DCF, never 40-50%, but your post value adjustments for failure and its consequences will still take their toll.

      The Aramco Valuation: Bringing in Truncation Risk 
      In my last post, I valued Aramco in a DCF, using three measures of cash flows from dividends to potential dividends to free cash flows to the firm and arrived at values that were surprisingly close to each other, centered around $1.65 trillion, for the equity. Note, though, that these are going concern values, and reflect the expectation that while there may be year to year changes in cash flows, as oil prices changes, management recalibrate and the government tweaks tax and royalty rates, the company will be a going concern and that it will not suffer catastrophic damage to its core asset of low-cost oil reserves. For many investors in Aramco, the prime concern may be less on these fronts and more on whether the House of Saud, as the backer of the promises that Aramco is making its investors, will survive intact for the next few decades.

      DCF Valuation: Going Concern Risk
      Reviewing my discounted cash flow valuations of Aramco, you will notice that I began with a risk free rate in US dollars, because my currency choice was that currency. I then adjusted for risk, using a beta for Aramco, based upon REITs/royalty trusts for the promised dividend model and integrated oil companies for the potential dividends/free cash flow models, and an equity risk premium for Saudi Arabia of only 6.23%, with a country risk premium of 0.79% estimated for the country added to the mature market premium estimated for the US. The end result is that I had costs of equity ranging from 4.82% for promised dividends to 8.15% for cash flows.

      The biggest push back I have had on my valuations is that the cost of equity seems low for a country like Saudi Arabia, and my response is that you are right, if you consider all of the risk in investing in a Saudi equity. However, much of the risk that you are contemplating in Saudi Arabia is political risk, or put more bluntly, the risk of regime change in the country, that could have dramatic effects on value. In fact, if you remove that risk from consideration and look at the remaining risk, Aramco is a remarkably safe investment, with the safety coming from its access to huge oil reserves and mind-boggling profits and cash flows. The DCF values that I have estimated, centered around $1.65 trillion, are therefore values before adjusting for the risk of regime change.

      Regime Change Concerns
      If you invest in Aramco, you clearly have an interests in who rules and runs the country, since every aspect of your valuation is dependent on that assumption. If the House of Saud continues to rule, I believe that the company will be the cash cow that I project it to be in my DCF and the values that I estimated hold. If the Arab spring comes to Riyadh and there is a regime change, the foundations of my value can either crack or be completely swept away, with cash flows, growth and risk all up for re-estimation. In fact, to complete my valuation, I need to bring both the probability of regime change and the consequences into my final valuation:

      Consider the most extreme case. If you believe that regime change in imminent and certain, and that the change will be extreme (with equity being expropriated and Aramco being brought back entirely into the hands of the state), my expected value for equity becomes zero:

      If at the other extreme, you either believe that regime change will never happen, or even if it does, the new regime will not want to hurt the goose that lays the golden eggs and leaves existing terms in place, the value effect of considering regime change will be zero. The truth lies between the extremes, though where it lies is open for debate. I believe that there remains a non-trivial chance (perhaps as high as 20%) that there will be a regime change over the long term and that if there is one, there will be changes that reduce, but not extinguish, my claim, as an equity investor, on the cash flows. 

      That, in an entirely subjective nutshell, is why I think Aramco's equity value is closer to $1.5 trillion than $1.7 trillion.  As with all my other valuations, I understand that your judgments on Aramco will be different from mine, but I think that the disagreements we have are not so much on the going concern estimates of cash flows and risk but on the likelihood and consequences of regime change. 

      Democracies versus Autocracies
      I am not a political scientist, but I have always been fascinated by the question of how political structure and economic value are intertwined. Specifically, would you attach more value to a company or project operating in a democracy or in an autocracy? The approach that I have described in this post to deal with going concern and regime change risk allows me one way of trying too answer the question. 
      • Democracies are messy institutions, where governments change and policies morph, because voters change their minds. Put simply, a democracy generally cannot offer any business iron clad guarantees about regulations not changing or tax rates remaining stable, because the government that offers those promises first has to get them approved by legislatures, often can be checked by legal institutions and, most critically, can be voted out of office. Consequently, companies operating in democracies will always complain more about the rules constantly changing, and how those changing rules affect cash flows, growth and risk. 
      • Autocracies offer more stability, since autocrats don't have to get policies approved by legislators, often are unchecked by legal institutions and don't have to worry about how their decision poll with voters. Companies operating in autocracies can be promise rules that are fixed, regulations that don't change and tax rates that will stay constant. The catch, though, is that autocracies seldom transition smoothly, and when change comes, it is often unexpected and wrenching.
      In valuation terms, democracies create more going concern risk and autocracies create more worries about regime change. The former will show up as higher discount rates in a DCF valuation and the latter as post-DCF adjustments. While I prefer democracies to autocracies, there is no way, a priori, that you can argue that democracies are always better than autocracies or vice versa, at least when it comes to value, and here is why:
      • The going concern risk that is added by being in a democracy will depend on how the democracy works. If you have a democracy, where the opposing parties tend to agree on basic economic principles and disagree on the margins, the going concern risk added will be small. In the United States, in the second half of the last century, both parties (Republicans and Democrats) agreed on the fundamentals of the economy, though one party may have been more favorable on some issues, for business, and less favorable on other issues. In contrast, if you have a democracy, where governments are unstable and the opposing parties have widely different views on the very fundamentals of how an economy should be structured, the effect on going concern risk will be much higher. 
      • The regime change risk in an autocracy will vary in how the autocracy is structured and how transitions happen. Autocracies structured around a person are inherently more unstable than autocracies built around a party or ideology, and transitions are more likely to be violent if the military is involved in regime change, in either direction. In addition, violent regime changes feed on themselves, with memories of past violent meted out to a group driving the violence that it metes out, when its turn comes.
      In summary, when you are trying to decide on whether a business is worth more in a democracy than in a dictatorship, you are being asked to trade off more continuous, going concern risk in the former for the more stable environment of the latter, but with more discontinuous risk. I have deliberately stayed away from using specific country examples in this section, because this argument is more emotion than intellect, but you can fill your own contrasts of countries, and make your own judgments. 

      Conclusion
      I have often described valuation as a craft, where mastery is an elusive goal and the key to getting better is working at doing more valuation. I am glad that I valued Aramco, because it is an unconventional investment, a company where I have to worry more about political risks than economic ones. The techniques I develop on Aramco will serve me well, not only when I value Latin American companies, as that continent seems to be entering one of its phases of disquiet, but when I value developed market companies, as Europe and the US seem to be developing emerging market traits.

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      1. A coming out party for an Oil Colossus: Aramco's IPO
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      A coming out party for the world's most valuable company: Aramco's long awaited IPO!

      In a year full of interesting initial public offerings, many of which I have looked at in this blog, it is fitting that the last IPO I value this year will be the most unique, a company that after its offering is likely to be the most valuable company in the world, the instant it is listed. I am talking about Aramco, the Saudi Arabian oil colossus, which after many false starts, filed a prospectus on November 10 and that document, a behemoth weighing in at 658 pages, has triggered the listing clock.

      Aramco: History and Set Up
      Aramco’s beginnings trace back to 1933, when Standard Oil of California discovered oil in the desert sands of Saudi Arabia. Shortly thereafter, Texaco and Chevron formed the Arabian American Oil Company (Aramco) to develop oil fields in the country and the company also built the Trans-Arabian pipeline to deliver oil to the Mediterranean Sea. In 1960, the oil producing countries, then primarily concentrated in the Middle East, created OPEC and in the early 1970s, the price of oil rose rapidly, almost quadrupling in 1973. The Saudi Government which had been gradually buying Aramco’s assets, nationalized the company in 1980 and effectively gave it full power over all Saudi reserves and production. The company was renamed Saudi Aramco in 1988.

      To understand why Aramco has a shot at becoming the most valuable company in the world, all you have to do is look at its oil reserves. In 2018, it was estimated that Aramco had in excess of 330 billion barrels of oil and gas in its reserves, a quarter of all of the world’s reserves, and almost ten times those of Exxon Mobil, the current leader in market cap, among oil companies. To add to the allure, oil in Saudi Arabia is close to the surface and cheap to extract, making it the most profitable place on oil to own reserves, with production costs low enough to break even at $20-$25 a barrel, well below the $40-$50 break even price that many other conventional oil producers face, and even further below the new entrants into the game. This edge in both quantity and costs plays out in the numbers, and Aramco produced 13.6 million barrels of oil & gas every day in 2018, and reported revenues of $355 billion for the year, on which it generated operating income of $212 billion and net income of $111 billion. In short, if your complaint about the IPOs that you saw this year was that they had little to show in terms of revenues and did not have money-making business models, this company is your antidote.

      Aramco, Saudi Arabia and the House of Saud!
      The numbers that are laid out in the annual report are impressive, painting a picture of the most profitable company in the world, with almost unassailable competitive advantages, investors need to be clear that even after its listing, Aramco will not be a conventional company, and in fact, it will never be one. The reason is simple. Saudi Arabia is one of the wealthier countries in the world, on a per capital basis, and one of the 20 largest economies, in terms of GDP, but it derives almost 80% of that GDP from oil. Thus, a company that controls those oil spigots is a stand in for the entire country, and over the last few decades, it should not surprise you to learn that the Saudi budget has been largely dependent on the cash flows it collects from Aramco, in royalties and taxes, and that Aramco has also invested extensively in social service projects all over the country. The overlap between company and country becomes even trickier when you bring in the Saudi royal family, and its close to absolute control of the country, which also means that Aramco’s fortunes are tied to the royal family’s fortunes. It is true that there will still be oil under the ground, even if there is a change in regime in Saudi Arabia, but the terms laid out in the prospectus reflect the royal family’s promises and may very well be revisited if control changed. Should this overlap between company, country and family have an effect on how you view Aramco? I don’t see how it cannot and it will play out in many dimensions:
      1. Corporate governance: After the IPO, the company will have all the trappings of a publicly traded company, from a board of directors to annual meetings to the rituals of financial disclosure. These formalities, though, should not obscure the fact that there is no way that this company can or ever will be controlled by shareholders. The Saudi government is open about this, stating in its prospectus that “the Government will continue to own a controlling interest in the Company after the Offering and will be able to control matters requiring shareholder approval. The Government will have veto power with respect to any shareholder action or approval requiring a majority vote, except where it is required by relevant rules for the government.” While one reason is that the majority control will remain with the government, it is that it would be difficult to visualize and perhaps to dangerous to even consider allowing a company that is a proxy for the country to be exposed to corporate control costs. After all, a hostile acquisition of the company would then be the equivalent of an invasion of the country. The bottom line is that if you invest in Aramco, you should recognize that you are more capital provider than shareholder and that you will have little or no say in corporate decision making.
      2. Country risk: Aramco has a few holdings and joint ventures outside Saudi Arabia, but this company is not only almost entirely dependent on Saudi Arabia but its corporate mission will keep it so. Put differently, a conventional oil company that finds itself overdependent on a specific country for its production can try to reduce this risk by exploring for oil or buying reserves in other countries, but Aramco will be limited in doing this, because of its national status.
      3. Political risk: For decades, the Middle East has had more than its fair share of turmoil, terrorism and war, and while Saudi Arabia has been a relatively untouched part, it too is being drawn into the problem. The drone attack on its facilities in Shaybah in August 2019, which not only caused a 54% reduction in oil production, but also cost billions of dollars to the company was just a reminder of how difficult it is to try to be oasis. On an even larger scale, the last decade has seen regime changes in many countries in the Middle East, with some occurring in countries, where the ruling class was viewed as insulated. The Saudi political order seems settled for the moment, with the royal family firmly in control, but that too can change, and quickly.
      In short, this is not a conventional company, where shareholders gather at annual meetings, elect boards of directors and the corporate mission is to do whatever is necessary to increase shareholder well being, and it never will be one. For some, that feature alone may be sufficient to take the company off their potential investment list. For others, it will be something that needs to be factored into the pricing and value, but at the right price or value, presumably with a discount built in for the country and political risk overlay, the company can still be a good investment.

      IPO Twists
      Before we price and value Aramco, there are a few twists to this IPO that should be clarified, since they may affect how much you are willing to pay. The prospectus, filed on November 10, sheds some light:
      1. Dividends: In the ending on September 30, 2019, Aramco paid out an ordinary dividend of $13.4 billion, entirely to the Saudi Government, and it plans to pay an additional interim dividend of at least $9.5 billion to the government, prior to the offering. The company commits to paying at least $75 billion in dividends in 2020, with holders of shares issued in the IPO getting their share, and to maintaining these dividends through 2024. Beyond 2024, dividends will revert back to their normal discretionary status, with the board of directors determining the appropriate amount. As an aside, the dividends to non-government shareholders will be paid in Saudi Riyal and to the government in US dollars.
      2. IPO Proceeds: The prospectus does not specify how many shares will be offered in the initial offering, but it is not expected to be more than a couple of percent of the company. None of the proceeds from the IPO will remain in Aramco. The government will redirect the proceeds elsewhere, in pursuit of its policy of making Saudi Arabia into an economy less dependent on oil.
      3. Trading constraints: Once the offering is complete, the shares will be listed on the Saudi stock exchange and its size will make it the dominant listing overnight, while also subjecting it to the trading restrictions of the exchange, including a limit of a 10% movement in the stock price in a day; trading will be stopped if it hits this limit.
      4. Inducements for Saudi domestic investors: In an attempt to get more domestic investors to hold the stock, the Saudi government will give one bonus share, for every ten shares bought and held for six months, by a Saudi investor, with a cap at a hundred bonus shares.
      5. Royalties & Taxes: In my view, it is this detail that has been responsible for the delay in the IPO process and it is easy to see why. For all of its life, Aramco has been the cash machine that keeps Saudi Arabia running, and the cash flows extracted from the company, whether they were titled royalties, taxes or dividends, were driven by Saudi budget considerations, rather than corporate interests. Investors were wary of buying into a company, where the tax rate and the royalties were fuzzy or unspecified and the prospectus lays out the following. First,  the corporate tax rate will be 20% on downstream taxable income, though tax rates on different income streams can be different. The Saudi government also imposes a Zakat, a levy of 2.5% on assessed income, thus augmenting the tax rate. In sum, these tax rate changes were already in effect in 2018, and the company paid almost 48% of its taxable income in taxes that year. Second, the royalties on oil were reset ahead of the IPO and will vary, depending on the oil price, starting at 15% if oil prices are less than $70/barrel, increasing to 45% of the incremental amount, if they fall between $70 and $100, and becoming 80%, if the oil price exceeds $100/barrel.
      A Pricing of Aramco
      The initial attempts by the Saudi government to take Aramco public, as long as two years ago, came with an expectation that the company would be “valued” at $2 trillion or more. Since the IPO announcement a few weeks ago, much has been made about the fact that there seem to be wide divergences in how much bankers seem to think Aramco is worth, with numbers ranging from $1.2 billion to $2.3 trillion. Before we take a deep dive into how the initial assessments of value were made and why there might be differences, I think that we should be clear eyed about these numbers. Most of these numbers are not valuations, based upon an assessment of business models, risk and profitability, but instead represent pricing of Aramco, where assessment of price being made by looking at how the market is pricing publicly traded oil companies, relative to a metric, and extending that to Aramco, adjusting (subjectively) for its unique set up in terms of corporate governance, country risk and political risk. In the table below, I look at integrated oil companies, with market caps in excess of $10 billion, in October 2019, and how the market is pricing them relative to a range of metrics, from barrels of oil in reserve, to oil produced, to more conventional financial measures (revenues, earnings, cash flows):

      Download spreadsheet
      The median oil company equity trades at about 13 times earnings, and was a business, at about the value of its annual revenues, and the market seems to be paying about $23 for every barrel of proven reserves of oil (or equivalent). In the table below, I have priced Aramco, using all of the metrics, and at the median and both the first and third quartiles:

      You can already see that if you are looking at how to price Aramco, the metric on which you base it on will make a very large difference: 
      • If you price Aramco based on its revenues of $356 billion or on its book value of equity of $271 billion, its value looks comparable or slightly higher than the value of Exxon Mobil and Royal Dutch, the largest of the integrated oil companies. 
      • That pricing, though, is missing Aramco’s immense cost advantage, which allows it to generate much higher earnings from the same revenues. Thus, when you base the pricing on Aramco’s EBITDA of $224 billion, you can see the pricing rise to above a trillion and if you shift to Aramco’s net income of $111 billion, the pricing approaches $1.5 trillion. 
      • The pricing is highest when you focus on Aramco’s most valuable edge, its control of the Saudi oil reserves and its capacity to produce more oil than any other oil company in the world. If you base the pricing on the 10.3 billion barrels of oil that Aramco produced in 2018, Aramco should be priced above $1.5 trillion and perhaps even closer to $2 trillion. If you base the pricing on the 265.9 billion barrels of proven reserves that Aramco controls for the next 40 years, Aramco’s pricing rises to sky high levels.
      If you are a potential investor, the pricing range in this table may seem so large, as to make it useless, but it can still provide some useful guidelines. First, you should not be surprised to see the roadshows center on Aramco’s strongest suits, using its huge net income (and PE ratios) as the opening argument to set a base for its pricing, and then using its reserves as a reason to augment that pricing. Second, there is a huge discount on the pricing, if just reserves are used as the basis for pricing, but there are two good reasons why that high pricing will be a reach:
      • Production limits: Aramco not only does not own its reserves in perpetuity, with the rights reverting back to the Saudi government after 40 years, with the possibility of a 20-year extension, if the government decides to grant it, but it is also restricted in how much oil it can extract from those reserves to a maximum of 12 billion barrels a year.
      • Governance and Risk: We noted, earlier, that Aramco’s flaws: the government’s absolute control of it, the country risk created by its dependence on domestic production and the political risk emanating from the possibility of regime change. To see how this can affect pricing, consider how the five companies on the integrated oil peer group that are Russian (with Gazprom, Rosneft and Lukoil being the biggest) are priced, relative to the global average:
      Russian oil companies are discounted by 50% or more, relative to their peer group, and while Saudi Arabia does not have the same degree of exposure, the market will mete out some punishment.

      A Valuation of Aramco
      The value of Aramco, like that of any company in any sector, is a function of its cash flows, growth and risk. In fact, the story that underlies the Aramco valuation is that of a mature company, with large cash flows and concentrated country risk. That said, the structuring of the company and the desire of the Saudi government to use its cash flows to diversify the economy play a role in value. 

      General Assumptions
      While I will offer three different approaches to valuing Aramco, they will all be built on a few common components.

      • First, I will do my valuation in US dollars, rather than Saudi Riyals, since as a commodity company, revenues are in dollars and the company reports its financials in US dollars (as well as Riyal). This will also allow me to evade tricky issues related to the Saudi Riyal being pegged to the US dollar though the reverberations from the peg unraveling will be felt in the operating numbers. 
      • Second, I will use an expected inflation rate of 1.00% in US dollars, representing a rough approximation of the difference between the US treasury bond rate and the US TIPs rate. Third, I will use the equity risk premium of 6.23% for Saudi Arabia, representing about a 0.79% premium over my estimate of a mature market premium of 5.44% at the start of November 2019. 
      • Finally, rather than use the standard perpetual growth model, where cash flows continue forever, I will use a 50-year growth period, representing the fact that the company's primary asset, its oil reserves, are not infinite and will run out at some point in time, even if additional reserves are discovered. In fact, at the current production level, the existing reserves will be exhausted in about 35 years.

      Valuation: Promised Dividends
      While the dividend discount model is far too restrictive in its assumptions about payout to be used to value most companies, Aramco may be the exception, especially given the promise in the prospectus to pay out at least $75 billion in dividends every year from 2020 and 2024, and the expectation that these dividends will continue and grow after that. There is one additional factor that makes Aramco a good candidate for the dividend discount model and that is the absolute powerlessness that stockholders will have at the company to change how much it returns to shareholders. To complete my valuation of Aramco using the promised dividends, I will make two additional assumptions:

      1. Growth rate: I will assume a long term growth rate in dividends set equal the inflation rate, and since this valuation is in US dollars, that inflation rate will be 1%.
      2. Discount rate: Rather than use a discount rate reflecting the risk of an oil company, I will be one that is closer to that demanded by investors in REITs and oil royalty trusts, investments where the bulk of the returns will be in dividends and those dividends are backed up by asset cash flows.
      The valuation picture is below:
      Download spreadsheet
      Based upon my assumptions, the value of Aramco is about $1.63 trillion. Seen through these lens, this stock is a dressed-up bond, where dividends will remain the primary form of return and there will be little price appreciation.

      Valuation: Potential Dividends
      The reason that dividend discount models often fail is because they look at the actual dividends paid and don’t factor in the reality that some companies pay out more than they can afford to do in dividends, in which case they are unsustainable and will fall under that weight, and some companies pay too little, in which case the cash that is paid out accumulates in the firm as a cash balance, and equity investors get a stake in it. While I noted that Aramco has signaled that it will pay at least $75 billion in dividends over the next five years, it has not indicated that it will cease investing and with potential dividends, you value the company based upon its capacity to pay dividends, rather than actual dividends.  In computing the potential dividends, I assumed that the company would be able to grow earnings at 1.80% a year, and be able to do so by continuing to generate sky high returns on equity (its 2018 return on equity was about 41%). However, the shift from promised dividends to potential dividends will also expose investors to more of the risk in an integrated oil company and I adjust the cost of equity accordingly:
      Download spreadsheet
      The value of equity, using potential dividends, is $1.65 trillion, reflecting not only Aramco’s capacity to pay much higher dividends than promised but also the higher risk in these cash flows.

      Valuation: As a Business
      When you value a business, you effectively allow for the options that the firm has to make changes to how much and where it invests, how it finances it business and how much it pays in dividends. One reason that this may provide only limited benefits in the Aramco case is that the company is significantly constrained, both because of its ownership and governance structure as well as its mission, on all three dimensions. Thus, it is likely that Aramco will remain predominantly a fossil fuel company, tethered to its roots in Saudi Arabia, is unlikely to alter its policy of being predominantly equity funded and its dividend policy is sticky even at as it starts life as a public company.  Following through with these assumptions, I assumed that the debt ratio for Aramco will stay low at 1.80% of overall capital, as will the cost of debt at 2.70%, in US dollar terms, based upon its bond rating. To get the reinvestment, I switch to using the return on capital of 44.61% that the company generated in 2018, as my base:
      Download spreadsheet
      Adding the cash and cross holdings and then subtracting out the debt and minority interests in the company yields an equity value of $1.67 trillion, that is close to what we obtained with the FCFE model, but that should not be surprising, given that the company has so little debt in its capital structure.

      Final Valuation Adjustments
      In summary, what is surprising about the valuations of Aramco, using the three approaches, is how close they are in their final assessments, all yielding values around $1.65 trillion. That said, there are three additional considerations that none of these models have factored in.

      1. Political Risk: While these models adjust for country risk in Saudi Arabia, I have used the default spread of the country as a proxy, but that misses the risk of regime change, a discontinuous risk that will have very large and potentially catastrophic effects on value. While you may believe that this risk is low, it is definitely not zero. 
      2. Upside limits: When you invest in any large integrated oil company, you are making a bet on oil prices, with the expectation that higher oil prices will deliver higher income and higher value. While that assumption still holds for Aramco, the royalty structure that the Saudi government has created, where the royalty rate will climb from 40% at current oil prices to 45% if they rise above $ 70 and 80% if they rise above $100/barrel will mean that your share of gains, as an equity investor, on the upside will be capped, dampening the value today.
      3. Price setter/taker: While the largest publicly traded oil companies in the world are still price takers, Aramco has more influence on the oil price than any of them, as a result of Saudi Arabia's role in the oil market. Put simply, while the power of the Saudi government to set oil prices has decreased from the 1970s, it does continue to wield more influence than any other entity in this process.
      The first two factors are clear negatives and should lead you to mark down the value of Aramco, but  the third factor may help provide some downside protection. Overall, I would expect the value of equity in Aramco to be closer to $1.5 trillion, after these adjustments are made. (I am assuming a small chance of regime change, but if you attach a much higher probability, the drop off in value will be much higher).

      Aramco: To invest or not to?
      Over the weekend, we got a little more clarity on the IPO details, with a rumored pricing of $1.7 trillion for the company's equity and a planned offering of 1.5% of the outstanding shares. That price is within shouting distance of my valuation, and my guess is that given the small size of the offering (at least on a percentage basis), it will attract enough investors to be fully subscribed. At this pricing, I think that the company will be more attractive to domestic than international investors, with Saudi investors, in particular, induced to invest by the company's standing in the country. It will be a solid investment, as long as investors recognize what they are getting is more bond than stock, with dividends representing the primary return and limited price appreciation. They will have no say in how the company is run, and if they don't like the way it is run, they will have to vote with their feet. If they are worried about risk, the research they should do is more political than economic, with the primary concerns about regime stability. The one concern that you should have, if you are a Saudi investor, with your human capital and real estate already tied to Saudi Arabia's (and oil's) well being, investing your wealth in Aramco will be doubling down on that dependence.

      In case you care about my investment judgment, Aramco is not a stock for me for two reasons. First, I am lucky enough not to be dependent on cash flows from my investment portfolio to meet personal liquidity needs, and have no desire to receive large dividends, just for the sake of reaching them, since they just create concurrent tax burdens. Second, if I were tempted to invest in the company as a play on oil prices, the rising royalty rates, as oil prices go up, imply that my upside will be limited at Aramco.  Finally, it is worth noting that this company will be the ultimate politically incorrect investment, operating both as a long term bet on oil, in a world where people are as dependent as ever on fossil fuels, but seem to be repelled by those who produce it, and as a bet on Saudi royalty, an unpopular institution in many circles. As a consequence, I am willing to bet that not too many college endowments in the United States will be investing in Aramco, and even conventional fund managers may avoid the stock, just to minimize backlash. I don't much care for political correctness nor for investors who seem to believe that the primary purpose of investing is virtue signaling, and I must confess that I am tempted to buy Aramco just to see their heads explode. However, that would be both petty and self-defeating, and I will stay an observer on Aramco, rather than an investor.

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      The Softbank-WeWork End Game: Savior Economics or Sunk Cost Problem?

      Since my pre-IPO post on WeWork, where I valued the company ahead of its then imminent offering, much has happened. The company’s IPO collapsed under the weight of its own pricing contradictions, and after a near-death experience, Softbank emerged as the savior, investing an additional $ 8 billion in the company, and taking a much larger stake in its equity. As the WeWork story continues to unfold, I am finding myself more interested in Softbank than in WeWork, largely because its actions cut to the heart of so many questions in investing, from how sunk costs can affect investing decisions, to the feedback effects from mark-to-market accounting, and finally on the larger question of whether smart money is really smart or just lucky.

      WeWork: The IPO Aftermath

      It has been only a few weeks since I valued WeWork for its IPO, but it seems much longer, simply because of how much has changed since then. As a reminder, I valued WeWork at about $10 billion pre-money, and $13.75 billion with the anticipated proceeds of $3.5 billion added on. I also argued that this was a company on a knife’s edge, a growth machine with immense operating and financial leverage, where misstep could very quickly tip them into bankruptcy, with a table illustrating how quickly the equity slips into negative territory, if the operating assumptions change:
      Download spreadsheet
      Soon after my post, the ground shifted under WeWork, as a combination of arrogance (on the part of VCs, bankers and founders) and business model risks caught up with the company, and the IPO was delayed, albeit reluctantly by the company. That action, though, left the company in a cash crunch, since it had been counting on the IPO to bring in $3 billion in capital to cover its near-term needs. In conjunction with a loss of trust in the top management of the company, created a vicious cycle with the very real possibility that the company would implode. As WeWork sought rescue packages, Softbank offered a lifeline, with three components to it:
      1. Equity Buyout: A tender offer of $3 billion in equity to buy out of existing stockholders in the firm to increase its share of the equity ownership to 80%. In an odd twist, Softbank contended that, after the financing, “it will not hold a majority of the voting rights… and does not control the company… WeWork will not be a subsidiary of Softbank. WeWork will be an associate of Softbank”. I am not sure whether this is a true confession of lack of control or a ploy to keep from consolidating WeWork (and its debt load) into Softbank's financials.
      2. Added Capital: Softbank would provide fresh debt financing of $5 billion ($1.1 billion in secured notes, $2.2 billion in unsecured notes and $1.75 billion as a line of credit) and an acceleration of a $1.5 billion equity investment it had been planning to make into WeWork in 2020, giving WeWork respite, at least in the short term, from its cash constraints.
      3. Neutering Adam Neumann (at a cost): The offer also includes a severing of Adam Neumann’s leadership of the company, in return for which he will receive $1 billion in cash, $500 million as a loan to repay a JP Morgan credit line and $185 million for a four-year position as a consultant. I assume that the consulting fee is more akin to a restraining order, preventing him from coming within sighting distance of any WeWork office or building.
      Since that deal was put together, the storyline has shifted, with Softbank now playing the lead role in this morality play, with multiple questions emerging:
      1. What motivated Softbank to invest so much more in a company where it had already lost billions? Some are arguing that Softbank had no choice, given the magnitude of what they had invested in WeWork, and others are countering that they were throwing good money after bad. 
      2. With mark-to-market rules in effect at Softbank, how will accountants reflect the WeWork disaster on Softbank’s books? I think that fair-value accounting is neither fair nor is it about value, but the WeWork write down that Softbank had to take is a good time to discuss how fair-value accounting can have a feedback effect on corporate decision making.
      3. Is Masa Son a visionary genius or an egomaniac in need of checks and balances? A year ago, there were many who viewed Masa Son, with his 300-year plans and access to hundreds of billions of dollars in capital, was a man ahead of his time, epitomizing smart money. Today, the consensus view seems to be that he is an impulsive and emotional investor, not to be trusted in his investment judgments. The truth, as is often the case, lies somewhere in the middle.
      4. Since Softbank is a holding company, deriving a chunk of its value from its perceived ability to find start-ups and young companies and convert them into big wins, how will its value change as a result of its WeWork missteps? To answer this question, I will look at how Softbank’s market capitalization has changed over time, especially around the WeWork fiasco, and examine the consequences for its Vision fund plans.
      Sunk Cost or Corporate Rescue!

      In the years that WeWork was a private company, Softbank was, by far, the largest investor in the company. In August 2019, when the IPO was first announced, Softbank had not only been its largest capital provider, investing $7.5 billion in the company, but had also supplied the most recent round of capital, at a pricing of $47 billion. That lead-in, though, raises questions about the motives behind its decision to invest an extra $ 8 billion to keep WeWork afloat. 
      • It’s a corporate rescue: There are some who would argue that Softbank had no choice, since without an infusion of capital, WeWork was on a pathway to being worth nothing and that by investing its capital, Softbank would avoid that worst-case scenario. In fact, if you believe Softbank, with the infusion, WeWork has a pre-money value of $8 billion, with the infusion, and while that is a steep write down from the $47 billion pricing, it is still better than nothing. 
      • Good money chasing bad: The sunk cost principle, put simply, states that when you make an investment decision, your choice should be driven by its incremental effects and not by how much you have already expended leading up to that decision. In practice, though, investors seem to abandon this principle, trying to make up for past mistakes by making new ones. In the context of Softbank’s new WeWork investment, this would imply that Softbank is investing $ 8 billion in WeWork, not because it believes that it can generate more than that amount in incremental value from future cash flows, but because it had invested $7.5 billion in the past.
      So, how do you resolve this question? As I see it, the Softbank rescue of WeWork may have helped it avoid a near term liquidity meltdown, but it has not addressed any of the underlying issues that I noted with the company’s business model. In fact, it has taken a highly levered company whose only pathway to survival was exponential growth and made it an even more levered company with constrained growth. In fact, Softbank has been remarkably vague about the economic rationale for the added investment and their story does not hold up to scrutiny. I do realize that Masa Son claims that “(t)he logic is simple. Time will resolve . . . and we will see a sharp V-shaped recovery,” in WeWork, but I don’t see the logic, time alone cannot resolve a $30 billion debt problem and there are enough costs in non-core businesses to cut to yield a quick recovery. At least from my perspective, Softbank’s investment in WeWork is good money chasing bad, a classic example of how sunk costs can skew decisions. To those who would counter that Softbank has a lot of money to lose and smart people working for it, note that the more money you have to lose and the smarter people think they are, the more difficult it becomes to admit to past mistakes, exacerbating the sunk cost problem. In fact, now that Softbank will have more than $15 billion invested in WeWork, they have made the sunk cost problem worse, going forward.

      Accounting Fair Value

      I understand the allure of fair value accounting to accountants. It provides them with a way to update the balance sheet, to reflect real world changes and developments, and make it more useful to investors. The fact that it also creates employment for accountants all over the world is a bonus, at least from their perspective. I think that the accounting response to Softbank’s WeWork mistake illustrates why fair value accounting is an oxymoron, more likely to do damage than good:
      1. It is price accounting, not value accounting: In Softbank’s latest earnings report, we saw the first installment of accounting pain from the WeWork mistake, with Softbank writing down its WeWork investment by $4.6 billion and reporting a hefty loss for the quarter. The reason for the write-down, though, was not a reassessment of WeWork’s value, but a reaction to the drop in the pricing of the company’s equity from the $47 billion before the IPO to $8 billion after the IPO implosion. 
      2. With Softbank supplying the pricing: If you are dubious about the use of pricing in accounting revaluations, you should even more skeptical in this case, since Softbank was setting the pricing, at both the $47 billion pre-IPO, and the $8 billion, post-collapse. As I noted in the last section, there is nothing tangible that I can see in any of Softbank’s numerous press releases to back these numbers. In fact, if WeWork had not been exposed in its public offering, my guess is that Softbank would have probably invested more capital in the company, marked up the pricing to some number higher than $47 billion and that we would not be having this conversation.
      3. Too little, too late: As is always the case with accounting write-downs and impairments, there was very little news in the announcement. In fact, given that the write down was based upon pricing, not value, the market knew that a write off was coming and approximately how much the write off would be, which explains why even multi-billion write offs and impairments usually have no price effect, when announced. Incidentally, the accountants will offer you intrinsic valuations (DCF) to back up their assessments, but I would not attach to much weight to them, since they are what I call “kabuki valuations”, where the analysts decide, based on the pricing, what they would like to get as value, and then reverse engineer the inputs to deliver that number.
      4. With dangerous feedback effects: If all fair value accounting did was create these write downs and impairments that don’t faze investors, I could live with the consequences and treat the costs incurred in the process as a jobs plan for accountants. Unfortunately, companies still seem to think that these accounting charges are news that moves markets and take actions to minimize them. In fact, a cynic might argue that one motivation for Softbank’s rescue of WeWork was to minimize the write down from its mistake. 
      I am not a fan of fair value accounting, partly because it is a delayed reaction to a pricing change and is not a value reassessment, and partly because companies are often tempted to take costly actions to make their accounting numbers look better. 

      Smart Money, Stupid Money!

      I hope that this entire episode will put to rest the notion of smart money, i.e., that there are investors who have access to more information than we do, have better analytical tools than the rest of us and use those advantages to make more money than the rest of us. In fact, it is this proposition that leads us to assume that anyone who makes a lot of money must be smart, and by that measure, Masa Son would have been classified as a smart investor, and wealthy investors funneled billions of dollars into Softbank Vision funds, on that basis. I am not going to argue that the WeWork misadventure makes Masa Son a stupid investor, but it does expose the fact that he is human, capable of letting his ego get ahead of good sense and that at least some of his success over time has to be attributed being in the right place at the right time. 

      So, if investors cannot be classified into smart and stupid, what is a better break down? One would be to group them into lucky and unlucky investors, but that implies a complete surrender to the forces of randomness that I am not yet willing to make. I think that investors are better grouped into humble and arrogant, with humble investors recognizing that success, when it comes, is as much a function of luck as it is of skill, and failure, when it too arrives, is part of investing and an occasion for learning. Arrogant investors claim every investing win as a sign of their skill and view every loss as an affront, doubling down on their mistakes. If I had to pick someone to manage my money, the quality that I would value the most in making that choice is humility, since humble investors are less likely to overpromise and overcommit. I think of the very act of demanding obscene fees for investment services is an act of arrogance, one reason that I find it difficult to understand why hedge funds are allowed to get away with taking 2% of your wealth and 20% of your upside.

      Leading into the WeWork IPO, the question of where Masa Son fell on the humility continuum was easy to answer. Anyone who makes three hundred year plans and things that bigger is always better has a God complex, and success feeds that arrogance. I would like to believe that the WeWork setback has chastened Mr. Son, and in his remarks to shareholders this week, he said the right things, stating that he had “made a bad investment decision, and was deeply remorseful”, speaking of WeWork. However, he then undercut his message by not only claiming that the pathway to profit for WeWork would be simple (it is not) but also asserting that his Vision fund was still better than other venture capitalists in seeking out and finding promising companies. in my view,  Masa Son needs a few more reminders about humility from the market, since neither his words nor his actions indicate that he has learned any lessons. 

      Softbank: The WeWork Effect

      WeWork may have been Masa Son’s mistake, but the vehicle that he used to make the investment was Softbank, through the company and its Vision fund. As WeWork has unraveled, it is not surprising that Softbank has taken a significant hit in the market. 

      Note that Softbank has lost more than $15 billion in value since August 14, when the WeWork IPO was announced, and much of that loss can be attributed to the unraveling of the IPO, and how investor perceptions of Masa Son’s investing skills have changed since.

      The knocking down of Softbank’s value by the market may strike some of you as excessive, but there is reason that Softbank’s WeWork investment has ripple effects. Softbank may be built around a telecom company, but like Berkshire Hathaway, the company that Masa Son is rumored to admire and aspire to be, it is a holding company for investments in other companies. In fact, its most valuable holding remains an early investment in Alibaba, now worth tens of billions dollars. While Alibaba is publicly traded and its pricing is observable, many of Softbank’s most recent investments have been in young, private companies like WeWork. With these investments, the pricing attached to them by Softbank, in its financials, comes from recent VC funding rounds and their valuations reflect trust in Softbank’s capacity to pick winners and the WeWork meltdown hurts on both counts. First, investors are more wary about trusting VC pricing, especially if Softbank has been a lead investor in funding rounds, since that is how you arrived at the $47 billion pricing for WeWork in the first place. Second, the notion of Masa Son as an investing savant, skilled at picking the winners of the disruption game, has been damaged, at least for the moment and perhaps irreparably. The easiest way to measure how investor perceptions have changed is to compare the market capitalization of Softbank to its book value, a significant proportion of which reflects its holdings, marked to market:

      Investors have been wary of Softbank’s investing skills, even before the WeWork IPO, but the write offs on Uber and WeWork has made them even more skeptical, as the price to book ratio continues its march towards parity, with the market capitalization at 123% of the book value of equity in November 2019. In fact, if you focus just on Softbank’s non-consolidated holdings, public and private, note that the market capitalization of Softbank now stands at 73% of the value of just these holdings, most of which are marked to market. Put simply, when you buy Softbank, you are getting Uber and Alibaba at a discount on their traded market prices, but before you put your money down on what looks like a great deal, there are two considerations that may affect your decision. The first is that the company has a vast amount of debt on its balance sheet that has to be serviced, potentially putting your equity at risk, and the second is that you are getting Softbank (and Masa Son) as the custodian of the investments. If you have lost faith in Masa Son’s investing judgments (in people and in companies), you may view the 27% discount that the market is attaching to Softbank’s holdings as entirely justifiable and steer away from the stock. In contrast, if you feel that WeWork was an aberration in an otherwise stellar investment picking record, you should load up on Softbank stock. As for me, I don’t plan to own Softbank! I don't like grandiosity and Masa Son seems to have been soaked in it.

      YouTube Video


      Blog Posts
      1. Runaway Story to Meltdown in Motion: The Unraveling of the WeWork IPO
      2. Sunk Costs and Investing



      The Market is Huge! Revisiting the Big Market Delusion

      For the high-profile IPOs that have reached the market in 2019, with apologies to Charles Dickens for stealing and mangling his words, it has been the best and the worst of years. On the one hand, you have seen companies like Uber and Slack, each less than a decade old, trading at market capitalizations in the tens of billions of dollars, while working on unformed business models and reporting losses. On the other, many of these new listings have not only had disappointing openings, but have seen their market prices drop in the months after. In September 2019, we did see an implosion in the value of WeWork, another company that started the listing process with lots of promise and a pricing to match, but melted down from a combination of self-inflicted wounds and public market scrutiny. While these companies were very different in their business models (or lack of them), they shared one thing in common. When asked to justify their high pricing, they all pointed to how big the potential markets for their products/services were, captured in their assessments of market size. Uber estimated its total accessible market (TAM) to be in excess of $ 6 trillion, Slack’s judgment was that it had 5 million plus prospective clients across the world and WeWork’s argument was that the commercial real estate market was massive. In short, they were telling big market stories, just as PC makers were in the 1980s, dot com firms in the 1990s and social media companies a decade later. In this post, we will start by conceding the allure of big markets, but argue that the allure can lead to delusional pricing. (This post is a not-so short summary of a paper that Brad Cornell and I have written on this topic. You can find it by clicking here.)

      The Ingredients
      There is nothing more exciting for a nascent business than the perceived presence of a big market for its products and services, and the attraction is easy to understand. In the minds of entrepreneurs in these markets, big markets offer the promise of easily scalable revenues, which if coupled with profitability, can translate into large profits and high valuations. While this expectation is not unreasonable, overconfidence on the part of business founders and their capital providers can lead to unrealistic judgments of future profits, and overly high estimates for what they think their companies are worth, in what I will term the “big market delusion”. That initial overpricing is a common feature of these markets, but results in an inevitable correction that brings the pricing back to earth. In fact, there are three pieces to this puzzle, and it is when they all come together that you see the most egregious manifestations of the delusion.
      1. Big Market: It is the promise of a big market that starts the process rolling, whether it be eCommerce in the 1990s, online advertising between 2010 and 2015, cannabis in 2018 or artificial intelligence today. In each case, the logic of impending change was impeccable, but the extrapolation that the change would lead create huge and profitable markets was made casually. That extrapolation was then used to justify high pricing for every company in the space, with little effort put into separating winners from losers and good from bad business models. 
      2. Overconfidence: Daniel Kahneman, whose pioneering work with Amos Tversky, gave rise to behavioral finance as a disciple described overconfidence as the mother of all behavioral biases, for three reasons. First, it is ubiquitous, since it seems to be present in an overwhelming proportion of human beings. Second, overconfidence gives teeth to, and augments, all other biases, such as anchoring and framing. Finally, there is reason believe that overconfidence is rooted in evolutionary biology and thus cannot be easily countered. The problem gets worse with big markets, because of a selection bias, since these markets attract entrepreneurs and venture capitalists, who tend to be among the most over confident amongst us. Big markets attract entrepreneurs, over confident that their offerings will be winners in these markets, and venture capitalists, over confident in their capacity to pick the winners. 
      3. Pricing Game: We will not bore you with another extended discourse on the difference between value and price, but suffice to say that young companies tend to be priced, not valued, and often on raw metrics (users, subscribers, revenues). As a consequence, there is no attempt made to flesh out the "huge market" argument, effectively removing any possibility that entrepreneurs or the venture capitalists funding them will be confronted with the implausibility of their assumptions.
      The end result is that young companies in big markets will operate in bubbles of overconfidence, leading them to over estimate their chances of succeeding, the revenues they will generate if they do and how much profit they can generate on these revenues:

      This does not mean that every company in the big market space will be over priced, since a few will succeed and exploit the big market to full effect, but it does mean that the companies will be collectively over priced. As is always the case with markets, there will be a time of reckoning, where investors and managers will wake up to the reality that the big market is not big enough to accommodate all their growth dreams and there will be a correction. In the aftermath, there will be finger-wagging and talk of "never again", but the process will be repeated, albeit in a different form, with the next big market.

      Case Studies
      We will not claim originality here, since the big market delusion has always been part of market landscapes, and big markets have always attracted overconfident start ups and investors, creating cycles of bubble and bust. In this section, we will highlight three high profile examples:

      1. Internet Retail in 1999
      The Big Market: As the internet developed and became accessible to the public in the 1990s, the promise of eCommerce attracted a wave of innovators, from Amazon in online retail in 1994 to Ebay in auctions in 1995, and that innovation was aided by the arrival of Netscape Navigator's browser, opening up the internet to retail consumers and PayPal, facilitating online payments. New businesses were started to take advantage of this growing market with the entrepreneurs using the promise of big market potential to raise money from venture capitalists, who then attached sky-high prices to these companies. By the end of 1999, not only was venture capital flowing in record amounts to young ventures, but 39% of all venture capital was going into internet companies.
      The Pricing Delusion: The enthusiasm that entrepreneurs and venture capitalists were bringing to online retail companies seeped into public markets, and as public market interest climbed, many young companies found that they could bypass the traditional venture capital route to success and jump directly to public listings. Many of the online retail companies that were listed on public markets in the late 1990s had the characteristics of nascent businesses, with small revenues, unformed business models and large losses, but all of these shortcomings were overwhelmed by the perception of the size of the eCommerce market. In 1999 alone, there were 295 initial public offerings of internet stocks, representing more than 60% of all initial public offerings that year. One measure of the success of these dot.com stocks is that data services created indices to track them. The Bloomberg Internet index was initiated on December 31, 1998, with a hundred young internet companies in it, and it rose 250% in the following year, reaching a peak market capitalization of $2.9 trillion in early 2000. Because the collective revenues of these companies were a fraction of that value, and most of them were losing money, the only way you could justify these market capitalizations was with a combination of very high anticipated revenue growth accompanied by healthy profit margins in steady state, premised on successful entry into a big market. 
      The Correction: The rise of internet stocks was dizzying, in terms of the speed of ascent, but its descent was even more precipitous. The date the bubble burst can be debated, but the NASDAQ, dominated in 2000 by young internet companies, peaked on March 10, 2000, and in the months after, the pricing unraveled as shown in the collapse of the Bloomberg Internet Index:
      The Bloomberg Internet Index
      Of the dozens of publicly traded retail companies in existence in March 2000, more than two-thirds failed, as they ran out of cash (and capital access) and their business models imploded. Even those that survived, like Amazon, faced carnage, losing 90% of their value, and flirting with the possibility of shutting down. 

      2. Online Advertising in 2015 & 2019
      The Big Market: The same internet that gave birth to the dot com boom in the nineties also opened the door to digital advertising and while it was slow to find its footing, the arrival of search engines like Yahoo! and Google fueled its growth.  The advent of social media altered the game even more, as businesses realized that not only were they more likely to reach customers on social media sites, but that social media companies also brought in data about their users that would allow for more focused and effective advertising. The net result of all these innovations was that digital advertising grew in the decade from 2005 to 2015, both in absolute numbers and as a percent of total advertising:

      As digital advertising grew, firms that sought a piece of this space also entered the market and were generally rewarded with infusions of capital from both private and public market investors.
      The Pricing Delusion: In a post in 2015, I looked at how the size of the online advertising market skewed the companies of companies in this market, by looking at publicly traded companies in the space and backing out from the market capitalizations what revenues would have to be in 2025, for investors to break even. To do this, I made assumptions about the rest of the variables required to conduct a DCF valuation (the cost of capital, target operating margin and sales to capital ratio) and held them fixed, while Ie varied the revenue growth rate until I arrived at the current market capitalization. With Facebook in August 2015, for instance, here is what I estimated:

      Put simply, for Facebook's market capitalization in 2015 to be justified, its revenues would have to rise to $129,318 million in 2025, with 93% of those revenues coming form online advertising. Repeating this process for all publicly traded online ad companies in August 2015:
      Imputed Revenues in 2025 in millions of US $
      The total future revenues for all the companies on the list totals $523 billion. Note that this list is not comprehensive, because it excludes some smaller companies that also generate revenues from online advertising and the not-inconsiderable secondary revenues from online advertising, generated by firms in other businesses (such as Apple). It also does not include the online adverting revenues being impounded into the valuations of private businesses like Snapchat, that were waiting in the wings in 2015. Consequently, we are understating the imputed online advertising revenue that was being priced into the market at that time. In 2014, the total advertising market globally was about $545 billion, with $138 billion from digital (online) advertising. Even with optimistic assumptions about the growth in total advertising and the online advertising portion of it climbing to 50% of revenues, the total online advertising market in 2025 comes to $466 billion. The imputed revenues from the publicly traded companies in August 2015 alone exceeds that number, implying that the companies in were being overpriced relative to the market (online advertising) from which their revenues were derived.
      The Correction? The online ad market has not had a precipitous fall from the heights of 2015, but it has matured. By 2019, not only had investors learned more about the publicly traded companies in the online advertising business, but online advertising matured. Using the same process that we used in 2015, we imputed revenues for 2029 using data up through November 2019. Those calculations are presented in the table below:

      Imputed Revenues in 2029 in millions of US $
      There are signs that the market has moderated since 2015. First, the number of companies shrank, as some were acquired, some failed, and a few consolidated. Second, the market capitalizations had been recalibrated and starting revenues in 2019 are much greater than they were in 2015. As a result, the breakeven revenue in 2029 is $573 billion, only slightly higher than the imputed revenues from the 2015 calculation, despite being four years further into the future. This suggests that the market is starting to take account of the limits imposed by the size of the underlying market. Third, more of the companies on the list have had moments of reckoning with the market, where they have been asked to show pathways to profitability and not just growth numbers. Two examples are Snap and Twitter. For both companies the market capitalizations have languished because of the perception that their pathways to profitability are rocky. In short, if there is a correction occurring in this market, it seems to be happening in slow motion.

      3. Cannabis in October 2018
      The Big MarketUntil recently, cannabis, in any of its forms, was illegal in every state in the United States in most of the world, but that is changing rapidly. By October 2018, smoking marijuana recreationally and medical marijuana were both legal in nine states, and medical marijuana alone in another 20 states. Outside the United States, much of Europe has always taken a more sanguine view of cannabis, and on October 17, 2018, Canada became the second country (after Uruguay) to legalize the recreational use of the product. In conjunction with this development, new companies were entering the market, hoping to take advantage of what they saw as a “big” market, and excited investors were rewarding them with large market capitalizations.  The widespread view as of October 2018 was that the cannabis market would be a big one, in terms of users and revenues. There were concerns that many recreational cannabis users would continue to use the cheaper, illegal version over the regulated but more expensive one, and that US federal law would be slow to change its view on legality. In spite of these caveats, there remained optimism about growth in this market, with the more conservative forecasters predicting that global revenues from marijuana sales will increase to $70 billion in 2024, triple the estimated sales in 2018, and the more daring ones predicting close to $150 billion in sales.
      The Pricing DelusionIn October 2018, the cannabis market was young and evolving, with Canadian legalization drawing more firms into the business. While many of these firms were small, with little revenue and big operating losses, and most were privately owned, a few of these companies had public listings, primarily on the Canadian market. The table below lists the top ten cannabis companies as of October 14, 2018, with the market capitalizations of each one, in conjunction with each company’s operating numbers (revenues and operating income/losses, in millions of US $).
      Cannabis Stocks on Oct 14, 2018 ($ values in millions of US$)
      Note that the most valuable company on the list was Tilray with a market cap of over $13 billion. Tilray had gone public a few months prior, with revenues that barely register ($28 million) and nearly equal operating losses, but had made the news right after its IPO, with its stock price increasing ten-fold in the following weeks, before subsequently losing almost half of its value in the following weeks. Canopy Growth, the largest and most established company on the list, had the highest revenues at $68 million. More generally, all of them trade at astronomical multiples of book value, with a collective market cap in excess of $48 billion, more than 20 times collective revenues and 10 times book value. For each company, the high market capitalization relative to any measure of fundamental value was justified using the same rationale, namely that the cannabis market was big, allowing for huge potential growth. 
      The Correction: In the of the cannabis market, the overreach on the part of both businesses and their investors caught up with them. By October 2019, the assumptions regarding growth and profitability were being universally scaled back, business models were being questioned, and investors were reassessing the pricing of these companies. The best way to see the adjustment is to look the performance of the major cannabis exchange-traded fund, ETFMG, over the period depicted in the figure below:
      Note that within a period of approximately one year, cannabis stocks lost more than 50% of their aggregate value. The damage cut across the board. Tilray and Canopy Growth, the two largest market capitalization companies in the October 2019 saw their market capitalizations decline by 80.7% and 38.6% respectively. Given that there was no significant shift in fundamentals, the apparent explanation is that investors came to realize that the “big market” was not going to deliver the previously expected growth rates or the profitability for the expanding group of individual companies.

      Common Elements
      The three examples that we listed are in very different businesses and have different market settings. That said, there are some common elements that you see in all three, and will in any big market setting:
      1. Big Market stories: In every big market delusion, there is one shared feature. When asked to justify the pricing of a company in the market, especially young companies with little to show in terms of fundamentals, entrepreneurs, managers and investors almost always point to macro potential, i.e., that the retail or advertising or cannabis markets were huge. The interesting aspect is that they rarely express the need to go beyond that justification, by explaining why the specific company they were recommending was positioned to take advantage of that growth. In recent years, the big markets have gone from just words to numbers, as young companies point to big total accessible markets (TAM), when seeking higher pricing, often adopting nonsensical notions of what accessible means to get to large numbers. 
      2. Blindness to competition: When the big market delusion is in force, entrepreneurs, managers and investors generally downplay existing competition, thus failing to factor in the reality that growth will have to be shared with both existing and potential new entrants. With cannabis stocks in late 2018, much of the pricing optimism was driven by the size of the potential market in the United States, assuming legalization, but very few entrepreneurs, managers and investors seemed to consider the likelihood that legalization would attract new players into the market and that illegal sources of supply would maintain their hold on the market.
      3. All about growth: When enthusiasm about growth is at its peak, companies focus on growth, often putting business models to the side or even ignoring them completely. That was true in all three of our case studies. With internet stocks, companies typically based their entire pricing pitch on how quickly they were growing. With social media companies, it took an even rawer form, with growth in users and subscribers being the calling cards for higher pricing. Investors, both private and public, not only went along with the pitch but often actively encouraged companies to emphasize growth at the expense of profits.
      4. Disconnect from fundamentals: If you combine a focus on growth as the basis for pricing with an absence of concern at these companies about business models, you get pricing that is disconnected from the fundamentals. In all three case studies presented in this paper, at the peak of the pricing run up, most of the stocks in each group had negative earnings (making earnings multiples not meaningful), little to show in assets (making book value multiples difficult to work with) and traded at huge multiples of revenues. Put simply, the pricing losing its moorings in value, but investors who look at only multiples miss the disconnect.
      The one area where the three case studies diverge is in how the pricing delusion corrects itself. For instance, the dot com bubble hit a wall in March 2000 and burst in a few months, as public markets corrected first, followed by private markets, but the question of why it happened at the time that it did remains a mystery. The online advertising run-up has moderated much more gradually over a few years, and if that trend continues, the correction in this market may be smooth enough that investors will not call it a correction. With cannabis stocks, the rise and fall were both precipitous, with the stocks tripling over a few months and losing that rise in the next few months.
      -->

      Implications
      If the big market delusion is a feature of big markets, destined to repeat over time, it behooves us as entrepreneurs, managers, investors and regulators to recognize that reality and modify our behavior.
      1. Entrepreneurs and Venture Capitalists
      The obvious advice that can be offered to entrepreneurs and venture capitalists, to counter the big market delusion, is to be less over confident, but given that it is not only part of their make up but the driver for exploiting the big market, it will have little effect. Our suggestions are more modest. First, testing out the plausibility of your market size assumptions and the viability of the business model you plan to use to exploit the market on people, whose opinion you value but don't operate in your bubble, is a sensible first step. Second, when you get results from your initial business forays that run counter to what you expected to see, don't be quick to rationalize them away as aberrations. By keeping the feedback loop open, you may be able to improve your business model and adjust your expectations sooner, to reflect reality. Third, build in safety buffers into your model, allowing you to keep operating even if capital dries up (as it inevitably will when the correction arrives), by accumulating cash and avoiding cost commitments that lock you in, like debt and long term cost contracts. Finally, while you may be intent on delivering the metrics that are priced highly, such as users or subscribers, pay attention to building a business model that will work at delivering profits, and if forced to pick between the two objectives, pick the latter.

      2.Public Market Investors
      The big market delusion almost never stays confined to private markets and sooner or later, the companies in the space list on public markets and are often priced in these markets, at least initially, like they were in private markets. While a risk averse investor may feel it prudent to entirely avoid these stocks, there are opportunities that can be exploited:
      • Momentum investors/traders: The big market delusion is one explanation for the momentum of young, growth stocks. When fascination with a big market like “transportation” takes hold, it can produce momentum in the prices of innovative companies in that space such as Uber and Lyft, and significant profits along the way. The risk, of course, is that the big market delusion fades and the market corrects as has happened in the case of both Uber and Lyft. As we have emphasized, however, there appears to be no way to time such corrections. 
      • Value investors:  The  obvious advice is to avoid young, growth stocks whose value is based on big market stories. But that carries its own risk. In the twelve year stretch beginning in 2007, growth stocks have dramatically outperformed value stocks. As one example, during this period the Russell 1000 growth index outperformed the Russell 1000 value index by an astonishing 4.3% per year. That outperformance was driven in part by stories regarding how technology companies were going to disrupt or invent big markets from housing to entertainment to automobiles. There is a riskier, higher payoff, strategy. Since the big market delusion leads to a collective over pricing, value investors can bet against a basket of stocks (sell short on an ETF like the ETFMG) and hope that the correction occurs soon enough to reap rewards.
      In sum, though, young companies make markets interesting and by making them interesting, they increase liquidity and trading.
      3. Governments and Market Regulators 
      In the aftermath of every correction, there are many who look back at the bubble as an example of irrational exuberance. A few have gone further and argued that such episodes are bad for markets, and suggested fixes, some disclosure-related and some putting restrictions on investors and companies. In fact, in the aftermath of every bursting bubble, you hear talk of how more disclosure and regulations will prevent the next bubble. After three centuries of futility, where the regulations passed in response to one bubble often are at the heart of the next one, you would think that we would learn, but we don't. In fact, over confidence will overwhelm almost every regulatory and disclosure barrier that you can throw up. We also believe that these critics are missing the point. Not only are bubbles part and parcel of markets, they are not necessarily a negative. The dot com bubble changed the way we live, altering not only how we shop but how we travel, plan and communicate with each other. What is more, some of the best performing companies of the last two decades emerged from the debris. Amazon.com, a poster child for dot com excess, survived the collapse and has become a company with a trillion-dollar market capitalization.  Our policy advice to politicians, regulators and investors then is to stop trying to make bubbles go away. In our view, requiring more disclosure, regulating trading and legislating moderation are never going to stop human beings from overreaching. The enthusiasm for big markets may lead to added price volatility, but it is also a spur for innovation, and the benefits of that innovation, in our view, outweigh the costs of the volatility. We would choose the chaos of bubbles, and the change that they create, over a world run by actuaries, where we would still be living in caves, weighing the probabilities of whether fire is a good invention or not.

      Conclusion
      Overconfident in their own abilities, entrepreneurs and venture capitalists are naturally drawn to big markets which offer companies the possibility of huge valuations if they can effectively exploit them. And there are always examples of a few immense successes, like Amazon, to fuel the fire. This leads to a big market delusion, resulting in too many new companies being founded to take advantage of big markets, each company being overpriced by its cluster of founders and venture capitalists. This overconfidence then feeds into public markets, where investors get their cues on price and relevant metrics from private market investors, leading to inflated values in those markets. This results in eventual corrections as the evidence accumulates that growth has to be shared and profitability may be difficult to achieve in a competitive environment. This post is a long one, but if you find it interesting, Brad Cornell and I have a paper expounding a more complete picture here. As always, your feedback is appreciated!

      Paper on the big market delusion
      Previous posts relating to the big market delusion




      A Teaching Manifesto: An Invitation to my Spring 2020 classes

      If you have been reading my blog for long enough, you should have seen this post coming. Every semester that I teach, and it has only been in the spring in the last few years, I issue an invitation to anyone interested to attend my classes online. While I cannot offer you credit for taking the class or much direct personal help, you can watch my sessions online (albeit not live), review the slides that I use and access the post class material, and it is free. If you are interested in a certificate version of the class, NYU offers that option, but it does so for a fee. You can decide what works for you, and whatever your decision is, I hope that you enjoy the material and learn from it, in that order.

      The Structure

      I will be teaching three classes in Spring 2020 at the Stern School of Business (NYU), a corporate finance class to the MBAs and two identical valuation classes, one to the MBAs and one for undergraduates. If you decide to take one of the MBA classes, the first session will be on February 3, 2020, and there will be classes every Monday and Wednesday until May 11, 2020, with the week of March 15-22 being spring break. In total, there will be 26 sessions, each session lasting 80 minutes. The undergraduate classes start a week earlier, on January 27, and go through May 11, comprising 28 sessions of 75 minutes apiece. 
      1. The Spring 2020 Classses: With all three classes, the sessions will be recorded and converted into streams, accessible on my website and downloadable, as well as YouTube videos, with each class having its own playlist. In addition, the classes will also be carried on iTunes U, with material and slides, accessible from the site. The session videos will usually be accessible about 3-4 hours after class is done and you can either take the class in real time, watching the sessions in the week that they are taught, or in bunches, when you have the time to spend to watch the sessions; the recordings will stay online for at least a couple of years after the class ends. There will be no need for passwords, since the session videos will be unprotected on all of the platforms. 
      2. The (Free) Online Version: During the two decades that I have been offering this online option, I have noticed that many people who start the class with the intent of finishing it give up for one of two reasons. The first is that watching an 80-minute video on a TV or tablet is a lot more difficult than watching it live in class, straining both your patience and your attention. The second is that watching these full-length videos is a huge time commitment and life gets in the way. It is to counter these problems that I created 12-15 minute versions of the each session for online versions of the classes. These online classes, recorded in 2014 and 2015, is also available on my website and through YouTube, and should perhaps be more doable than the full class version.
      3. The NYU Certificate Version: For most of the last 20 years, I have been asked why I don’t offer certificates of completion for my own classes and I have had three answers. The first is that, as a solo act, I don’t have the bandwidth to grade and certify the 20,000 people who take the classes each semester. The second is that certification requires regulatory permission, a bureaucratic process in New York State that I have neither the stomach nor the inclination to go through. The third is, and it is perhaps the most critical, is that I am lazy and I really don't want to add this to my to-do list. One solution would be to offer the classes through platforms like Coursera, but those platforms work with universities, not individual faculty, and NYU has no agreements with any of these platforms. About three years ago, when NYU approached me with a request to create online certificate classes, I agreed, with one condition: that the free online versions of these classes would continue to be offered. With those terms agreed to, there are now NYU Certificate versions of each of the online classes, with much of the same content, but with four add ons. First, each participant will have to take quizzes and a final exam, multiple choice and auto-graded, that will be scored and recorded. Second, each participant will have to complete and turn in a real-world project, showing that they can apply the principles of the class on a company of their choice, to be graded by me. Third, I will have live Zoom sessions every other week for class participants, where you can join and ask questions about the material. Finally, at the end of the class, assuming that the scores on the exams and project meet thresholds, you will get a certificate, if you pass the class, or a certificate with honors, if you pass it with flying colors.
      The Classes
      I have absolutely no desire to waste your time and your energy by trying to get you to take classes that you either have no interest in, or feel will serve no good purpose for you. In this section, I will  provide a short description of each class, and provide links to the different options for taking each class.

      I. Corporate Finance

      Class description: I don’t like to play favorites, but corporate finance is my favorite class, a big picture class about the first principles of finance that govern how to run a business. I will not be egotistical enough to claim that you cannot run a business without taking this class, since there are many incredibly successful business-people who do, but I do believe that you cannot run a business without paying heed to the first principles. I teach this class as a narrative, staring with the question of what the objective of a business should be and then using that objective to determine how best to allocate and invest scarce resources (the investment decision), how to fund the business (the financing decision) and how much cash to take out and how much to leave in the business (the dividend decision). I end the class, by looking at how all of these decisions are connected to value.

      Chapters: Applied Corporate Finance Book, Sessions: Class session
      I am not a believer in theory, for the sake of theory, and everything that we do in this class will be applied to real companies, and I will use six companies (Disney, Vale, Tata Motors, Deutsche Bank, Baidu and a small private bookstore called Bookscape) as lab experiements that run through the entire class.

      I say, only half-jokingly, that everything in business is corporate finance, from the question of whether shareholder or stakeholder interests should have top billing at companies, to why companies borrow money and whether the shift to stock buybacks that we are seeing at US companies is good or bad for the economy. Since each of these questions has a political component, and have now entered the political domain, I am sure that the upcoming presidential election in the US will create some heat, if not light, around how they are answered.

      For whom?

      As I admitted up front, I believe that having a solid corporate finance perspective can be helpful to everyone. I have taught this class to diverse groups, from CEOs to banking analysts, from VCs to startup founders, from high schoolers to senior citizens, and while the content does not change, what people take away from the class is different. For bankers and analysts, it may be the tools and techniques that have the most staying power, whereas for strategists and founders, it is the big picture that sticks. So, in the words of the old English calling, "Come ye, come all", take what you find useful, abandon what you don't and have fun while you do this.

      Links to Offerings

      1. Spring 2020 Corporate Finance MBA class (Free)
      2. Online Corporate Finance Class (Free)

      3. NYU Certificate Class on Corporate Finance (It will cost you...)

      II. Valuation

      Class description: Some time in the last decade, I was tagged as the Dean of Valuation, and I still cringe when I hear those words for two reasons. First, it suggests that valuation is a deep and complex subject that requires intense study to get good at. Second, it also suggests that I somehow have mastered the topic. If nothing else, this class that I first taught in 1987 at NYU, and have taught pretty much every year since, dispenses with both delusions. I emphasize that valuation, at its core, is simple and that practitioner, academics and analysts often choose to make it complex, sometimes to make their services seem indispensable, and sometimes because they lose the forest for the trees. Second, I describe valuation as a craft that you learn by doing, not by reading or watching other people talk about it, and that I am still working on the craft. In fact, the more I learn, the more I realize that I have more work to do.  This is a class about valuing just about anything, from an infrastructure project to a small private business to a multinational conglomerate, and it also looks at value from different perspectives, from that of a passive investor seeking to buy a stake or shares in a company to a PE or VC investor taking a larger stake to an acquirer interested in buying the whole company. 

      Finally, I lay out my rationale for differentiating between value and price, and why pricing an asset can give you a very different number than valuing that asset, and why much of what passes for valuation in the real world is really pricing. 

      Along the way, I emphasize how little has changed in valuation over the centuries, even as we get access to more data and more complex models, while also bringing in new tools that have enriched us, from option pricing models to value real options (young biotech companies, natural resource firms) to statistical add-ons (decision trees, Monte Carlo simulations, regressions). 

      For whom?

      Do you need to be able to do valuation to live a happy and fulfilling life? Of course not, but it is a skill worth having as a business owner, consultant, investor or just bystander. With that broad audience in mind, I don't teach this class to prepare people for equity research or financial analysis jobs, but to get a handle on what it is that drives value, in general, and how to detect BS, often spouted in its context. Don't get me wrong! I want you to be able to value or price just about anything by the end of this class, from Bitcoin to WeWork, but don't take yourself too seriously, as you do so.

      Links to Offerings
      1a. Spring 2020 Valuation MBA class (Free)
      1b. Spring 2020 Valuation Undergraduate class (Free)
      2. Online Valuation Class (Free)
      3. NYU Certificate Class on Valuation (Paid)
      III. Investment Philosophies

      Class description: This is my orphan class, a class that I have had the material to teach but never taught in a regular classroom. It had its origins in an couple of observations that puzzled me. The first was that, if you look at the pantheon of successful investors over time, it is not only a short one, but a diverse grouping, including those from the old time value school (Ben Graham, Warren Buffett), growth success stories (Peter Lynch and VC), macro and market timers (George Soros), quant players (Jim Simon) and even chartists. The second was that the millions who claim to follow these legends, by reading everything ever written by or about them and listening to their advice, don’t seem to replicate their success. That led me to conclude that there could be no one ‘best’ Investment philosophy across all investors but there could be one that is best for you, given your personal makeup and characteristics, and that if you are seeking investment nirvana, the person that you most need to understand is not Buffett or Lynch, but you.  In this class, having laid the foundations for understanding risk, transactions cost and market efficiency (and inefficiency), I look at the entire spectrum of investment philosophies, from charting/technical analysis to value investing in all its forms (passive, activist, contrarian) to growth investing (from small cap to venture capital) to market timing. With each one, I look at the core drivers (beliefs and assumptions) of the philosophy, the historical evidence on what works and does not work and end by looking at what an investor needs to bring to the table, to succeed with each one.

      I will try (and not always succeed) to keep my biases out of the discussion, but I will also be open about where my search for an investment philosophy has brought me. By the end of the class, it is not my intent to make you follow my path but to help you find your own.

      For whom?
      This is a class for investors, not portfolio managers or analysts, and since we are all investors in one way or the other, I try to make it general. That said, if your intent is to take a class that will provide easy pathways to making money, or an affirmation of the "best" investment philosophy, this is not the class for you. My objective in this class is not to provide prescriptive advice, but to instead provide a menu of choices, with enough information to help you can make the choice that is best for you. Along the way, you will see how difficult it is to beat the market, why almost every investment strategy that sounds too good to be true is built on sand, and why imitating great investors is not a great way to make money.


      Links to Offerings

      1. Online Investment Philosophies Class (Free)
      2. NYU Certificate Class on Valuation (Paid)
      • NYU Entry Page (Coming soon)
      Conclusion
      I have to confess that I don't subscribe to the ancient Guru/Sishya relationship in teaching, where the Guru (teacher) is an all-knowing individual who imparts his or her fountain of wisdom to a receptive and usually subservient follower. I have always believed that every person who takes my class, no matter how much of a novice in finance, already knows everything that needs to be known about valuation, corporate finance and investments, and it is my job, as a teacher, to make him or her aware of this knowledge. Put simply, I can provide some structure for you to organize what you already know, and tools that may help you put that knowledge into practice, but I am incapable of profundity. I hope that you do give one (or more) of my classes a shot and I hope that you both enjoy the experience and get a chance to try it out on real companies in real time.

      YouTube Video



      An Ode to Luck: Revisiting my Tesla Valuation

      When investing, I am often my own biggest adversary, handicapped by the preconceptions and priors that I bring into analysis and decision making, and no company epitomizes the dangers of bias more than Tesla. It is a company where there is no middle ground, with the optimists believing that there is no limit to its potential and the pessimists convinced that it is a time bomb, destined to implode. I have tried, without much luck, to navigate the middle ground in my valuations of the company and have been found wanting by both sides. For much of Tesla’s life, I have pointed to its promise but argued that it was too richly priced to be a good investment, and during that period, Tesla bulls accused me of working for the short sellers. They did not believe me when I argued that you could like a company for its vision and potential, and not like it as an investment. When I bought Tesla in June 2019, arguing that the price had dropped enough (to $180) to make it a good investment, they became my allies, but that decision led to a backlash from Tesla bears, who labeled me a traitor for abandoning my position, again not accepting my argument that at the right price, I would buy any company. I would love to chalk it to my expert timing, but luck was on my side, the momentum shifted right after I bought, and the stock has not stopped rising since. When Tesla’s earnings reported its earnings yesterday (January 29th), the stock was trading at $581, before jumping to $650 in after-market trading. It is time to revisit my valuation and reassess my holding!

      Tesla in June 2019: A Story Stock loses its story!
      It was in June 2019 just over seven months ago, when the sky was full of dark clouds for Tesla, as a collection of wounds, some internal and others external had pushed the stock price down more than 40% in a few months, that I took a look at the company and valued it at just over $190 per share:
      Download spreadsheet
      In arriving at this value, I told a story of a company that would grow to deliver $100 billion in revenues in a decade, while also earning a 10% pre-tax operating margin. One concern that I had at the time was that the debt load for the company, in conjunction with operating losses and a loss of access to new capital, would expose the company to a risk of default; I estimated a 20% probability that Tesla would not survive.  At the time that I wrote the post, I posted a limit order to buy the stock at a $180 stock price, and when it executed a short while later,  some of you pointed out that I was not giving myself much margin of safety. I argued that the distribution of Tesla value outcomes gave me a much larger chance of upside than downside. At the time of the investment, I also described the company as a corporate teenager, with lots of potential but a frustrating practice of risking it all for distractions.

      A Story Update, through January 2020
      When I bought Tesla, I had no indication that it had hit bottom. In fact, given how strongly momentum and mood had shifted against the stock, I expected to lose money first, before any recovery would kick in, and I certainly did not expect a swift return on my investment. The market, of course, had its own plans for Tesla and the stock’s performance since the time I bought it is in the graph below:

      One of my concerns, as an investor, is that I can sometimes mistake dumb luck for skill, but in this case, I  am operating under illusions. The timing on this investment was pure luck, but I am not complaining. What happened to cause the turnaround. There were three factors that fed into the upward spiral in the stock price:
      1. Return to growth: In the middle of 2019, Tesla’s growth seemed to have run out of steam and there were some who believed that its best days were behind it. In the two quarters since, Tesla has shown signs of growth, albeit not at the breakneck pace that you saw it grow, earlier in its life.
      2. Operating improvements: One of Tesla’s weaknesses has been an inability to deliver on time and maintain anything resembling an efficient supply chain. In the second half of 2019, Tesla seemed to be paying attention to its weakest link, focusing on producing and delivering cars, without drama, and even running ahead of schedule on new capacity that it was adding in Shanghai.
      3. Radio Silence: I know that this will sound petty to Musk fans, but Elon Musk has always been a mixed blessing for the company. While his vision has been central to building the company, he has also made it a practice of creating diversions that take people’s attention away from the story line. He has also had a history of pre-empting operating decisions with rash missives (pricing the Tesla 3 at $35,000 and producing 5,000 cars/week) that led to operating and credibility problems for the company. Musk has been quieter and more focused of late, and the last six months have been blessedly free of distractions, allowing investors to focus on the Tesla story.
      In earlier posts, I have drawn a distinction between the value of a stock and its price, noting that traders play the pricing game (trying to gauge momentum and shifts) and investors play the value game, where they invest based upon value, hoping for price convergence. While price and value are driven by different factors, in the case of Tesla, there is a feedback effect from price to value because of (a) its high debt obligations and (b) its need for more capital to fund its growth. As stock prices rise, the debt obligation becomes less onerous for two reasons. First, some of it is convertible debt, at high enough stock prices, it gets converted to equity. Second, Tesla’s capacity to raise new equity at high stock prices gives it a fall back that it can use, if it chooses to pay down debt. By the same token, the number of shares that Tesla will need to issue to cover its funding needs, as it grows, will decrease as the stock price rises, reducing their dilution effect on value.

      Valuing Tesla in January 2020
      There have been three earnings reports from Tesla since my June 2019 report, and the table below shows how the base year numbers have shifted, as a consequence:
      Tesla Quarterly Reports & Earnings Call on January 29, 2020
      The base revenues have increased by about 9%, and operating margins continued to get less negative (turning positive in the last quarter of the year), as long-promised economies of scale finally manifested themselves. In the table below, I highlight the changes that I have made in key inputs relating to growth, profitability and reinvestment. 
      Download spreadsheet
      Specifically, here is what I changed:
      • Higher end revenues: My revenue growth rate, while only marginally higher than the growth rate I used in June 2019, delivers revenues of just above $125 billion in 2030, about 25% higher than the end revenues that I forecast a year ago. Since this will require that Tesla sell more than 2 million cars in 2030, I am not making this assumption lightly.
      • Higher margins: My target pre-tax operating margin has also been pushed up from 10% to 12%, reflecting the improvements in margins that the company has already delivered and an expectation that the company will continue to work on a more efficient production model than conventional automakers. 
      • More efficient reinvestment: My reinvestment assumptions for the long term resemble those that I made in June, with every dollar in invested capital delivering $2 in revenues, as the company adds capacity. In the near term, though, I assume less reinvestment, assuming $3 in revenues for every new dollar of capital invested, since Tesla contends in its January 2020 earnings call to have capacity online to produce 640,000 cars, enough to cover growth for the next year or two.
      If you are surprised about the lower cost of capital in January 2020, that drop has little to do with Tesla and more to do with changes in the market. First, the US treasury bond rate has dropped to 1.75% from 2.26% in June 2019, creating a lower base for both the costs of equity and debt for the company. Second, while Tesla’s bond rating has not improved dramatically, default spreads on bonds have dropped over the course of the year. Finally, the price feedback effect has silenced talk about imminent default, but I understand that a momentum shift and a lower stock price can rekindle it, and I have halved the probability of default. With this more upbeat story, the value that I get per share for Tesla is $427, and the details are shown below:
      Download spreadsheet
      If your criticism of this valuation is that I am letting the good times in the stock feed into my intrinsic value estimate, I am guilty as charged, but I have never been able to completely ignore what markets are doing, when doing intrinsic value. To see how each assumption that I have altered feeds into the value, I broke down the value change into constituent pieces.
      The biggest increase in value comes from increasing the margin, accounting for a little bit more than half of the value change, followed by higher revenue growth and then by lower costs of capital. Note that the firm’s debt load magnifies the effects of changes in the value of operating assets on equity value, and the options that had dropped in value with the stock price in June 2019, are reasserting their role as a drain on value. If there is a lesson that I would take away from this table, it is that the key debate that we should be having on Tesla is not about whether it can grow. Given the size of the auto market, and the shift towards electric cars, the growth is both possible and plausible. It is about the margins that Tesla can command, once it becomes a mature company, which in turn requires an assessment of what the auto market will look like a decade from now. If you believe that an electric car is an automobile first, and electric next, it will be difficult to reach and sustain double-digit operating margins, if you are not a niche auto company. If, in contrast, your view is that the electric car market will be viewed as an electronic or tech product, you may be able to justify higher margins.

      What now?
      In the interests of transparency, I should start with a confession. I went into this valuation wanting to hold on to Tesla for a little while longer, partly because it has done so well for me (and it tough to let winners go, when they are still winning) but mostly because at a 7-month holding period, selling it now will expose me to a fairly hefty tax liability; short-term capital gains (less than a one-year holding period) are taxed at my ordinary tax rate and long term capital gains (greater than a year holding period) are taxed at a 20% lower rate. This desire to derive a higher value for Tesla (to justify continuing to hold it) may be driving the optimism in my assumptions in the last section, but even with those optimistic assumptions, my value per share of $427 was well below the closing price of $581 at the end of trading and even further below the $650 that Tesla was trading at after the earnings release. Could tweaking the assumptions give me a value higher than the price? Of course! I could raise my end year revenues to $200 billion ( plausible in a market this size) and give Tesla an 18% operating margin (perhaps by calling it a tech company) and arrive at a value of $ 1,168 per share, but that to me is pushing the limits of possibility, and one reason why I hold back on simple what-if analyses. A Monte Carlo simulation allows for a more complete assessment of uncertainty and in the table below, I vary four key assumptions (revenue growth, target margin, reinvestment efficiency and cost of capital) to arrive at a value distribution for Tesla:
      Simulation Results
      At the price of $650/share, post-earnings report, Tesla is close to the 90th percentile of my value distribution. While it possible that Tesla could be worth more than $650, it is neither plausible nor probable, at least based on my assumptions.

      A Post Script
      Holding on to the hope that I could defer my sale of Tesla until June (to qualify for long term capital gains), I looked at buying puts to protect my capital gains, but that pathway is an expensive one at Tesla, given how much volatility is priced into the options. Reluctantly, I  sold my Tesla holdings at $640 this morning, and as with my buy order in June, I don’t expect immediate or even near-term gratification. The momentum is strong, and the mood is delirious, implying that Tesla’s stock price could continue to go up. That said, I am not tempted to stay longer, though, because I came to play the investing game, not the trading game, and gauging momentum is not a skill set that I possess. I will miss the excitement of having Tesla in my portfolio, but I have a feeling that this is more a separation than a permanent parting, and that at the right price, Tesla will return to my portfolio in the future. 

      YouTube Video

      Spreadsheets
      Posts on Tesla
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      Data Update 2 for 2020: Retrospective on a Disruptive Decade

      My data updates usually look at the data for the most recent year and what I learn from them, but 2020 also marks the end of a decade. In this post, I look back at markets over the period, a testing period for many active investors, and particularly so for value investors, who found that even as financial assets posted solid returns, what they thought were tried and true approaches to "beating the market" seemed to lose their power. In addition, trust in mean reversion, i.e., that things would go back to historic norms was shaken as interest rates remained low for much of the period and PE ratios rose above historical averages and continued to rise, rather than fall back. 

      1. It was a great year, and a very good decade, for equities, and a very good year for bonds!
      While investing should always be forward-looking, there is a benefit to pausing and looking backwards. If you had US stocks in your portfolio, 2019 was a very good year. The S&P 500 started the year at 2506.85 and ended the year at 3230.78, an increase of 28.88%, and with dividends added, the return for the year was 31.22%. To get a sense of how this year measures up against other good years, I compared it to the annual returns from 1927 to 2019 in this graph:
      Download spreadsheet with annual market data
      Over the 92 years that are in this historical assessment, 2019 ranked as the sixteenth best year and second only to 2013 (annual return of 32.15%) in this century. While stocks have garnered the bulk of the attention for having a good year, bonds were not slackers in the returns game. In 2019, the ten-year US treasury bond returned 9.64% and ten-year Baa corporate bonds weighing in with a 15.33% return. That may surprise some, given how low interest rates have been, but the bulk of these returns came from price appreciation, as the US treasury bond rate declined from 2.69% to 1.92%, and the corporate bonds also benefited from a decline in default spreads (the price of risk in the bond market) during the year. The year also capped off a decade of gains for stocks, with the S&P almost tripling from 1115.10 on January 1, 2010 to 3230.78 on January 1, 2020, and with dividends included and reinvested, the cumulated return for the decade is 252.96%. To put these returns in perspective, I have compared this cumulated return to the eight full decades that I have data for in the table below, in conjunction with the cumulated returns for treasury and corporate bonds over each decade:
      Download spreadsheet with annual market data
      While 2010-19 represented a bounce back for stocks from a dismal 2000-09 time period, with the 2008 crisis ravaging returns, it falls behind three other decades of even higher returns (1950-59, 1980-89 and 1990-1999). It was a middling decade for both treasury and corporate bonds, with cumulated returns running ahead of the three decades spanning 1940 to 1969 but falling behind the other decades, in terms of returns delivered. Treasury bills delivered their worst decade of returns, since the 1940s, with the cumulated return amounting to 5.25%. I don’t want to overanalyze historical data, but there are interesting nuggets of information in the data:
      a. Historical Risk Premium: The US historical data has been used by many analysts in corporate finance and valuation as the basis for computing historical risk premiums and in the table below, I compute the risk premiums that investors would have earned in this market, investing in stocks as opposed to treasury bills and bonds, over different time periods, and with different averaging approaches:
      Download spreadsheet with annual market data
      If you go with the geometric average premium from 1927-2019 as your predictor for the equity risk premium in 2020, US stocks should earn about 4.83% more than US treasury bonds for the year:
      Expected return on stocks in 2020 = T.Bond Rate + Historical ERP 
      = 1.92% + 4.83% = 6.75%
      Since a portion of this return will come from dividends, the expected price appreciation in stocks is the difference:
      Expected price appreciation on stocks = Expected Return - Dividend yield 
      = 6.75%- 1.82% = 4.93%
      I am not a fan of historical premiums, not only because they represent almost an almost slavish faith in mean reversion but also because they are noisy; the standard errors in the historical premiums are highlighted in red and you can see that even with 92 years of data, the standard error in the risk premium is 2.20% and that with 10 or 20 years of data, the risk premium estimate is drowned out by estimation error.
      b. Asset Allocation: The fact that stocks have beaten treasury and corporate bonds by wide margins over the entire history is often the sales pitch used to push investors to allocate more of their savings to stocks, with the argument being that stocks always win in the long term. The data should yield cautionary notes:
      • First, in three decades out of the nine in the table, stocks under-performed treasury bonds and treasury bills, and if your response is that ten years is not a long enough time period, you may want to check the actuarial tables. 
      • Second, there is a selection bias in our use of the US markets for computing the historical premium. Looking across the globe, the US was one of the most successful equity markets of the last century and using it may be skewing our results upwards. Put bluntly, if you had invested in the Nikkei at the height of its climb in the 1980s, you would still be struggling to get back the money you lost, when the Japanese markets collapsed.
      c. Market Timing: It is human nature to try to time markets, and some investors make it the central focus of their investment philosophies. I will not try to litigate the good sense of doing so in this post, but the historical return data gives us a sense of both the upside and the downside of doing so. In terms of pluses, an investor who was able to avoid the doomed decades (when stocks earned less than T.Bills and T.Bonds) would be comfortably ahead of an investor who did not, if he or she stayed fully invested in the remaining decades. In terms of minuses, if the market timing investor failed to stay invested in stocks in the good decades, the opportunity costs would quickly overwhelm the benefits. Between 2010 and 2019, there were many investors who believed that a correction was around the corner, driven by their perception that interest rates were being kept artificially low by central banks and that they would revert to historic norms quickly. When that reversion did not occur, these investors paid a hefty price in returns foregone. All of the historical returns that I have reported in this section are nominal, and to the extent that you are interested in real returns, you may want to download the historical data from my website and check out the results. (Hint: Not much changes)

      2. A Low Interest Rate Decade
      If there was a defining characteristic for the decade, it was that interest rates, both in the US and globally, dropped to levels not seen in decades. You can see this in the path of the US 10-year treasury bond rate in the graph below:
      Download historical treasury rates, by year
      Since the drop in rates occurred after the 2008 crisis, and in the aftermath of concerted actions by central banks to bolster weak economies, it has become conventional wisdom that it is central banks that have kept rates artificially low, and that the ending of quantitative easing would cause rates to revert back to historical averages. As many of you who have been reading my posts know, I don't believe that central banks have the power to keep long term market-set rates low, if the fundamentals don't support low rates. In fact, one of my favorite graphs is one where I compare the 10-year treasury bond rate each year to the sum of the inflation rate and real GDP growth rate that year (intrinsic riskfree rate):
      Download historical treasury rates, by year
      As you can see, the main reason why rates have dropped in the US and Europe has been fundamental. As inflation has declined (and become deflation in some parts of the world) and real GDP growth has been anemic, intrinsic and actual risk free rates have dropped. To the extent that the difference between the two is a measure of central banking actions, it is true that the Fed’s actions kept actual rates lower than intrinsic rates more in the last decade than in prior years, but it is also true that even in the absence of central banking intervention, rates would not have reverted back to historical norms. 

      3. It was a tech decade, and FAANG stocks stole the show!
      While it was a good decade for stocks,  the gains varied across sectors. Using the S&P 500 again as the indicator, you can see the shift in value over the decade by looking at how the different sectors evolved over the decade, as a percent of the S&P 500:
      The most striking shift is in the energy sector, which dropped from 11.51% of the index to 4.60%, in market capitalization terms. Some of this drop is clearly due to the decline in oil prices during the decade, but some of it can be attributed to a general loss of faith in the future of fossil fuel and conventional energy companies. The biggest sector through the entire decade was technology but its increase in percentage terms seems modest at first sight, rising from 19.76% in 2009 to 21.97% in 2019, but that is because two of the biggest names in the sector, Google and Facebook, were moved to the communication services sector; if they had been left in technology, its share of the index would have risen to more than 30%. In fact, five companies (Facebook, Amazon, Apple, Netflix and Google), representing the FAANG stocks, had a very good decade, with their collective market capitalization increasing by $3.4 trillion over the ten years:

      Put in perspective, the FAANG stocks accounted for 22% of the increase in market capitalization of the S&P 500, and any portfolio that did not include any of these stocks for the entire decade would have had a tough time keeping up with the market, let alone beating it. (This is an approximation, since not all five FAANG stocks were part of the S&P 500 for the entire decade, with Facebook entering after its IPO in 2012 and Netflix being added to the index in 2014).

      4. Mean Reversion or Structural Shift
      One of the perils of being in a market like the US, where rich historical data is available and easily accessible is that analysts and academics have pored over the data and not surprisingly found patterns that have very quickly become part of investment lore. Thus, we have been told that value beats growth, at least over long periods, and that small cap stocks earn a premium, and have converted these findings into investing strategies and valuation practices. While it is dangerous to use a decade’s results to abandon a long history, the last decade offered sobering counters to old investing nostrums.

      a. Value versus Growth
      The basis for the belief that value beats growth is both intuitive and empirical. The intuitive argument is that value stocks are priced cheaper and hence need to do less to beat expectations and the empirical argument is that stocks that are classified as value stocks, defined as low price to book and low price to book stocks, have historically done better than growth stocks, defined as those trading at high price to book and high price earnings ratios. Looking at the annual returns on the lowest and highest PBV stocks in the United States, going back to 1927:
      Raw Data from Ken French
      The lowest price to book stocks have historically earned 5.22% more than the highest price to book stocks, if you look at 1927-2019. Broken down by decades, though, you can see that the assumption that value beats growth is not as easily justified:
      Raw Data from Ken French
      While there are some, especially in the old-time value crowd, that view the last decade as an aberration, the slide in the value premium has been occurring over a much longer period, suggesting that there are fundamental factors at play that are eating away at the premium. If you are a believer in value, as I am, there is a consolation prize here. Assuming that low PE stocks and low PBV stocks are good value is the laziest form of value investing, and it is perhaps not surprising that in a world where ETFs and index funds can be created to take advantage of these screens, there is no payoff to lazy value investing. I believe that good value investing requires creativity and out-of-the-box thinking, as well as a willingness to live with uncertainty, and even then, the payoff 

      b. The Elusive Small Cap Premium
      Another accepted part of empirical wisdom about stocks not only in the US, but also globally, is that small cap stocks deliver higher returns, after adjusting for risk using conventional risk and return models, than large cap stocks. 
      Raw Data from Ken French
      Looking at the data from 1927 to 2019, it looks conclusively like small market cap stocks have earned substantially higher returns than larger cap stocks; relative to the overall market, small cap stocks have delivered about 4-4.5% higher returns, and conventional adjustments for risk don't dent this number significantly. Not only has this led some to put their faith in small cap investing but it has also led analysts to add a small cap premium to costs of equity, when valuing small companies. I have not only never used a small cap premium, when valuing companies, but I am skeptical about its existence, and wrote a post on why a few years ago. Again, updating the data by decades, here is what I see:
      Raw Data from Ken French
      As with the value premium, the size premium had a rough decade between 2010 and 2019, dropping close to zero, on a value weighted basis, and turning significantly negative, when returns are computed on a equally weighted basis. Again, the trend is longer term, as there has been little or no evidence of a small cap premium since 1980, in contrast to the dramatic premiums in prior decades. If you are investing in small cap stocks, expecting a premium, you will be disappointed, and if you are still adding small cap premiums to your discount rates, when valuing companies, you are about four decades behind the times.

      5. New buzzwords were born
      Every decade has its buzzwords, words that not only become the focus for companies but are also money makers for consultants, and the last decade was no exception. At the risk of being accused of missing a few, there were two that stood out to me. The first was big data, driven partly by more extensive collection of information, especially online, and partly by tools that allowed this data to be accessed and analyzed. The other was crowd wisdom, where expert opinions were replaced by crowd judgments on a wide range of applications, from restaurant reviews to new (crypto) currencies.

      a. Big Data
      Earlier in this post, I looked at the surge in value of the FAANG stocks, and how they contributed to shaping the market over the last decade. One common element that all five companies shared was that they were not only reaching tens of millions of users, but that they were also collecting information on these users, and then using that information to improve existing products/services and add new ones. Other companies, seeking to emulate their success, tried their hand at “big data”, and it became a calling card for start-ups and young firms during the decade. While I agree that Netflix and Amazon, in particular, have turned big data into a weapon against competition, and Facebook’s entire advertising business is built on using personal data to focus advertising, I personally believe that like all buzz words, big data has been over sold. In particular, I noted, in a post from 2018 ,that for big data to create value,
      1. The data has to be exclusive: For data to be valuable, there has to be some exclusivity. Put simply, if everyone has it, no one has an advantage. Thus, the fact that you, as a business, can trace my location has little value when two dozen other applications and services on my iPhone are doing exactly the same thing. 
      2. The data has to be actionable: For value conversion to occur, the data that has been collected has to be usable in modifying and adapting the products and services you offer as a business. 
      Using these two-part test, you can see why Amazon and Netflix are standouts when it comes to big data, since the data they collect is exclusive (Netflix on your viewing habits/tastes and Amazon on your retail behavior) and is then used to tailor their offerings (Netflix with its original content investments and offerings and Amazon with its product nudging). Using the same two-part test, you can also see why the claims of big data payoffs at MoviePass and Bird Scooters makers never made sense.

      b. Crowd Wisdom
      One consequence of the 2008 crisis was a loss in faith in both institutional authorities (central banks, governments, regulators) but also in experts, most of whom had been hopelessly wrong in the lead up to the crisis. It is therefore not surprising that you saw a move towards trusting crowds on answers to big questions right after the crisis. It is no coincidence that Satoshi Nakamoto (whoever he might be) posted the paper laying out the architecture of Bitcoin in November 2008, a proposal for a digital currency without a central bank or regulatory overlay, where transactions would be crowd-checked (by miners). While Bitcoin has been more successful as a speculative game than as a currency during the last decade, the block chains that it introduced have now found their way into a much wider range of businesses, threatening to replace institutional oversight (from banks, stock exchanges and other established entities) with cheaper alternatives. The crowd concept has expanded into almost every aspect of our lives, with Yelp ratings replacing restaurant reviewers in our choices of where to eat, Rotten Tomatoes supplanting movie critics in deciding what to watch and betting markets replacing polls in predicting election outcomes. I share the distrust of experts that many others have, but I also wary of crowd wisdom. After all, financial markets have been laboratories for observing how crowds behave for centuries, and we have found that while crowds are often much better at gauging the right answers than market gurus and experts, they are also prone to herding and collective bad choices. For those who have become too trusting of crowds, my recommendation is that they read “The Madness of Crowds”, an old manuscript that is still timely.

      The decade to come
      It has been said that those who forget the past are destined to relive it, and that is one reason why we pore over historical track records, hoping to get insight for the future. But it has also been said that army generals who prepare too intensely to fight the last war will lose the next one, suggesting that reading too much into history can be dangerous. To me the biggest lesson of the last decade is to keep an open mind and to not take conventional wisdom as a given. I don’t know what the next decade will bring us, but I can guarantee you that it will not look like the last one or any of the prior ones, So, strap on your seat belts and get ready! It’s going to be a wild ride!

      YouTube Video


      Data Links

      1. Stocks, Bonds and Bills: 1928-2019
      2. Intrinsic and Actual Risk free Rates: 1954-2019
      3. Ken French Data on Value and Size Effects
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      Data Update 1 for 2020: Setting the table

      Starting in the early 1990s, I have spent the first week or two of every new year playing my version of Moneyball, downloading raw market and accounting data on publicly traded companies and using that data to compute operating, pricing and risk metrics for them. This year, I got a later start than usual on January 6, but as the week draws to a close, the results of my data exploration are posted on my website and will be the basis for a series of posts here over the next six weeks. As you look at the data, you will find that the choices I have made on how to classify companies and compute metrics affect my findings, and I will use this post to cast some light on those choices.

      The Data
      Raw Data: We live in an age when accessing raw data is easy, albeit not always cheap, and the tools to analyze that data are also widely available. My raw data is drawn from a variety of sources, ranging from S&P Capital IQ to Bloomberg to the Federal Reserve, and there are two rules that I try to follow. The first is to be careful about attributing sources for the raw data, and the second is to not undercut my raw data providers by replicating their data on my site, if they have commercial interests. 
      Data Analysis: Broadly speaking, I would categorize my data updates into three groups. The first is macro data, where my ambitions tend to be modest, and the only numbers that I update are numbers that I need and use in my valuation and corporate financial analysis. The second is business data, where I consolidate the company-level data into industry groupings, and report statistics on how companies invest, finance their operations and return cash (dividends and buybacks). The third are my data archives, where you can look at trend lines in the statistics by accessing my statistics from prior years. 

      A. Macro Data
      I am not a market timer or a macro economist, and my interests in macro data are therefore limited to numbers that I cannot easily look up, or access, on a public database. Thus, there is no point in my reporting exchange rates between major currencies, when you have FRED, the Federal Reserve site , that I cannot praise more highly for its reach and its accessibility. I do report and update the following:
      • Risk free rates in currencies: The way in which currencies are dealt with in valuation and corporate finance leaves us exposed to multiple problems, and I have written about both why risk free rates vary across currencies and why government bond rates are not always risk free. At the start of every year, I update my currency risk free rates, starting with the government bond rates, and then netting out default spreads and report them here. As risk free rates in developed market currencies hit new lows, and central banks are blamed for the phenomenon, I also update an intrinsic measure of the US dollar risk free rate, obtained by adding the inflation rate to real GDP growth each year, and report the time series in this dataset.
      • Equity Risk Premiums: The equity risk premium is the price of risk in equity markets and plays a key role in both corporate finance and valuation. The conventional approach to estimating this risk premium is to look at history, and to compare the returns that you would have earned investing in stocks, as opposed to investing in risk free investments. I update the historical risk premium for US stocks, by bringing in 2019 returns on stocks, treasury bonds and treasury bills in this dataset; my updated geometric average premium for stocks over US treasuries. I don't like the approach, both because it is backward looking and because the risk premium estimates are noisy, and have argued for a forward looking or implied ERP. I estimate the implied ERP to be 5.20% at the start of 2020 and report the year-end estimates of the premium going back to 1960 in this dataset. 
      • Corporate Default Spreads: Just as equity risk premiums measure the price of risk in equity markets, default spreads measure the price of risk in the debt markets. I break down bonds into bond rating classes (S&P and Moody's) and report my estimates of default spreads at the start of 2020 in this spreadsheet (and it includes a way of estimating a bond rating for a firm that does not have one).
      • Corporate Tax Rates: Ultimately, companies and investors count on after-tax income, though companies are adept at keeping taxes paid low. While I will report the effective tax rates that companies actually pay in my corporate data, I am grateful to KPMG for going through tax codes in different countries and compiling corporate tax rates, which I reproduce in this dataset.
      • Country Risk Premiums: As companies expand their operations beyond domestic markets, we are faced with the challenge of bringing in the risk of foreign markets into our corporate financial analyses and valuation. I have spent much of the last 25 years trying to come up with better ways of estimating risk premiums for countries, and I describe the process I use in excruciating detail in this paper. At the start of 2020, I use my approach, flaws and all, to estimate equity risk premiums for 170 countries and report them in this dataset.
      With macro data, it is generally good practice in both corporate finance and valuation to bring in the numbers as they are today, rather than have a strong directional view. So, uncomfortable though it may make you, you should be using today's risk free rates and risk premiums, rather than normalized values, when valuing companies or making investment assessments.

      B. Micro Data
      The sample: All data analysis is biased and the bias starts with the sampling approach used to arrive at the data set. My data sample includes all publicly traded companies, listed anywhere in the world, and the only criteria that I impose is that they have a market capitalization number available as of December 31, 2019. The resulting sample of 44,394 firms includes firms from 150 countries, some of which have very illiquid markets and questionable disclosure practices. Rather than remove these firms from my sample, which creates its own biases, I will keep them in my sample and deal with the consequences when I compute my statistics.

      While this is a comprehensive sample, it is still biased because it includes just publicly listed companies. There are tens of thousands of private businesses that are part of the competitive landscape that are not included here, and the reason is pragmatic: most of these companies are not required to make public disclosures and there are few reliable databases that include data on these firms. 
      The Industry Groupings: While I do have a (very large) spreadsheet that has the data at the company level, I am afraid that my raw data providers do not allow me to share that data, even though it is entirely comprised of numbers that I estimate. I consolidate that data into 94 industry groupings, which are loosely based on the industry groupings I created from Value Line in the 1990s when I first started creating my datasets. To see my industry grouping and what companies fall into each one, try this dataset. As you look at individual companies, there are two challenges that I face. First, there are companies that are in many businesses and I classify these companies into the industry groups from which they derive the most revenues. Second, some companies are shape shifters when it comes to industry grouping, and it is unclear which grouping they belong to; for a few high profile examples, consider Apple and Amazon. There is little that I can do about either problem, but consider yourselves forewarned.
      The statistics: My interests lie in corporate finance and valuation and selfishly, I report the statistics that matter to me in that pursuit. Luckily, as I described it in my post a few weeks ago, corporate finance is the ultimate big picture class and the statistics cover the spectrum, and I think the best way to organize them is based upon broad corporate finance principles:
      If you are interested, you will find more in-depth descriptions of how I compute the statistics that I report both in the datasets themselves as well as in this glossary.
      The timing: I use a mix of market and accounting data and that creates a timing problem, since the accounting data is updated at the end of each quarter and the market data is updated continuously. Using the logic that I should be accessing the most updated data for every item, my January 1, 2020, updated has market data (for share prices, interest rates etc) as of December 31, 2019 and the accounting data as of the most recent financial statement (usually September 30, 2019 for most companies). I don't view this an inconsistent but a reflection of the reality that investors face.

      C. Archived Data
      When I first started compiling my datasets, I did not expect them to be widely used, and certainly did not believe that they would be referenced over time. As I starting getting requests for datasets from earlier years, I decided that it would save both me and you a great deal of time to create an archive of past datasets. As you look at these archives, you will notice that not all datasets go back in time to the 1990s, reflecting first the expansion of my analysis from just US companies to global companies about 15 years ago and second the adding on of variables that I either did not or could not report in earlier years.

      The Rationale
      If you are wondering why I collect and analyze the data, let me make a confession, at the risk of sounding like a geek. I enjoy working with the data and more importantly, the data analysis is a gift that keeps on giving for the rest of the year, as I value companies and do corporate financial analysis.
      1. It gives me perspective: In a world where we suffer from data overload, the week that I spend looking at the numbers gives me perspective not only on what comprises normal in corporate financial behavior, but also on the differences across sectors and geographies. 
      2. Possible, Plausible and Probable: I have long argued that the valuation of a company always starts with a story but that a critical part of the process of converting narrative to value is checking the story for possibility, plausibility and probability. Having the global data aggregated and analyzed can help significantly in making this assessment, since you can see the cross section of revenues and profit margins of companies in the business and see if your assessments are out of line, and if so, whether you have a justification. 
      3. Rules of thumb: In spite of all of the data that we now have available, investors and companies seem to still rely on rules of thumb devised in a different time and market. Thus, we are told that companies that trade at less than book value, or six times EBITDA, are cheap, and that the target or right debt ratio for a manufacturing company is 40%. Using the global data, we can back up or dispel these rules of thumb and perhaps replace them with more dynamic and meaningful decision rules.
      4. Fact-based opinions: Many market prognosticators and economists seem to have no qualms about making up stuff about investor and corporate behavior and stating them as facts. Thus, it has become conventional wisdom that US companies are paying less in taxes that companies operating elsewhere in the globe, and that they have borrowed immense amounts of cash over the last decade to buy back stock. Those "facts" are now driving political debate and may well lead to change in policy, but these are more opinions than facts, and the data can be arbiter.
      If you are wondering why I am sharing the data, let's get real. Nothing that I am doing is unique, and I have no secret data stashes. In short, anyone with access to data (and there are literally tens of thousands who do) can do the same analysis. I lose nothing by sharing, and I get immense karmic payoffs. So, please use whatever data you want, and in whatever context, and I hope that it saves you time and helps you in your decision making and analysis. 

      The Caveats
      The last decade has seen big data and crowd wisdom sold as the answers to all of our problems, and as I listen to the sales pitches for both, I would offer a few cautionary notes, born out of spending much of my life time working with data:
      1. Data is not objective: The notion that using data makes you objective is nonsense. In fact, the most egregious biases are data-backed, as people with agendas pick and choose the data that confirms their priors. Just as an example, take a look at the data that I have in what US companies paid in taxes in 2019 in this dataset. I have reported a variety of tax rates, not with the intent to confuse, but to note how the numbers change, depending on how you compute them.  If you believe, like some do, that US companies are shirking their tax obligations, you can point to average tax rate of 7.32% that I report for all US companies, and note that this is well below the federal corporate tax rate of 21%. However, someone on the other side of this debate can point to the 19.01% average tax rate across only money making companies (since only profits get taxed) as evidence that companies are paying their taxes. 
      2. Crowds are not always wise: One of the strongest forces in corporate finance is me-tooism, where companies decide how to invest, how much to borrow and what to pay in dividends by looking at what their peers do. In my datasets, I offer them guidance in this process, by reporting debt ratios and dividend payout ratios for sectors, as well as regional breakdowns. The implicit assumption is that what other companies do, on average, must be sensible, but that assumption is not always true. This warning is particularly relevant when you look at the pricing metrics (PE, EV to EBITDA etc.) that I report, by sector and by region. The market may be right, on average, but it can also over price or under price a sector, at times.
      I respect data, but I don't revere it. I don't believe that just having data will give me an advantage over other investors or make me a better investor, but harnessing that data with intuition and logic may give me a leg up (or at least I hope it does).

      YouTube Video


      Links



      Data Update 5: Relative Risk and Hurdle Rates

      In my last four posts, I focused on the macro variables that we draw on, in both corporate finance and valuation, to estimate required returns or hurdle rates. In data post 3, I looked at how the prices of risk in both the bond market (default spreads) and the equity market (equity risk premiums) dropped in 2019, in the US. In data post 4, I extended the discussion to cover country and currency risk. In this one, I will bring in the micro variables that cause differences in risk across firms, and how to convert them into risk measure.

      Relative Risk Measures
      To get from the macro risk measures to company-level hurdle rates, you need to make judgments on relative risk. Put simply, if you buy into the proposition, like I do, that some companies/investments are riskier than others, you need a measure of relative risk that captures this variation.  It is in this context that I think of betas, a loaded concept that carries with it the baggage of modern portfolio theory and efficient markets. If you add to this the standard approach to estimating betas, built on looking at past prices and running regressions against market indices, you have the makings of a perfect storm, designed to drive value investors to apoplexy. I have no desire to re-litigate these arguments, partly because those for and opposed to betas are set in their ways, but let me suggest some compromise propositions.
      Relative Risk Proposition 1: You do not need to believe in betas to do financial analysis and valuation. 
      While there are many who seem to tie discounted cash flow valuations to the use of beta or betas, there is nothing inherently in  a DCF that requires that you make this leap:


      While the discount rate in a DCF is a risk-adjusted number, the approach is agnostic about how you measure risk and adjust discount rates for that risk.
      Relative Risk Proposition 2: If you don't like to or want to measure relative risk with betas, you can come up with alternate measures that better reflect your view of how risk should be measured. 
      While I do use beta as my proxy for risk, I do so with open eyes, recognizing its many limitations as a risk measure, and I have been always willing to consider competing risk measures. In fact, I have presented alternate measures of risk, drawing on the two building blocks of betas that draw the most pushback. The first is the assumption that marginal investors are diversified, and that the only risk that needs to be measured is the risk that cannot be diversified away. The second is its use of prices (stock and market) to estimate risk, seemingly contradicting intrinsic value's basic precept that market prices are not trustworthy. Since a picture is worth a thousand words, here a few alternative risk measures to consider, if you don't trust betas;
      Put simply, if your primary problem with betas is the assumption that marginal investors are diversified, there are total risk measures that are built around measuring the total risk in a company or investment, by looking at either the standard deviation or adding premiums (small cap, company-specific risk) to the traditional risk and return model. If your concern is that past prices are being used to estimate betas, you can switch to using accounting earnings and computing risk measures either from the perspective of diversified investors (accounting beta) or undiversified ones (earnings variability).
      Relative Risk Proposition 3: The margin of safety is not a competitor to any of the risk measures above, since it is a post-value adjustment for risk.
      Rather than repeat what I said in a much longer post that I had on the topic, let me summarize the points that I made there. When value investors talk about protecting themselves from risk by using a margin of safety, they are talking about building a buffer between value and price, but to use the margin of safety, you need to value a stock first. To get that value, you need a risk measure, and that brings us back full circle to how you adjust for risk, when valuing companies.

      Relative Risk in 2020
      With that long lead-in, let's take a look at how companies measured up on relative risk measures, at the start of 2020. In keeping with my argument in the last section that you can use alternative risk measures, I will report on three alternative risk measures:
      • Betas: I start with betas, estimated with conventional regressions of returns on the stock against a market index, for each of the companies in my sample. To get a measure of how these betas vary across companies, I have a distribution of betas, broken down globally and for regions of the world:
        It is worth noting that, at least for public companies, half of all companies have betas between 0.85 and 1.45, globally. If you are wondering why the betas are not higher for companies in riskier parts of the word, it is worth emphasizing that betas are scaled around one, no matter of the world you are in, and are not designed to convey country risk. (The equity risk premiums that I wrote about in my last post carry that weight.)
      • Relative Standard Deviation: For those who do not buy into the notion that the marginal investors are diversified and that the only risk that matters is market risk, I report on the standard deviation in stock prices (using the last two years of data):
        Note that you can convert these numbers into relative measures, resembling betas, by dividing by the average standard deviation of all stocks. Thus, if you have a US stock with an annualized standard deviation of 35.00% in stock returns, you would divide that number by the average for US equities of 42.36% to arrive a relative standard deviation of 0.826 (=35.00%/42.36%).
      • High-Low Risk: For those who prefer a non-parametric and more intuitive measure of risk, I compute a risk measure by looking at the difference between high and low prices in the most recent year, and dividing by the sum of the two numbers. Thus, for a stock that has a high price of 20 and a low price of 12, during the course of a year, this measure would yield 0.25 ((20-12)/ (20+12)). Note that the bigger the range in prices, the more risky a stock looks on this measure, and this too is broken down globally and by region:
        As with the other risk measures, this too can be converted into a relative risk measure, by dividing by the average.
      • Earnings Variability: Finally, for those who trust accountants more than markets (even though I am not one of them), I have computed a risk measure that is built around earnings variability, computed by looking at the standard deviation in net income over the last 10 years for each firm, and converted into a standardized measure, by dividing by the average net income over the ten years (a coefficient of variation in net income), The global and regional breakdown is below:
        The earnings variability number has a bigger selection bias than the other measures, because it requires a longer history (10 years of data) and positive earnings, cutting the sample size down significantly. Here again, dividing a company's coefficient of variation in net income by the average value across all companies will give you a relative risk measure.
      I follow up by looking at median values for each of the risk measures by industry grouping. Since I have 94 industry groupings, I will not report them all here, but you can download the data on all of the industry groupings, by clicking here.

      Hurdle Rates in 2020
      The relative risk measures are a means to an end, since the only reason for computing them is to use them to get to required returns. In this section, I begin by looking at the cost of equity, then bring in the cost of debt and close of by looking at the cost of capital.

      a. Cost of Equity
      There are three ingredients that go into the cost of equity and the last few posts have laid the foundations for the three inputs:

      • The risk free rate is a function of the currency you choose to compute your hurdle rates in, and will be higher for high-inflation currencies than low-inflations ones. Since I will be comparing and aggregating costs of equity across more than 40,000 firms spread across the world, I will compute their costs of equity in US dollars, using the US T.Bond rate as of January 1, 2020, as the risk free rate. You can convert these into any other currency, using the differential inflation approach that I described in my earlier post from a couple of weeks ago.
      • The equity risk premium for a company is a function of where it does business, and in my last data update post, I described my approach to estimating equity risk premiums for individual countries, and the process of weighting these (using either revenues or production) to get equity risk premiums for companies.
      • For the relative risk measure, I will use betas but as I argued in the last section, I am agnostic about what you prefer to use instead. Thus, if you prefer earnings variabliity as a measure, you can use relative earnings variability as your risk measure.
      With these inputs, I estimate the costs of equity for all of the companies in my database, and report the distribution in the table below:
      Comparing this distribution to the one for betas, earlier in this post, you will notice a wider spread in the numbers across regions, as we bring in equity risk premium differences into the calculation.

      b. Cost of Debt
      The cost of debt is a simpler exercise, since it is a measure of the rate at which companies can borrow money today, not a reflection of the rates at which they have borrowed in the past. It is a function of the risk free rate and the default spread:
      As with the cost of equity, the risk free rate is a function of the currency in which you estimate the cost of debt in, and I will estimate the costs of debt for all companies in US dollars, again to make comparisons across companies. For the default spread, I have little choice but to use bludgeon measures, since I cannot assess credit risk for 40,000 plus companies. For companies that have an S&P bond rating (about 15% of the sample), I use the rating to estimate a default spread. For the rest, I estimate synthetic bond ratings based on financial ratios (interest coverage and debt ratios). The US $ pre-tax cost of debt distribution is below:

      Since these costs are all in US dollars, the differences across regions reflect difference in country default risk and reflect wide divergences. It is worth noting that the tax law tilt towards debt, represented in the fact that interest expenses are tax deductible and cash flows to equity (dividends and buybacks) have to come from after-tax cash flows, is not just a phenomenon for the US, but true over much of the world, with the Middle East representing the holdout. This tax benefit shows up in the cost of capital, through the conversion of the pre-tax cost of debt into an after-tax cost, using the marginal tax rate to make the adjustment:
      After-tax cost of debt = Pre-tax cost of debt (1 - Marginal Tax Rate)
      In my sample, I use the marginal tax rate of the country in which a company is incorporated. You can find these marginal tax rates, which KPMG should be credited for collecting, also on my website for download.

      c. Debt Ratios and Costs of Capital
      The final piece of the puzzle in computing the cost of capital is the mix of debt and equity that companies use in funding their operations. In keeping with the cost of capital being a measure of what companies have to pay for their debt and equity today, I use the market values of equity and debt, with leases converted into debt and included in the latter, to compute the cost of capital. While I will talk in more detail about debt loads and choices in a future post, you can sense of the debt load at companies, as a percent of capital (in market value terms) in the table below below:

      With these debt ratios, and using the costs of equity and debt also shown above, I compute costs of capital, in US dollar terms, for all publicly traded companies and the resulting distribution is below:

      This is a table that I will use, and have already put to use, in valuing companies since it provides a quick and effective way to estimate discount rates for companies, without losing yourself in the details. Thus, when valuing a young, money-losing public company in the US (like Casper, the only mattress-maker that went public last week), I will use a cost of capital of 9.15%, representing the 90th percentile of US firms, whereas to value a slow-growing European company in a stable business,  like Heineken, my cost of capital will be 6.02%, the 25th percentile of European companies. For all companies, the median cost of capital of 7.58% is a good proxy for the number that all companies will converge towards, as they approach maturity. If all of these numbers look low to you, that is because they reflect a risk free rate, in US dollars, that is low, and if it does rise, it will carry these numbers upwards.  As with the risk measures, I have estimated costs of equity, debt and capital, by industry group and you can download them for all companies globally, as well as regionally (US, Emerging Markets, Europe, Japan and Australia/Canada) and for India and China, separately.

      YouTube Video


      Downloadable Data

      1. Industry Average Risk Measures at start of 2020
      2. Betas, by industry (GlobalUSEmerging MarketsEuropeJapan,  Australia/Canada, India, China)
      3. Costs of Debt, Equity and Capital, by industry (GlobalUSEmerging MarketsEuropeJapan,  Australia/Canada, India, China)
      4. Marginal tax rates, by country, for 2020



      A Viral Market Meltdown: Fear or Fundamentals?

      It has become almost a rite of passage for investors, at least since 2008, that they will be tested by a market crisis precipitated sometimes by political developments (Brexit), sometimes by governments (trade wars), sometimes by war and terrorism (the US/Iran standoff) and sometimes by economics (Greek default). With each one, the question that you face about whether this is the “big one”, a market meltdown that you have to respond to by selling everything and fleeing for safety (or the closest thing you can find to it) or just another bump in the road, where markets claw back what they gave up, and then gain more. After yesterday’s global meltdown in equity markets, I think it is safe to say that we are back in crisis mode, with old questions returning about the global economic strength and market valuations. I have neither the stomach nor the expertise to play market guru, but I will go through my playbook for coping.

      Start at the source
      This crisis has an uncommon source, insofar as it is one of the few that is not man-made (at least based upon what we know now) and is thus more difficult to predict, in terms of how it will play out. As a novice in infectious diseases, here is what I know at the moment:
      1. The virus (COVID-19) had its origins in China, though what caused it to spread into the human population is still unclear and rife with conspiracy theories. In an attempt to keep the populace from panicking and to give the impress of being in control, the Chinese government initially went into crisis mode, trying to control the information that is being made public and that has created both confusion and skepticism about official claims.
      2. Within China, the virus has had its biggest impact in the Wuhan province, but it has affected other parts, though there is still not clear by how much or how many. The count, which is obviously a moving target, is that there are more than 80,000 cases of the virus, with more than 2700 fatalities so far. The latest reports from China is that new infections are falling, and if true, this would suggest that the spread is being controlled. 
      3. The most immediate spread has been to the neighboring Asian countries, with Singapore being an early casualty and South Korea a recent-add on. It has jumped borders and is showing up in more distant parts of the world, mostly in occasional cases. Over the weekend, though, the Italian government set alarm bells ringing with an announcement of a large cluster of cases in the country, which suggests that earlier assessments that the virus was not easily communicable may need to be rethought, and it was this news that seems to have precipitated this week’s sell off. On February 25, the CDC warned Americans that the disease could make significant inroads in the United States and suggested that states prepare cautionary measures.
      4. There is no cure or vaccine yet for the virus, but the mortality rate from the virus seems to vary across the population, with the very young and the very old being the most likely to die from it, and across geographies, with more deaths in Asia than in Europe or the United States. The overall mortality rate is low ( about 3%), but it is higher for people who are hospitalized with complications. 
      In short, there is a lot more that we do not know about COVID-19, than we do, at least at the moment. While it has not been labeled a pandemic yet, it seems to have the potential to become one, and we do not yet have a clear idea of how quickly it will spread, how many people will be affected and what will push it into dormancy. It is also clear that much of this uncertainty will get resolved by real-time developments, not by collecting data or by listening to experts to tell us what will happen.

      Get perspective
      There is no denying that the last week has been a rocky one for investors, and a 1800-point drop for the Dow over two days (February 24 &25) is bound to add to the sense of foreboding. Since the first casualty of a crisis is perspective, it may be worth stepping back and looking at the market through wider lens. After the drop yesterday (February 24), the S&P 500 was at 3225.89, slightly above where it started this month (February 2020) at. In short, investors in the index were back where they were 18 trading days ago. Bringing in February 25 into the picture does put you below that level, but it still way above what it was a year ago:

      In fact, extending the comparison to longer time periods only makes the hand wringing over the last week’s losses look even more absurd. This is both good and bad news. The good news is that, if you are a diversified investor, your portfolio should not look dramatically different from what it looked like at the start of the year and much, much healthier than it looked a year ago, five years ago or ten years ago. The bad news is that the big run-up in stocks over the last decade has left you exposed to more and bigger losses to come. The bottom line is that your concern should not be about the damage to your portfolio from the last week’s developments, but the damage that is yet to come.

      Have a framework
      With perspective in place, I am now in a position to look to the future, since that should govern how we react to last week’s developments. Given my investment philosophy of trusting fundamentals and value, I have to go back to my basic framework for valuation, which is to tie the value of an investment to its cashflows, growth and risk. When valuing the overall market, here is what it looks like:

      With my value framework, the effects of the Corona Virus will play out in my forward-looking numbers in the following inputs:

      1. Earnings Growth: Even at this early stage in this crisis, it is clear that the virus is having an effect on corporate operations. With some companies like hotels and airlines, the effect that the virus has had on global travel has clearly had an effect on revenues and operations, and it should come as no surprise that United Airlines announced, after close of trading on February 24, 2020, that it was withdrawing its guidance for revenues this year, as it was waiting for more information. With others, it is concern about supply chain disruptions, especially with Chinese facilities, and how this will affect operations in the rest of the world. The follow up question then becomes one of specifics:
      • Drop in 2020 Earnings: This is the number that will reflect how you see Corona Virus affect the collective earnings on stocks in 2020. This will include not only earnings declines caused by lower revenues growth at companies like United Airlines, but also the earnings decline caused by higher costs faced by companies due to virus related problems (supply chain breakdowns). The wider the swath of companies that are affected, the bigger will be the earnings effect. As to how big this effect will be on overall earnings, we can only guess, given where we are in this process. To provide some perspective, the 2008 banking crisis caused an earnings implosion, with earnings dropping almost 40% in 2008, from 2007, but the World Trade Center attacks in September 2001 barely made an impact on overall S&P 500 earnings in the last quarter of 2001.
      • Drop in long term Earnings: In previous crises, where consumers and workers stayed home, either for health reasons or because of fear, the business that was lost as a result of the peril was made up for, when it passed. If consumption is just deferred or delayed, the growth in subsequent quarters will be higher, to compensate for the lost business in the crisis quarter. If consumption is lost, the drop in earnings in the crisis quarter will never be made up. 
      To illustrate the point, I look at how three different perspectives on growth will play out in growth rates, based upon how much of the drop in earnings this year is recovered over the following years:


      Note that the first series is the unadjusted earnings, prior to the corona virus scare and that in all three of the scenarios, there is a drop in earnings of 5% in 2020, putting earnings well below expected values for 2020, but the difference arises in how earnings recover after that. If none of the drop in earnings in 2020 is recouped in the following years, the earnings in 2025 is 179.22, well below the pre-virus estimate of 199.28. If only half of the earnings drop is recouped, the earnings in 2025 is 189.41 and if all of the earnings drop is recouped, the earnings in 2025, even with the virus effect, matches up to the original estimates.

      2. Cash Returned: In 2019, US companies returned 92.33% of earnings as cash to stockholders, with a big chunk (about 60%) coming from buybacks. That high number reflects not only the cash that many US companies had on hand, but a confidence that they could maintain earnings and continue to pay out cash flows. To the extent that this confidence is shaken by the virus, you may see a pull back in this number to perhaps something closer to the 85.24% that is the average for the last decade.

      3. Risk and Discount Rates: Finally, the required return on stocks will be impacted, with one of the effects being explicit and visible in markets, in the form of the US treasury bond rate and the other being implicit, taking the form of an equity risk premium. If investors become more risk averse, they will demand a higher ERP, though as the fear factor fades, this number will fall back as well, but perhaps not to what it was prior to the crisis. The fact that the equity risk premium is already at the higher end of the historical norms, at about 5.50% on February 25, 2020, does indicate limits, but there could be a short-term jump in the number, at least until there is less uncertainty.

      Using this framework on the S&P 500, you can see how each of these variables play out in value.
      I am not an expert on infectious diseases, and the health and economic impacts of this virus are likely to play out as developments in real time, requiring that I revisit this framework frequently. Based upon my estimates of how this virus will affect the numbers, the value that I get for the index is 3003, about 4.14% less than the index level of 3128.21 at the close of trading on February 25, 2020, which, in turn, represents a significant drop from the level of the index a week ago. To the question of whether a virus can cause this much damage to the markets, the answer is yes, though whether it is an overreaction or not will depend on how it plays out in the numbers. For the moment, though, if you are tempted to buy on what looks like a dip, I would suggest caution just as I would argue for slowing down to someone who wants to do the opposite and sell. As you look at my assumptions about how the virus will play out in earnings (both short term and long term), cash flows and risk premiums, some of you may disagree (and perhaps even strongly) and you can use this spreadsheet to arrive at your own valuation of the index, and use it to drive your actions. 

      To thine own self, be true...
      It is entirely possible that I am underestimating the impact of this virus on economic growth and earnings and that I should be panicking more, but it is also plausible that I am over adjusting my numbers too much. The bottom line with my calculations is that I am inclined to do very little, at the moment. I don’t feel the urge to buy the market, because there is a plausible case to be made that the adjustment in value, steep and sudden, was merited. I feel little need to sell either, because I don’t see an over valuation large enough to trigger action. As for whether I should be reducing my exposure to companies that are directly affected by the virus (hotels and airlines) and increasing my exposure to companies that are more insulated, I don’t believe there will be any segment of the market that is fully protected from the consequences, no matter how far you get from China and from travel-oriented companies. In fact, if there is a segment of the market where you are likely to see over reaction, it is likely to be in airline, travel and energy stocks, precisely because they are in the center of the storm. Do I now wish that I had bought Zoom before this crisis reached full blown status? Yes, but I am not sure buying it now will do much for me. I am loath to offer advice, but my only suggestion is that rather than listen to the experts on either side of this debate tell you what to do, you should make your own best judgments, recognizing that they can and will change as more facts emerge, and act accordingly.

      YouTube Video


      Spreadsheets

      1. Spreadsheet to value Corona Virus Effects on S&P 500 (February 25, 2020)



      Data Update 4: Country Risk and Currency Questions!

      In my last post, I looked at the risk premiums in US markets, and you may have found that focus to be a little parochial, since as an investor, you could invest in Europe, Asia, Africa or Latin America, if you believed that you would receive a better risk-return trade off. For some investors, in countries with investment restrictions, the only investment options are domestic, and US investment options may not be within their reach. In this post, I will address country risk, and how it affects investment decisions not only on the part of individual investors but also of companies, and then look at the currency question, which is often mixed in with country risk, but has a very different set of fundamentals and consequences.

      Country Risk
      There should be little debate that investing or operating in some countries will expose you to more risk than in other countries, for a number of reasons, ranging from politics to economics to location. As globalization pushes investors and companies to look outside of their domestic markets, they find themselves drawn to some of the riskiest parts of the world because that is where their growth lies. 

      Drivers and Determinants
      In a post in early August 2019, I laid out in detail the sources of country risk. Specifically, I listed and provided measures of four ingredients:
      1. Life Cycle: As companies go through the life cycle, their risk profiles changes with risk dampening as they mature. Countries go through their own version of the life cycle, with developed and more mature markets having more settled risk profiles than emerging economies which are still growing, changing and generally more risky. High growth economies tend to also have higher volatility in growth than low growth economies. 
      2. Political Risk: A political structure that is unstable adds to economic risk, by making regulatory and tax law volatile, and adding unpredictable costs to businesses. While there are some investors and businesses that believe autocracies and dictatorships offer more stability than democracies, I would argue for nuance. I believe that autocracies do offer more temporal stability but they are also more exposed to more jarring, discontinuous change. 
      3. Legal Risk: Businesses and investments are heavily dependent on legal systems that enforce contracts and ownership rights. Countries with dysfunctional legal systems will create more risk for investors than countries where the legal systems works well and in a timely fashion.
      4. Economic Structure: Some countries have more risk exposure simply because they are overly dependent on an industry or commodity for their prosperity, and an industry downturn or a commodity price drop can send their economies into a tailspin. Any businesses that operate in these countries are consequently exposed to this volatility.
      The bottom line, if you consider all four of these risks, is that some countries are riskier than others, and it behooves us to factor this risk in, when investing in these countries, either directly as a business or indirectly as an investor in that business.

      Measures
      If you accept the proposition that some countries are riskier than others, the next step is measuring this country risk and there are three ways you can approach the task:
      a. Country Risk Scores: There are services that measure country risk with scores, trying to capture exposure to all of the risks listed above. The scores are subjective judgments and are not quite comparable across services, because each service scales risk differently. The World Bank provides an array of governance indicators (from corruption to political stability) for 214 countries (https://databank.worldbank.org/source/worldwide-governance-indicators#) , whereas Political Risk Services (PRS) measures a composite risk score for each country, with low (high) scores corresponding to high (low) country risk. 
      b. Default Risk: The most widely accessible measure of country risk markets in financial markets is country default risk, measured with a sovereign rating by Moody’s, S&P and other ratings agencies for about 140 countries and a market-based measure (Sovereign CDS) for about 72 countries. The picture below provides sovereign ratings and sovereign CDS spreads across the globe at the start of 2020:
      Download spreadsheet
      c. Equity Risk: While there are some who use the country default spreads as proxies for additional equity risk in countries, I scale up the default spread for the higher risk in equities, using the ratio of volatility in an emerging market equity index to an emerging market bond index to estimate the added risk premium for countries: 


      Note that the base premium for a mature equity market at the start of 2020 is set to the implied equity risk premium of 5.20% that we estimated for the S&P 500 at the start of 2020. The picture below shows equity risk premiums, by country, at the start of 2020:
      Looking back at these equity risk premiums for countries going back to 1992, and comparing the country ERP at the start of 2020 to my estimates at the start of 2019, you see a significant drop off, reflecting a decline in sovereign default spreads of about 20-25% across default classes in 2019 and a drop in the equity risk, relative to bonds.

      Company Risk Exposure to Country Risk
      The conventional practice in valuation, which seems to be ascribe to all countries incorporated and listed in a country, the country risk premium for that country, is both sloppy and wrong. A company’s risk comes from where and how it operates its businesses, not where it is incorporated and traded. A German company that manufactures its products in Poland and sells them in China is German only in name and is exposed to Polish and Chinese country risk. One reason that I estimate the equity risk premiums for as many countries as I need them in both valuation and corporate finance, even if every company I analyze is a US company.

      Valuing Companies 
      If you accept my proposition that to value a company, you have to incorporate the risk of where it does business into the analysis, the equity risk premium that you use for a company should reflect where it operates. The open question is whether it is better to measure operating risk exposure with where a company generates its revenues, where its production is located or a mix of the two. For companies like Coca Cola, where the production costs are a fraction of revenues and moveable, I think it makes sense to use revenues. Using the company’s 2018-19 revenue breakdown, for instance, the equity risk premium for the country is:

      For companies where production costs are higher and facilities are less moveable, your weights for countries should at least partially based on production. At the limit, with natural resource companies, the operating exposure should be based upon where it produces those resources. Thus, Aramco’s equity risk premium should be entirely based on Saudi Arabia’s, since it extracts all its oil there, but Royal Dutch’s will reflect its more diverse production base:

      Put simply, the exposure to country risk does not come from where a company is incorporated or where it is traded, but from its operations.

      Analyzing Projects/Investments
       If equity risk premiums are a critical ingredient for valuation, they are just as important in corporate finance, determining what hurdle rates multinationals should use, when considering projects in foreign markets. With L’Oreal, for instance, a project for expansion in Brazil should carry the equity risk premium for Brazil, whereas a project in India should carry the Indian equity risk premium. The notion of a corporate cost of capital that you use on every project is both absurd and dangerous, and becomes even more so when you are in multiple businesses.

      The Currency Effect
      When the discussion turns to country risk, it almost always veers off into currency risk, with many conflating the two, in their discussions. While there are conditions where the two are correlated and draw from the same fundamentals, it is good to keep the two risks separate, since how you deal with them can also be very different.

      Decoding Currencies: Interest Rates and Exchange Rates
      When analyzing currencies, it is very easy to get distracted by experts with macro views, providing their forecasts with absolute certainty, and distractions galore, from governments keeping their currencies stronger or weaker and speculative trading. To get past this noise, I will draw on the intrinsic interest rate equation that I used in my last post to explain why interest rates in the United States have stayed low for the last decade, 
      Intrinsic Riskfree Rate = Inflation + Real GDP Growth
      That identity can be used to both explain why interest rates vary across currencies as well as variation in exchange rates over time. 

      Risk free Rates
      If you accept the proposition that the interest rate in a currency is the sum of the expected inflation in that currency and a real interest that stands in for real growth, it follows that risk free rates will vary across currencies. Getting those currency-specific risk rates can range from trivial (looking up a government bond rate) to difficult (where the government bond rate provides a starting point, but needs cleaning up) to complex (where you have to construct a risk free rate out of what seems like thin air).

      1. Government Bond Rates
      There are a few dozen governments that issue ten-year bonds in their local currencies, and the search for risk free rates starts there. To the extent that these government bonds are liquid and you perceive no default risk in the government, you can use the government bond rate as your risk free rate. It is that rationale that we use to justify using the Swiss Government’s Swiss Franc 10-year rate as the risk free rate in Swiss Francs and the Norwegian government’s ten-year Krone rate as the riskfree rate in Krone. It is still the rationale, though you are likely to start to get some pushback, in using the US treasury bond rate as the risk free rate in dollars and the German 10-year Euro as the risk free rate in Euros. The pushback will come from some who argue that the US treasury can choose to default and that the German government does not really control the printing of the Euro and could default as well. While I can defend the practice of using the government bond rate as the risk free rate in these scenarios, arguing that you can use the Nigerian government’s Naira bond rate or the Brazilian government’s Reai bond rate as risk free is much more difficult to do. In fact, these are government’s where ratings agencies perceive significant risk even in the local currency bonds and attach ratings that reflect that risk. Moody’s rates Brazil’s local currency bonds at Ba2 and India’s local currency bonds at Baa2. In my pursuit of a risk free rate in currencies like these (where there is no Aaa-rated entity issung a bond), I compute a risk free rate by netting out the default spread:
      • Riskfree Rate in currency = Government bond rate – Default Spread for sovereign local-currency rating
      Using this approach on the Indian rupee and the Brazilian reai,
      • Riskfree Rate in Rupees on January 1, 2020 = Indian Government Rupee Bond rate on January 1, 2020 – Default spread based on Baa2 rating = 6.56% - 1.59% = 4.95%
      • Riskfree Rate in Brazilian $R = Brazilian Government $R Bond rate on January 1, 2020 – Default spread based on Ba2 rating = 6.77% - 2.51% = 4.26%
      Extending this approach to all countries where a local currency government bond is available, we get the following risk free rates:
      Download spreadsheet
      Note that these estimates are only as good as the three data inputs that go into them. First, the government bond rates reported have to reflect a traded and liquid bond, clearly not an issue with the US treasury or German Euro bond, but a stretch for the Zambian kwacha bond. Second, the local currency rating is a good measure of the default risk, a challenge when ratings agencies are biased or late in adjusting. Third, the default spread, given the ratings class, is estimated without bias and reflects the market at the time of the assessment. 

      2. Synthetic Risk free Rates
      If you have doubts about one or more of three assumptions needed to use the government-bond approach to getting to risk free rates, don’t fear, because there is an alternative that I will call my synthetic risk free rate. To use this approach, let’s start with a currency in which you feel comfortable estimating a risk free rate, say the US dollar. If the key driver of risk free rates is expected inflation, the risk free rate in any other currency can be estimated using the differential inflation between that currency and the US dollar. In the short cut, you add the differential inflation to the US T.Bond rate to get a risk free rate:
       Local Currency Risk free rate = US T.Bond Rate + (Inflation rate in local currency - Inflation rate in US dollars)
      In the full calculation, you incorporate the compounding effects of the differential inflation
      This approach can be used in almost any setting to estimate a local currency risk free rate, including the following:
      1. Currencies with no government bonds outstanding: There are more than 120 currencies, where there are no government bonds in the local currency; the country borrows from banks and the IMF, not from markets. Without a government bond rate, the approach described above becomes moot.
      2. Currencies where the government bond rate is not trustworthy: There are currencies where there is a government bond, with a rate, but an absence of liquidity and/or the presence of institutions being forced to buy the bond by the government that may make the rates untrustworthy. I don't mean to cast aspersions, but I seriously doubt that the Zambian Kwacha bond, whose rate I specified in the last section, has a deep or wide market.
      3. Pegged Currencies: There are some currencies that have been pegged to the US dollar, either for convenience (much of the Middle East) or stability (Ecuador). While analysts in these markets often use the US T.Bond rate as the risk free rate, there is a very real danger that what is pegged today may be unpegged in the future, especially when the fundamentals don't support the peg. Specifically, if the local inflation rate is much higher than the inflation rate in the US, it may be more prudent to use the synthetic risk free rate instead of the US T.Bond rate as the risk free rate.
      The key inputs here are the expected inflation rate in the US dollar and the expected inflation rate in the local currency. The former can be obtained from market data, using the difference between the US T.Bond rate and the TIPs rate, but the latter is more difficult. While you can always use last year’s inflation rate, but that number is not only backward looking but subject to manipulation. I prefer the forecasts of inflation that you can get from the IMF, and I have used those to get expected risk free rates in other currencies, using the US T.Bond rate as my base risk free rate, and you can find them at this link.

      Currency Choice
      Having belabored the reasons for why riskfree rates vary across currencies, let’s talk about how to pick a currency to use in valuing a company. The key word is choice, since you can value any company in any currency, though it may be easiest to get financial information on the company, in a local currency. An Indian company can be valued in US dollars, Indian Rupees or Euros, or even in real terms, and if you are consistent about dealing with inflation in your valuation, the value should be the same in every currency. At first sight, that may sound odd, since the risk free rate in US dollars is much lower than the risk free rate in Indian rupees, but the answer lies in looking at all of the inputs into value, not just the discount rate. In fact, inflation affects all of your numbers:

      With high inflation currencies, the damage wrought by the higher discount rates that they bring into the process are offset by the higher nominal growth you will have in your cash flows, and the effects will cancel out. With low inflation currencies, any benefits you get from the lower discount rates that come with them will be given back when you use the lower nominal growth rates that go with them. In practice, there is perhaps no other aspect of valuation where you are more likely to be see consistency errors than with currencies, and here are some scenarios:
      1. Casual Dollarization: In casual dollarization, you start by estimating your costs of equity and capital in US dollars, partly because you do not want to or cannot estimate risk free rates in a local currency. You then convert your expected future cash flows in the local currency and convert them to dollars using the current exchange rate. That represents a fatal step, since the inflation differentials that cause risk free rates to be different will also cause exchange rates to change over time. Purchasing power parity may be a crude approximation of reality, but it is a reality that will eventually hold, and ignoring can lead to valuation errors that are huge.
      2. Corporate hurdle rates: I have long argued against computing a corporate cost of capital and using it as a hurdle rate on investments and acquisitions, and that argument gets even stronger, when the investments or acquisitions are cross-border and in different currencies. If a European company takes its Euro cost of capital and uses it to value Hungarian, Polish or Russian companies, not correcting for either country risk or currency differentials, it will find a lot of “bargains”.
      3. Mismatched Currency Frames of Reference: We all have frames of reference that are built into our thinking, based upon where we live and the currencies we deal with. Having lived in the US for 40 years and dealt with more US companies than companies in any other market, I tend to think in US dollar terms, when I think of reasonable, high or low growth rates. While that is understandable, I have to remember that when conversing with an Indian analyst in Mumbai, whose day-to-day dealings in rupees, the growth rates that he or she provides me for a company will be in rupees. Consequently, it behooves both of us to be explicit about currencies (my expected growth rate for Infosys, in US dollars, is 4.5% or my cost of capital, in Indian rupees, is 10%) when making statements, even though it is cumbersome.
      One of the side costs of globalization is that you can no longer assume, especially if you are a US investor or analysts, that the conversations that you will be having will always be on your currency terms (presumably dollars). Understanding how currencies are measurement tools, not instruments of risk or asset classes, will make that transition easier.

      Conclusion
      In this post,  I looked at two variables, country and currency, that are often conflated in valuation, perhaps because risky countries tend to have volatile currencies, and separated the discussion to examine the determinants of each, and why they should not be lumped together. I can invest in a company in a risky country, and I can choose to do the valuation in US dollars, but only if I recognize that the currency choice cannot make the country risk go away. In other words, a Russian or Brazilian company will stay risky, even if you value it in US dollars, and a company that gets all of its revenues in Northern Europe will stay safe, even if you value it in Russian Rubles.

      YouTube Video


      Data Links

      1. Ratings and Sovereign CDS spreads, by country (January 2020)
      2. Country Equity Risk Premiums in January 2020
      3. Government Bond Rates and Riskfree Rates by Currency in January 2020
      4. Synthetic Riskfree Rates in 2020 (with inflation rates by currency)

      Data Update Posts
      1. Data Update 1 for 2020: Setting the Table
      2. Data Update 2 for 2020: Retrospective on a Disruptive Decade
      3. Data Update 3 for 2020: The Price of Risk!
      4. Data Update 4 for 2020: Country and Currency Effects





      Data Update 3 for 2020: The Price of Risk!

      When investing, risk is a given and if you choose to avoid it, at any cost, you will and in the last decade, you have borne a staggering cost in terms of returns unearned. At the other extreme, seeking out risk for the sake of taking risk is more suited to casinos than to financial markets, and as in casinos, the end game is almost always disastrous. The middle ground on risk is to accept that it is part and parcel of investing, to try to gauge how exposed you are to it and to make sure that your expected return is high enough to compensate you for taking that risk. Put simply, you are charging a price to take risk, and that price will reflect not only your history and experiences as an investor, but how risk averse you are, as an individual. In this post, rather than focus on your or my price of risk. I want to talk about the market price of risk, as assessed by all investors, and how that price changed in 2019.

      The Price of Risk
      There are almost as many definitions of risk, as there are investors, but I find many of them wanting. There is, of course, the definition of risk as uncertainty, a circular play on words, since it just replaces one nebulous word (risk) with another. There is the definition of risk as encompassing all the bad outcomes you can have on an investment, which by making risk into a negative and something to be avoided, leads you right into the arms of those selling your protection against it (in the form of hedging). In finance, we have become so used to measuring risk in statistical terms (standard deviation, variance, covariance etc.) that we have taken to defining risk with these measures, an arid and antiseptic view of risk.  The truth is that risk, at least in business, is neither a good nor a bad, but a given. It is a combination of danger (the likelihood that bad things will happen to you) and opportunity (often emerging from exposing yourself to danger, and I think that the Chinese symbol for crisis captures its essence perfectly:
      (I know! I know! I have been corrected and recorrected on both the symbols and the definition by people who know far more Chinese than I do, which is pretty much everyone in the world… So, please cut me some slack!) It is this definition of risk that allows us to frame the risk/return trade off that lies at the heart of investing. While you can choose a pathway of taking no risk and earning guaranteed returns, those returns in today’s markets would be close to zero in the United States and Europe. If you want to earn higher returns, you have no choice but to expose yourself to risk, and when you do, the key question becomes whether you are being compensated sufficiently for taking that risk. 
      • When you invest in fixed income securities (bonds), your compensation takes the form of a default spread, i.e., what you charge over and above the risk free rate to invest in that bond.
      • · When you invest in equities, the payoff to taking risk comes in the form of an equity risk premium, i.e., the premium you demand over and above the risk free rate for investing in equities as an asset class.
      Both the default spread and the equity risk premium are market-set numbers and are driven by demand and supply. The default spread is a function of what investors believe is the likelihood that borrowers will fail to make their contractually obligated payments, and it will rise and fall with the economy. The equity risk premium is a more complex number and I think of it as the receptacle for everything from changes in investor risk aversion to perceptions of economic growth and stability to corporate choices on leverage and cash return to global flash points (war, health scares etc.).

      The Default Spread
      The default spread is the premium that investors demand on a bond to compensate for default risk, and not surprisingly, it varies across bond issuers, with safer (riskier) borrowers being charged less (more) to borrow money. One assessment of corporate default risk is a bond rating, a measure of default risk computed by ratings agencies. While ratings agencies have been criticized for bias and delay, these bond ratings are still widely used, and are a convenient proxy not only for measuring default risk, but also for estimating default spreads. In the graph below, I have listed the default spreads at the start of 2020 and compared them to default spreads that I had estimated at the start of 2019, by ratings class:
      Source: Damodaran Online
      The first conclusion, and a completely unsurprising one, is that companies that are lower rated (and thus perceived to have more default risk) have larger default spreads than companies that are highly rated; a BBB (Baa) rated bond, at the cusp of investment grade and junk bonds, for instance, saw its default spread drop from 2.00% at the start of 2019 to 1.56% at the start of 2020. To get some longer-term perspective on how much default spreads change over time, the default spread on the investment grade (BBB, Baa) rated bond is graphed below from 1980 to 2019:
      Source: FRED (Federal Reserve St. Louis)
      At the risk of stating the obvious, the default spreads on bonds change over time, decreasing when times are good and investors are sanguine, and increasing during economic downturns and market crises.

      The US Equity Risk Premium
      In my last data update post, where I looked at markets over the last decade, I also posted a table that reported historical equity risk premiums, i.e., the premiums earned by stocks over treasury bills and bonds over long periods, ranging from a decade to 92 years. 
      Source: Damodaran Online
      There are many practitioners, who use these historical equity risk premiums as the best estimates for what you will earn in the future, using mean reversion as their basic argument. I have already made clear my problems with using a backward-looking number with a large estimation error (see the standard errors in the table above) as an expectation for the future, but it cuts against the very essence of an equity risk premium as a number that should be dynamic and constantly changing, as new information comes into markets. For almost three decades, I have computed an implied equity risk premium, a forward-looking value computed by looking at what investors are paying for stocks today, and the expected cash flows on those stocks. Specifically, I take an approach that is used with bonds to compute a yield to maturity to stocks, computing an IRR for stocks and then subtracting out the risk free rate. At the start of 2020, the implied equity risk premium for the S&P 500 was 5.20% and the calculations are in the graph below:
      Download spreadsheet

      Since I have been computing this number at the start of each month, since September 2008, I can look at how this number moved in the twelve months of 2019:
      Damodaran Online
      During the course of the year, the implied equity risk premium has decreased from 5.96% to 5.20%, driven down by increasing stock prices and lower interest rates.

      I am fascinated by the implied equity risk premium because it captures the market’s current standing in one number and frames debates about the overall market. A contention that markets are overvalued, or in a bubble, is equivalent to claiming that the equity risk premium is too low, relative to what you believe is a reasonable value. In contrast, a bullish assessment of the entire equity market can be viewed as a statement about equity risk premiums being too high, again relative to reasonable values. But what is a reasonable value? I have no idea, since I am not a market timer, but to help you make your own assessment, I have reproduced the implied equity risk premium for the S&P 500 going back to 1960:
      Download spreadsheet
      You could use the computed averages embedded in the graph as your basis for reasonable, and using that comparison, the market looks closer to under than overpriced, since the ERP on January 1, 2020 was 5.20%, higher than the average for the last 60 years (4.20%) or the last 20 years (4.86%). Even with a 10-year average, the market is only very mildly overpriced. It is true that the current implied ERP of 5.20% is being earned on a riskfree rate of 1.92%, low by historical standards, yielding an expected return of 7.12% and that may be too low for some. I will let you make your own assessment, but this is a healthier one that just looking at PE ratios (Shiller, trailing, forward) or other market metrics.

      A Real Estate Risk Premium?
      If default spreads measure the price of risk in bond markets and equity risk premiums measure the risk for investing in stocks, what is the price of risk of investing in other asset classes? It may be more difficult to assess what this value is in other risky markets, but it exists without a doubt, and one way of evaluating how much of your portfolio to allocate to these asset classes is to compare their risk premiums to the risk premiums of bonds and stocks. To get a sense of how this would play out, consider the real estate market, perhaps the biggest asset class outside of stocks and bonds. Investors in commercial real estate attach prices to properties, based upon their expectations of income from the properties and capitalization rates. Thus, a property with expected income of $10 million and a capitalization rate of 8% will be valued at $125 million = $10/.08. Since the capitalization rate is effectively a measure of expected return on real estate, subtracting out the risk free rate should yield a measure of the risk premium in real estate. 
      Risk Premium for Real Estate = Cap Rate – Risk free rate
      In the graph below, I have estimated the real estate risk premium and provided a comparison to the equity risk premium and default spread, over time:

      Note that the real estate risk premium in the 1980s was not only well below the equity risk premium and the default spread, it was sometimes negative. While that may strike you as odd, it makes sense if you think of real estate as an asset class that is not only uncorrelated with financial asset returns but also provides insurance against inflation. As real estate was securitized in the 1990s and fears of inflation receded, the real estate risk premium has started behaving like the risk premiums in stock and bond markets, and the rising correlation between them reflects that co-movement. Put simply, we live in a world, where the real estate you own (often your house or apartment) will tend to move with, rather than against, your financial assets, and in the next market crisis, as the stocks and bonds that you own plummet in value, you should expect the value of your house to drop as well!

      Conclusion
      The debate about equity risk premiums is not an abstract one, since which side of the debate you come down upon (whether risk premiums today are too high or low) is going to drive your asset allocation judgments. If you are a bear, you believe that equity risk premiums should be higher, either for fundamental reasons or by instinct, and you should put less of your wealth into stocks than you normally would, given your age, liquidity needs and risk aversion. The challenge that you will face is in deciding where you will invest your money until you think that the ERP becomes more reasonable, since bonds are likely to also be overpriced (according to your view of the world) and real assets will often be no better. If you are a market bull, your story has to be one of equity risk premiums declining in the future, perhaps because you believe in your own version of mean reversion or because of continued economic growth. For both market bulls and bears, the perils with bringing these views into every valuation that they do is that every company they value will then jointly both their views about the company and the overall market. It is for this reason that I think it makes sense to revert back to a market neutral view, when valuing individual companies, even if you have strong market views. Since my market timing skills are non-existent, I prefer to stay market neutral, and stick to valuing companies using the prevailing equity risk premiums. 

      YouTube Video

      Spreadsheets
      Datasets
      Data Update Posts

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      A Viral Market Meltdown V: Back to Basics!

      My first post on this blog was on September 17, 2008, a week into the 2008 crisis, and I honestly did not expect to be posting for long, anticipating that after a few posts, that crisis would be behind us, and that we could go back to our lives. That of course turned out not to be the case, as the crisis not only extended for months, but left its imprint on almost everything market or economy related for the next decade. Almost twelve years later, and six weeks into another market crisis, I have a sense of deja vu, as the days of volatility stretch into weeks, and each week brings new surprises. Unlike my four previous updates, this one will describe a week of market recovery, at least in sum, but like the previous weeks, the increase in market values came with wide swings, and continued uncertainty and volatility. It was also a week that saw governments around the world rush to pass rescue packages designed to get both individuals and businesses through a period where the global economic machine has been shut down. These bailouts, in addition to being many times larger than prior bailouts, have also reignited debates about what governments should be demanding in return. In the United States, a central issue that is being argued is how much stock buybacks done by companies in the last decade are contributing to the pain that companies are facing, and whether there need to be restrictions on them. While I will consider this issue in depth in a post later this week, I will look at the interaction between dividends, buybacks and market damage in this post.

      A Macro Review
      As in prior weeks, I will start this week's post by updating how the different asset classes performed last week, partly to put the six-week period (from February 14, 2020 - March 27, 2020) in perspective and partly to get a sense of where we are going next. The place to start is with equities, and in the table below, I look at the changes in equity indices across the world, both in the last week (March 20 -  March 27) and the last month.
      Download data
      Markets around the world had a good week, with the US and Japan delivering the most positive returns. Even those solid weekly returns were insufficient to make up for an otherwise painful month, where most indices lost 20% or more of their value. Moving on to US treasuries, in a week where the Fed continued to aggressively support the market, rates dropped across maturity classes, with treasury bill rates again hovering around zero. The ten-year rate ended the week at 0.72% and the 30-year rate at 1.29%
      Download data
      As in the previous week, stocks and bonds moved together, albeit with positive, not negative, returns. The  positive mood in the equity and treasury markets spilled over into the corporate bond markets, where default spreads that had spiked in the previous week dropped during the week, as default risk fears subsided strongly for the higher ratings and mildly for the lowest ratings.
      Download data
      Moving on to oil and copper, the two commodities that I reported on last week, it was a week of divergence, with copper having a flat week but oil continued its fall, as Russia and Saudi Arabia tried, but failed to reach a detente.
      Download data
      Finally, I look at gold and Bitcoin, my stand-ins for crisis assets and both gained for the week, though Bitcoin had a much larger deficit to make up, from its drop in prior weeks.
      Download data
      All in all, it is telling that last week, with all its volatility, felt calmer than prior weeks, perhaps because more of it was on the upside and it is all relative. That said, we are still on a roller coaster and there are more thrills to come in the coming weeks.

      Equity Market Breakdown
      In keeping with my practice in prior weeks, I will break down the equity movement last week by region and sector first, looking to see if there are divergences. I begin by breaking down the change in market value, in both dollar and percentage terms, by region during the 3/20-3/27 week:

      In the aggregate, Japanese stocks had the strongest returns this week (3/20-3/27), followed by US and UK stocks. In fact, last week was the strongest week for US equities since the 1930s, with stocks up more than 10% for the week. Globally, stocks added $5.7 trillion in market cap, but remain down $21 trillion since February 14, 2020, even with that revival. Moving on to sectors, and looking at the same metrics, I get the following:

      The results here are consistent with the earlier findings that corporate bond default spreads declined last week, after the surge in the prior one, and the most highly levered sectors (real estate and utilities) benefited. Updating the list of the ten industries that have been hurt the most and least during this crisis (dating back to February 14, 2020, I get this list:
      Download full list of industries
      Some of the worst performing industries over the six-week period had the best weekly performance last week, but remain deeply damaged.

      In previous weeks, I have looked at classes of stocks, focusing on a different dimension each week. in the first two weeks, I looked at stocks classified based upon growth/value (with PE standing in as proxy) and momentum (based upon the stock performance in the year leading into February 14, 2020) and found little differentiation in market damage across the classes. Put simply, there is very little evidence, at least during these six weeks, that the market is punishing high growth stocks or high momentum stocks more or less than other stocks. In last week's update, I noted that companies with high financial leverage were more exposed to damage at least during the week than less levered companies. In this week's update, I focus on another variable that people have pointed to, often with nothing more than anecdotal evidence, as a potential culprit  in the crisis, and that is stock buybacks. Their argument is that companies that have bought back stock, often with borrowed money, are the ones that have led us to the precipice, and that the viral shock to the economy is just a tipping point for these companies. To test this hypothesis, I classified global companies into those that bought back stock last year and those that did not, and looked at the market damage across the two classes:

      It is true that companies that bought back stock last year were slightly more exposed to market damage than companies that did not, but the differences are small. Globally, buyback-companies have lost about 25% of their market capitalization between February 14, 2020 and March 27, 2020, whereas non-buyback companies have lost 21% of their market capitalization; for US companies, the analogous numbers were 26% for buyback-companies and 23% for non-buyback firms. To see if it was buybacks that were the drivers of this difference, I also classified firms into those that paid dividends in 2019 and those that did not, and got results very similar to the ones with the buyback categorization.
      Companies that paid dividends suffered more market damage of almost the same magnitude as the the buyback companies did, suggesting that the old value investing adage of buying companies with big dividends is providing little solace in this crisis. 

      Finally, I returned to buybacks and focused just on US companies, where the buyback phenomenon has been most pronounced, but looked at the cross effect of leverage and buybacks, to test the proposition that it is not buybacks per se that are the problem, but buybacks by companies that either already carry high debt loads or borrow money to fund the buybacks:

      There are two groups, where buybacks make a discernible difference on returns. The first are companies with negative EBITDA that bought back stock (which strikes me as foolhardy), with market values dropping about 31% from 2/14/20 to 3/20/20, relative to negative EBITDA companies that did not buy stock, where market values dropped only 24%. The second is in the companies with the least debt, where market values for buyback companies declined  26%, as opposed to 16% for non-buyback companies. All in all, while it is true that some of the companies that are the recipients of government bailouts have bought back stock in past years, there is little evidence for the proposition that without the buybacks, they would not need the bailouts. I know that I am giving short shrift to buyback arguments, for and against, but I will return to this question, with a more in-depth breakdown in a post later this week.

      Back to Basics
      As with all of my viral update posts, I will end with a focus on the future and a return to fundamentals, by looking at how to value companies in the midst of a market and economic crisis unlike any in history. While many investors have put their valuation tools away, using the argument that there is too much uncertainty now to even try, I will argue that this is exactly the time to go back to basics and try valuing companies, uncertainty notwithstanding.

      The Dark Side beckons..
      If your concept of valuation is downloading last year's financials for a company into a spread sheet and then using historical growth rates, with some mean reversion thrown in, to forecast future numbers, you are probably feeling lost right now, and with good reason. Specifically, the last six weeks have upended almost all of the assumptions, explicit and implicit, that justified this practice.
      1. Historical data may be recent, but it is already dated: For most companies globally, the most recent financial statements are for 2019, and in calendar time, these financials are only a few weeks old. As the global economy shuts down, though, the one thing we know with certainty is that the revenues and earnings numbers reported in those recent financial statements are almost useless, a reflection of a different economic setting. The same can be said about equity risk premiums and default spreads, as I am painfully aware, since the numbers that I updated on January 1, 2020, are so completely out of sync with where the market is today that I plan to do a full update at the end of today. (March 31, 2020).
      2. This year will deliver bad news: There is almost no doubt that 2020 will be a bad year for all companies, with the key questions being how much of a drop in revenues companies will see this year, and how this will translate into earnings shocks. It is true that there are a handful of companies, like Zoom, Slack and Instacart, to name just three, that may actually benefit from the global quarantine, but they are the exceptions. 
      3. Survival has become a central question: The magnitude of the shock to corporate bottom lines and the speed with which it has happened has put companies at risk, leaving debt-burdened and young companies exposed to default and distress. While some of the largest may get help from governments to make it through this crisis, their smaller and lower-profile peers may have to shut down or let themselves be acquired.
      4. The post-virus economy will be different from the pre-crisis version:  Every major crisis creates changes in business environment, regulations and business models that reshapes the economy and resets competitive games, setting the stage for new winners and losers. Thus, for some companies, the bad news on revenues and earnings this year may be a precursor to superior operating performance in the post-virus economy, as their competition fades 
      Put simply, this is not the time for purely mechanical number crunching and a blind trust in mean reversion, since the landscape has changed. It is also not a time to wring our hands, complain that there is too much uncertainty and argue that the fundamentals don't matter. If you do so, you will be drawn to the dark side of investing, where fundamentals don't matter (paradigm shifts, anyone?), new pricing metrics get invented and you are at the mercy of mood and momentum. Ironically, it is precisely at times like these that you need to go back to basics.

      A Jedi Guide to Valuation
      With these lessons in mind, I decided to revisit my basic valuation model, which has always been built around fundamentals:

      While the fundamentals remain the same, I considered how best to incorporate the effects of this crisis into the model and arrived at the following:

      Note that this post-Corona valuation model stays true to the fundamentals but introduces three crisis-specific inputs into the valuation:
      1. Revenue Change & Operating Margin in 2020: These are the inputs that will reflect the effects of the global economic shut down on your company's revenues and operating margin in the next 12 months. For companies close to the center of the viral storm (travel-related companies, people-intensive businesses and producers of discretionary products), the revenue decline this year will be large and they will almost certainly lose money. (See my third viral market update for a way of visualizing this damage)
      2. Expected Revenue Growth in 2021-2025 and Target Operating Margin: If you feel drained from having to estimate the 2020 number, I don't blame you, but the more forward-looking part of this valuation is estimating how your company will fare in the post-virus economy (assuming it does not fail). For some companies, like cruise liners, the answers will be depressing, because the sights of large cruise ships stranded on the high seas, and acting as Petri dishes for spreading diseases will linger, but other companies will find themselves in a  stronger position in  the post-viral economy, partly because of their product offerings but also because of their financial strengths. In the tales told about Amazon, people often forget how much its current stature and success is due to the dot com bust (not the boom) of 2001, which wiped out their online competitors and handicapped their brick-and-mortar competitors.
      3. Failure probability and consequences: In good times and when valuing mature companies, we become lazy and forget that conventional valuation approaches, where you project cash flows as far as the eye can see and beyond, and discount them back at a risk adjusted discount rate, are designed for going concerns. These are not good times, and even mature companies are facing threats to survival. It is almost impossible to adjust for this concern in discount rates and it is therefore imperative that you make judgments about the likelihood that your company will not make it, and this probability will be higher for smaller companies, young companies and more indebted companies. Even with large companies that may be recipients of bail outs, because they are too big to fail, your equity may go to zero, if that is one of the conditions of the bailout (as was the case in the 2009 GM bailout).
      I have updated the equity risk premiums (not only for the US but the rest of the world) to reflect the market convulsions over the last few weeks, as well as default spreads for debt, and suffice to say that there has been a surge in the price of risk.  I know that that you are trying to make a judgment call in a period of incredible volatility, where no one (managers, analysts, governments) know what is coming,  but your reasoned guess is as good as anyone's estimate. So, be bold, make your best estimate and move on! If you get a chance, you may also want to watch this video guide I put together last Friday for using my spreadsheet:
      I value Boeing in the webcast but rather than focus on my story and valuation of the company, please focus on the process, so that you make it your own. There is nothing magical in the spreadsheet, and I am sure that there are flaws in it and that you can make it better. Use it as a starting point, adapt it and make it better.  Carpe diem! 


      YouTube Video


      Data Links

      1. Macro Market data (stocks, bonds, commodities, gold) on March 27, 2020
      2. Industry Breakdown on March 27, 2020

      Spreadsheets
      1. A Post-Corona Valuation spreadsheet (with a video guide on how to use it)




      A Viral Market Meltdown IV: Investing for a post-virus Economy

      At the end of each of the weeks leading into the last one, I have done a market update, reflecting the changes that occurred in the week, not just to market values, but also to investor psyches, and each week, I have hoped that it would be the last one needed for this crisis. That hope was dashed last week, as markets continued on their downward spiral, and here I am again, writing another viral market update. In this week's update, I will begin by again first chronicling the market damage, across asset classes, and within equities, across sectors, industries and company types, but I will follow up by looking at four different investment strategies for those who have the capacity and the willingness to look past the near term, recognizing that many of you might not have that luxury.

      Surveying the Market
      In what has now become a common component of each of these weekly updates, I will start with a survey of overall market performance in different asset classes, and  and then break down the damage in equity markets across the globe.

      The Macro Picture
      As was the case in 2008, it was difficult, perhaps impossible, to find a safe place to hold your money last week and no market was spared during the week. It was a week when equities lost trillions in value, across the world, but it was also a week when treasuries that had appreciated in prior weeks due to a flight to quality also saw no gain, oil continued its falls to multi-decade lows, and gold did not play its historic role as a crisis asset. Let's start with equities. The week started badly and did not get much better, as fear ruled across markets:
      Download spreadsheet
      The European equity markets, at least collectively, did better than the American and Australian markets between March 6 and March 13, with the Asian and African markets falling in the middle. When equities are in free fall, US treasuries are usually the beneficiary, but last week proved to be an exception, as treasury rates at the long end stabilized, perhaps spooked by the prospect of inflation from the trillions of dollars in rescue packages being proposed:
      Download spreadsheet
      The fears that this crisis will create an extended and deep recession, which, in turn, will cause corporate defaults to rise, especially in natural resource and travel-related companies, caused corporate bonds to have their worst week of this five-week crisis period:
      Download spreadsheet
      The damage in the corporate bond market, not surprisingly, was worse for lower-rating bonds, but the even highest rated bonds were not spared. Speaking of natural resource companies, oil continued on its downward trend, falling well below what many analysts had pronounced as its floor:
      Download spreadsheet
      The fact that copper, another commodity sensitive to global growth, has not dropped as much shows how much of an effect the Russia-Saudi tussle is having on oil prices.  Closing off, gold had a better week than stocks, but it too was down, but bitcoin ended the week on a little bit of an upswing.
      Download spreadsheet
      All in all, no asset class was safe and creative asset allocation would have best reduced the pain, not eliminated it.

      The Breakdown
      As in the weeks before, I will take apart the drop in equities around the world and look at the differences meted out, both in the last week and cumulatively over the five weeks since February 14.


      Sector and Industry
      I start by looking at the loss in value, broken down by sector, with the percentage changes in value computed over a week and over five weeks:
      Energy remains the most damaged sector, with financial services and real estate close behind., and  consumer staples and health care have held up the best. Breaking the sectors down to industries, and looking at the ten best and worst performers last week:
      Download spreadsheet
      The industries that were worst hit were infrastructure companies (with the exception of healthcare support services and automotive retail) that tend to have debt. Read in conjunction with the earlier table on the widening of default spreads for corporate bonds, last week's market collapse seems to have been driven more by default risk concerns than the prior weeks. The least affected businesses tend to be those that cater to non-discretionary demand.

      Region
      Earlier in this post, I looked at market indices around the world to conclude that stocks listed on the American and Australian continents were more affected than European stocks. Expanding on that proposition, I look at the market value lost, both in dollar and percentage terms, across regions:
      Globally, companies have lost $26.1 trillion in market capitalization over the last five weeks, and US stocks alone have lost $11.8 trillion in market cap. Canadian, Australian and Latin American stocks have been worst hit, in percentage terms, and China and the Middle East have taken the smallest hits, in percentage terms.

      Net Debt and Profitability
      It looks like debt concerns rose to the top of the worry heap last week, and to see how this shows up at the company level, I broke companies down into five quintiles, in terms of net debt ratios, and five quintiles in terms of operating profit margins. Specifically, I want to see how much having a profit buffer and low debt has protected companies during this meltdown. 

      I apologize if this table is a little overwhelming, but the way to read it to look at the combinations of net debt and profitability. For instance, companies with the least debt are in the bottom quintile of the net debt column and companies with the highest profitability are the top quintile of the profitability column. I don't want to read too much into this table, but if you look at last week's action, stocks with lower net debt ratios (in the bottom two quintiles) did much better than stocks in the top debt quintile.  At least for the moment, the profitability effect is being drowned out by the debt effect, since there is little discernible relationship between operating profit margins and market markdown. If you squint hard enough, you may be able to find something, especially in the middle quintile, but I will leave that up to you.

      Looking Past the Crisis
      In one on my first posts on this viral market crisis, I mentioned that the first casualty in a crisis is perspective. As you get deeper and deeper into the specifics of the crisis, you will find yourself not only getting bogged down in numbers, and in despair. I have had moments in the last few weeks, when I have had to force myself to step back from the abyss, think about a post-virus world and to reclaim the initiative as an investor. If you are a pessimist, you may view this as being in denial about what you see as an economic catastrophe that is about to unfold, but I am a natural optimist, and I believe that this too shall pass!

      The Economy
      There is no disagreement that the virus will cause the economy to go into a deep recession, since commerce is effectively shut down for at least a few weeks. During that period, economic indicators such as unemployment claims and measures of economic activity will hit levels not seen before, bur that should come as no surprise, given how large and broadly based the shock thas been. There are two questions, though, where there can be disagreement.
      • How quickly will the global economy come back from the shut down, and when it does how completely will it recover?
      • How much permanent change will be created by this crisis in terms of both consumer (and investor) behavior and economic structure?
      There are some who are more optimistic than others, arguing that once the viral fears disappear, there will be a return to business as usual for most parts of the global economy, stretched out over months rather than years, and that the changes to consumer behavior and economic structure will be small. At the other end, there are many more who feel that economies take time, measured in many years,to recover from shocks of this magnitude and also that there will be significant changes in consumer behavior and economic structure in the making.

      Investment Strategies
      Your views on the economy, both in terms of how quickly it will come back from this shock and how much change you see in economic structure, will determine your next steps in investing. If you believe that recovery will be quicker and with less structural change, there are two strategies you can adopt. 
      • Bargain Basement: In this strategy, you focus on stocks that have been pounded in the last few weeks, losing 50% or more of market value, but which have the ingredients that you believe will allow them to survive, perhaps stronger, in the post-virus economy. Key among these ingredients will be low net debt ratios (Net Debt to EBITDA less than one) and pre-virus  operating margins that were solid enough to take the hit from the crisis. To the extent that survival until the turnaround occurs is key, you may also keep your search restricted to larger market cap companies.
      • Distressed Equity: There is a more risky strategy you can adopt, where you also look for stocks that have seen a significant loss in value over the last five weeks, but focus on the most endangered of these, with high net debt and fixed costs. You are effectively buying options, with some already out-of-the-money, and as with any strategy built around doing that, you will see a significant number of your investments go to zero. The payoff from this strategy comes the companies that make it back to life, with equity values increasing by enough to cover your losses. At first sight, the airlines and Boeing meet these criteria, but there is a catch, insofar as they are large enough to be targeted for government bailouts, which are a mixed blessing, since they allow companies to survive, while wiping out or severely constraining equity claims. Thus, smaller companies that have to make it through on their own may be better candidates  for this strategy than companies that are too big to fail, that attract large bailouts. 
      If you are more pessimistic about economic recovery, both in terms of its length and strength, and believe that the recovery will restructure the economy and how companies operate in many businesses, there are two strategies that you may find work for you:
      • Safety at a Reasonable Price (SARP): Here, you focus on companies that are best positioned to not just survive a long downturn, but have the ammunition to make it work to their advantage. Large market cap firms with low debt ratios and high cash balances, that had high growth and profit margins in the pre-virus economy, would be good candidates. Facebook, Alphabet, Apple and Microsoft, for instance, clearly fit these criteria, but  since these companies are already sought after in a market where safety is rare and highly valued, you should add pricing screens that allow you to get them at reasonable prices. 
      • Change Agents: This is as much a bet on changes in consumer behavior and economic structure as it is on individual companies. Thus, if you believe that this crisis will make people more comfortable with delivery services for a wider range of goods and online interaction (in business and education), you could seek out companies that are innovators in these spaces. Again, the highest profile players, like Zoom, may be priced out of your reach, but there are others like Chegg that may meet your criteria.
      The picture below summarizes the four strategies:

      My views on the economy are mixed. I do think that the global economy will come back, but it will take more than a few months, and there will be structural changes in some sectors. I ran screens for all of the strategies, other than the Change Agents strategy (which is less about screening, and more about detecting macro trends), across all publicly traded stocks (about 40,000+) on March 20, 2020. As I look at the companies that go through the screens, I realize that there is more work to be done and better screens that can be devised, but think of it as work in progress, and if you have access to a large database, try your own.

      YouTube Video


      Data
      1. Market Changes by Asset Class, through March 20, 2020
      2. Market Changes by Industry, through March 20, 2020
      Screened Stocks
      1. Bargain Basement, as of March 20, 2020
      2. Distressed Equity (Options), as of March 20, 2020
      3. Safety at a Reasonable Price (SARP), as of March 20, 2020 (Add your pricing screen)



      Data Update 7 for 2020: Debt Delusions and Reality

      In the midst of a crisis, it is very difficult to think about life in its aftermath, but there will come a time, when investors and companies will shift their focus. To be able to do so, they have to survive the crisis, and for many companies, that has become the immediate challenge. In the last post, I looked at one factor that will determine survival risk, and that is the buffer than companies have on growth, profitability and reinvestment, with companies in higher margin businesses being more protected than companies in businesses with slim or negative margins. In this one, I look at the other factor that will determine survival and that is the debt burden on firms, since companies with higher debt burdens, other things remaining equal, will be more exposed to failure and distress than companies without those burdens.  I will look at the degree of indebtedness of companies around the world, broken out by industry and region, partly with an eye on assessing how much danger they are exposed to right now, as their near term business prospects collapse, and partly to see which firms, industries and regions are best positioned to make it through this crisis.

      The Debt Trade Off
      The question of how much a firm should borrow is one of the three questions that comprise corporate finance, but there are a number of delusions about debt that need to be dispelled first. The picture below, that I also used in last year's debt update captures what I term the "illusory benefits" of debt:

      Thus, the argument that borrowing money lowers your cost of capital, just because it costs less to borrow than to raise equity, does not hold up, since the risk from the investments taken with the capital raised remain unchanged, no matter what the debt mix. The counter argument that you should never borrow money, since borrowing money will lower your net income, misses the fact that borrowing money to fund a company leads to fewer shares outstanding.

      The real trade off on debt is determined by the tax benefits that are endowed on debt by tax law in much of the world, with interest expenses being tax deductible and cash flows to equity not, and the offsetting effects of expected distress costs, low for firms with stable, predictable earnings and in good economic times, and high for firms with more unstable earnings and more unstable economic settings. There are a couple of secondary factors, with debt acting as a mechanism to keep managers from taking investments that are bad enough to put the company's survival (and management jobs) at risk and the costs associated with managing the conflict of interests between stockholders and bondholders.
      This trade off, intuitive and simple, can be a powerful device for making predictions about what should happen to the use of debt over time. In the United States, for instance, the corporate tax reform act of 2017, in addition to lowering the federal corporate tax to 21% from 35, also put limits on interest deductions, thus making debt significantly less beneficial to companies. Even before this crisis hit, there were questions about whether a long stretch of good times for companies had made them too complacent about distress risks and expected bankruptcy costs, and now after the crisis, there is no debating that many companies have too much debt, given near term earnings and perhaps even long term earnings.

      The Debt Burden
      As companies scramble to get out from under their debt burdens, they will face challenges, and to see the magnitude of the tasks they face, I will chronicle how much debt was held across the world at the start of 2020. I will also break the debt down by region, and by industry, to see how steep the climb will be for companies, and to assess which sectors have the largest capacity to withstand the earnings shocks that are sure to come.

      Defining Debt
      As a prelude to assessing the debt burden at companies, I want to start by deciding what to include in debt. For those who trust accountants, this may seem redundant, given that there is a debt number listed on balance sheets, reflecting what companies owe at least on the date of the statement. As someone who does not share that trust, I use a two-part test to determine whether to include a claim in debt or not:
      1. Does the claim give rise to a contractual commitment that you have to meet in good times and in bad? 
      2. If you fail to meet that commitment, are there consequences that result in the business shutting down or assets being controlled by lenders?
      To start, a bank loan or corporate bond clearly meets both requirements, with interest expenses and principal payments being contractual commitments, and failure to meet those can result in either default or loss of control over the business.
      • All interest bearing debt, short term as well as long term, floating or fixed, meets the requirements for debt. 
      • Accounts payable and supplier credit don't meet that test, because they do not have explicit interest expenses; to the extent that you get less favorable terms or lose a discount by using supplier credit, there are implicit interest expenses, and if you are willing to make those explicit, they can be treated as debt. 
      • All lease commitments are debt, though we can debate the maturity of the commitment (based upon escape clauses and renewal terms in the leases) and whether it is secured or unsecured debt. In fact, converting lease commitments to debt is a simple present value exercise, where the contractual commitments for future years are discounted back to today using the pre-tax cost of debt as the discount rate, a practice that I have followed all through my valuation years. Until 2019, accountants followed a misguided practice, allowing companies to categorize leases, based upon whether they had ownership of the asset, into operating and capital leases, with only the latter being treated as debt. In the process, operating leases became the biggest source of off-balance sheet debt for retailers, restaurants and other big lessees. In 2019, both GAAP (FASB 842) and IFRS (IAS 16) came to their senses and required companies to treat all leases as debt, creating a significant change in balance sheet debt at many companies. Later in this post, I will compare my calculations of lease debt to the accounting lease debt, to probe differences.
      Debt Measures
      There are different measures of the debt burden, with each measure serving a different purpose. Broadly speaking, these measures can either look at debt as a percent of the total capital invested in business or look at debt payments due, relative to earnings and cash flows of the company. The first becomes an input into hurdle rates and the latter becomes a measure of the buffer against downturns and crisis:

      To the extent that having cash on your balance sheet offsets some of the debt burden, you can compute all of these measures, using net debt ratio (where cash is netted out against total debt) and net interest expenses (where interest income from cash is netted out from interest expenses). Note that the two approaches measuring debt can give different signals. Thus, a company can have a low debt ratio (as a percent of capital, in either book value or market value terms), an indicator of a low debt burden, while having dangerously low interest coverage ratios and high debt as a multiple of EBITDA. The table below captures the possible combinations:


      Note that the predictably of revenues and earnings brings an additional dimension brought into the comparison. To the extent that some companies have more predictable earnings than others, because they sell more non-discretionary products and services, they are less exposed to risk than other companies, with similar debt burdens; a discount retailer with a debt to EBITDA multiple of four is safer than a luxury retailer with a debt to EBITDA multiple of four.

      Interest Bearing Debt & Lease Commitments in 2020
      I begin by looking at debt burdens, relative to both book and market capital, across the world. In making this assessment, note that I have done the following:
      • I have counted all interest bearing debt, as reported by the company, on its most recent financial statements. I use this book value of debt as roughly equivalent to the market value of debt, because much of the debt taken by companies taken by companies is in the form of bank loans, and there is no observable market value. While there are ways of converting book value of debt to market value of debt, they require inputs on debt maturity that are not available for many companies.
      • I have computed the lease debt, using lease commitments and an estimated cost of debt for each company, rather than trust the accounting estimates of this debt, at least for 2019. That is partly because the rule change applies only to those sections of the world that are covered by IFRS and GAAP and partly because I don't trust accountants yet, on this measure.
      • To compute the net debt, I subtract out the cash and marketable securities that the company reports on its latest financial statements.
      • Since debt to a financial service firm is more raw material than capital, and determining what comprises debt is almost an unsolvable puzzle, I have excluded banks, insurance companies and brokerage firms/investment banks from my sample.
      Recognizing that the most recent financial statements for most companies in my January 2020 update are from September 2019 and with the even more important caveat that the market capitalization, while updated through March 16, 2020, is a moving target in a market like this one.
       Download spreadsheet
      On a book capital basis, US companies have the highest proportion of debt, but relative to market value, Canadian companies have the most debt. Across global non-financial service companies, total debt is about 34% of market capital and 49% about book capital. Doing the same analysis across industries, again excluding financial service firms, the ten industries with the highest debt to market cap ratios and the ten with the lowest are listed below:
      Download spreadsheet
      Notice the preponderance of technology firms on the least levered list and the bunching up of infrastructure and manufacturing companies on the most levered list.  All of the numbers reported above for debt include my estimate of the lease debt, and since the accounting rule changes this year have brought lease debt on to balance sheets, I can compare my estimates to the accounting numbers. For non-financial firms collectively, my estimate of lease debt is about 60% higher in the aggregate that the accounting estimates, reflecting partly the additional information that accountants have on lease specifics that I do not, partly the fact that there are segments of the world where leases are still not treated as debt and partly the complexity of accounting rules on lease debt.

      Earnings and Cashflow Coverage
      As we noted earlier, companies that look lightly levered, when debt is measured against capital, can still face a significant burden if their earnings and cash flows are insufficient to meet debt payments. In the table below, I look at the regional differences on debt as a multiple of EBITDA and interest coverage ratios:

      Download spreadsheet
      With the caveat that the EBITDA and operating income numbers are from 2019 and do not reflect the damage that is going to be caused by the Virus, companies in Africa/Middle East and Eastern Europe have the least debt, relative to EBITDA, but Japanese companies have the most buffer, based upon interest coverage ratio. Canadian and Indian companies have the least buffer, on an interest coverage ratio basis. Extending this analysis to industries and looking at the ten industries with the most buffer and the ten with the least:
      Download spreadsheet
      While most of the firms in the most buffered list mirror the earlier ranking based upon low debt levels, the presence of integrated oil and oil production companies indicates how transient these buffers may be, since the dramatic drop in oil prices in the last few weeks will ravage the EBITDA and operating income numbers at these companies. Among the least buffered list are utilities, which may be able to weather the storm with stable revenues, and a number of real estate related industries, which will be exposed if real estate values drop. At the top of the list of the most exposed industries are investment and asset management companies, reflecting both their access to and use of debt to accentuate returns to equity investors.

      Lessons from a Crisis
      Every crisis teaches investors and companies lessons that are temporarily learned, but quickly forgotten. This one is a reminder to firms that debt, while making good times better for equity investors, makes bad times worse. For some of these firms, that debt will threaten their continued existence and result in liquidations, fire sales and distress. For others, it will create constraints for the near future on growth and investment, and change business plans. For firms that are lightly burdened, it may create opportunities, as they use their liquidity as a strategic weapon to fund acquisitions and to increase market share. If you were worried about winner take all markets before this crisis, you should be doubly worried now!

      YouTube Video


      Datasets
      1. Debt measures, by region
      2. Debt measures, by industry
      3. Lease effects on profitability and debt measures, by industry



      Data Update 6 for 2020: Profitability, Returns and the value of Growth

      In an age, where scaling up and growth seems to have won out over building business models and profitability, as the most desirable business traits, it is worth stating the obvious. The measure of a good business is its capacity to generate not just profits, but also to convert these profits into cash flows that investors can collect. If we needed a reminder of this age-old premise, the last three weeks should have provided a wake-up call. In fact, if your central concern is about the negative economic consequences of the viral meltdown, in the short and the long term, higher growth and margin  companies will be best suited to not just survive them, but emerge stronger in the post-virus economy. In this post, I will try to look at growth, earnings and cash flows, and how they interact in value, and use that framework to examine how companies around the world, in different sectors, measure up. 

      Growth, Profits and Cash Flows
      The trickiest part of valuation is negotiating a balance between growth, profitability and reinvestment, with a plausible story holding them together, to derive value.
      • The Scaling Factor: Growth plays the 'good guy' role, allowing small companies to become big, and big firms to become even bigger.  While a growth rate can be computed on any metric, the metric that best reflects operating growth is revenue growth, accomplished by either selling more units or raising prices.
      • The Profitability Driver: Growth, by itself, can only scale up a firm's operations and revenues, but for that scaling up to pay off, it has to become profitable. Again, while there are many measures of profitability, scaling profits to revenues to arrive at profit margins makes the most sense.
      • The Reinvestment Lever: To grow, a company has to reinvest in capacity, in whatever form, and this reinvestment can drain cash flows. This reinvestment can be tied to earnings, as a retention ratio or a reinvestment rate, or to sales, as a sales to invested capital ratio.
      If that sounds familiar, it is perhaps because you have seen me value many companies on this blog, using these three variables, added on to a risk component, to value companies as diverse as Kraft Heinz to Tesla to Beyond Meat. In fact, the cash flows that you observe for a firm can be captured by the interactions between these three forces, and those interactions let us differentiate between great, average and bad firms:

      The extremes represent the best and worst possible combinations of these variables. Great firms pull off the trifecta, scaling up revenues with relatively little reinvestment, while deliver high margins. Terrible firms are saddled with the worst possible mix of low revenue growth, low or even negative margins and large capital investment requirements to deliver even their growth. The bulk of the business world falls in the middle, facing tradeoffs that determine value. Some trade off low margins for high growth, hoping that the dollar profits they deliver will be large enough, simply because of scale. Others are willing to reinvest more in the short term, to build barriers to entry and generate higher and more sustainable margins and returns for the long term.  In the rest of this post, I plan to look at how companies around the world measure up on each of these dimensions, beginning with the growth that they have recorded in the recent past, moving on to measures of profitability and ending with reinvestment numbers. I will then close by bringing in the hurdle rates that I estimated in my last post as benchmarks, to measure how firms measure up on value creation or destruction.

      Growth 
      The first variable that I will look at is growth, and focus primarily on past growth in different metrics, ranging from revenues (the top line) to net income (the bottom line). Along the way, I will argue that the way growth rates are estimated and the periods used for the estimation can have large effects on the numbers that emerge, and that bias, as with everything else in valuation, can affect choices.

      Growth Metrics
      Investors often make the mistake of assuming that, since the past is behind the, a historical growth rate for a company is a fact, not an estimate. That is a myth, since the historical growth rate that is reported for a company is a function of multiple choices made on estimation, as can be seen in the picture below:

      So what? First, it is worth remembering that that the biases an investor brings to the table will often determine how, and in what metric, growth is computed. In general, at least in good times, earnings per share growth will be the mantra of bullish investors in a stock, whereas top line growth will the number offered by more pessimistic about the stock. Second, if you are using growth rates for companies from a data service, it is always worth asking questions about the approach used to compute growth (arithmetic or compounded) and time period used (starting and ending years), since they can skew growth rates up or down.

      Growth Rates - A Global Overview
      In keeping with the theme that with growth rates, it behooves us to be transparent about estimation choices, I will start by explaining my choices when it comes to growth. For historical growth rates, computed at the start of 2020, I use the compounded average growth rate in the previous five financial years. For most firms in my sample, this is the geometric average growth rate from 2014, as the base year, to 2019, as the final year in the sample. I will also compute growth rates in revenues (top line) and net income (the proverbial bottom line). With the latter, there will no growth rates computed for companies that are money losing, since the growth rate becomes a meaningless number. With that lead-in, I start by estimating growth rates by industry group, and in the table below, I list the ten industries with the highest growth rate in revenues in the last 5 years (2014-19) and the ten with the lowest:
      Download spreadsheet
      Note that even before the crisis, oil companies were shrinking, computers/peripherals had close to flat sales, and software dominates the list of high growth businesses. For a full list of growth rates, by industry, please click here.  To see if there are differences in growth in different parts of the world, I then break down growth rates in revenues and net income, by region, between 2014 and 2019.
      Download spreadsheet
      Note that more than a quarter of all publicly traded firms saw revenues shrink, in US dollar terms, over the last five years, and that across all firms, the median growth rate in net income is much higher than the median growth rate in revenues, across all regions. However, the range on net income growth is wider than the range on revenue growth. Finally, it is worth noting that investing is based upon future growth, not past growth, and I use estimates of expected growth rate in earnings per share as my proxy. Notwithstanding the biases that analysts bring into this estimation process, it remains a forward-looking number, and I look at how expected growth in earnings per share varies across companies in different PE ratio classes:

      While this data is too raw to draw big conclusions from, higher PE stocks have, not surprisingly, have higher expected growth rates than low PE stocks. As investors, though, that tells you little about whether high PE stocks are good, bad or neutral investments, since the enduring question becomes whether (a) the high expected growth reflects reality or hopeful thinking on the part of analysts and (b) the PE ratio fully, under or over reflects this expected growth rate. It is one reason that I remain wary of using pricing screens to pick stocks, since there is no short cut or formula, that will answer this question. That will require a deep dive into the company's business model and full forecasting of earnings, cash flows and risk, i.e., an intrinsic valuation.

      Profitability
      Growth is only one part of the valuation puzzle, since without profits that come with it, it will be wasted. In this section, I will look at profitability across regions, sectors and subsets of stocks, again with the intent of eking out lessons that I can  to in corporate finance, investing and valuation. 

      Margin Definitions & Usage
      With profit margins, you scale profits to revenues, and as with growth, there are multiple metrics that can be used to compute margins, and which one is used is often a reflection of the biases that investors bring to the game. In the picture below, I look at a list of possible profit margins, and what each one is trying to measure:


      By itself, each margin serves a purpose and tells a tale, and is worth calculating. Thus, the contribution margin measures the pure profits that you generate with every marginal unit you sell, since it nets out only the variable cost associated with producing that unit, giving many software companies close to 100% contribution margins. Gross margins are a close relative, providing a direct measure of marginal profitability and an indirect measure of how revenue increases flow into profits. To illustrate, Zoom, one of the few stocks that has seen its value increase during the crisis, reported a gross margin of 92% in 2019. Operating margins measure what is left after the other operating expenses of the company, which cannot be directly traced to individual unit sales, but are nevertheless necessary for its operations. Thus, R&D expenses and SG&A costs are netted out from gross profit to get to operating profit, yielding a measure that will capture economies of scale, as the company scales up. Netting out taxes and interest expenses, and adding back income from cash and cross holdings, yields net margin, a measure of what equity investors get to keep out of every dollar of revenues. It is a mixed and noisy measure, reflecting a company's operating model, its tax liabilities and its financial leverage (since debt creates interest expenses and affects taxes), as well as non-operating assets. Along the way, there are diversions. If you take the operating income, act like you have no debt and net the taxes you would have paid on that operating income, you get after-tax operating margin, a measure of operating profitability that takes into account taxes. If you take operating income, and add back depreciation and amortization, you get EBITDA margin, a measure of operating cash flows, before reinvestment. In recent year, companies with large stock based employee compensation have taken the tack that since it is in the form of shares or options, it is not an expense, and have added back this and other "extraordinary" expenses (with lots of leeway on what comprises extraordinary) to compute adjusted EBITDA margins that supposedly capture even better the cash flows at the firm. 

      As you look at margins, whether reported by a company or computed by a third party (including me), here are some general principles to keep in mind. First, desperation drives a money-losing company up the income statement to use more expansive forms of margin. Notice that Microsoft, which has operating margins of close to 35% and net margins of 20% plus, never talks about gross margins, whereas some of Tesla's biggest promoters keep bring up the fact that its gross margin is 25%. Boasting that your gross margin is positive is akin to being on a diet and claiming that you consume only 1800 calories a day, but that is before you count the calories in the second courses at meals, desserts and snacks. Second, not all adjustments are created equal. I have long argued that while adding back depreciation and amortization to get to an EBITDA margin may be justifiable, adding back stock based compensation is not, since it is effectively using a barter system to evade cash flows. Put differently, you could have issued those restricted shares or options in the market, and used the cash to pay your employees, and chose not to.

      Margins: A Global Overview
      As with growth rates, I am going to begin by offering some background on the data that I use to compute my margins, and the adjustments that I make along the way. I use the revenues and income numbers from the trailing 12 months, which at the start of 2020, would give me the financials for most firms from October 2018 to September 2019. While that may seem short sighted, I have the archived numbers from the last decade on my website, for you to download and make your own judgments. Of course, with the market crisis fully upon us and a recession looming, you will be well served looking at the historical data. I start looking at margins across industries, to get a rough measure of how revenues flow through as earnings to the firm and its equity investors. In the table below, I list the ten industry groups with the highest and lowest operating margins, using global companies:
      Download spreadsheet
      Note that retail is particularly exposed in this crisis, simply because margins were low to begin with, though the question of how much will vary across retail. Thus, grocery and online retail may be more resilient than automotive and general retail from a prolonged shut down of commerce. Among the highest margin businesses, there are many that will see margins deteriorate very quickly from this crisis, with energy (both oil and green) showing the biggest near term hits. Real estate will also be exposed if there is a deep recession, but software, beverages and tobacco should see profitability hold up better. Looking across regions, I compute profitability measures across all companies in each region, recognizing that the industries that dominate each region be very different. 
      Download spreadsheet
      Note that the Asia had the lowest margins in 2019, a warning that high growth does not always translate into profitability. Conversely, Eastern European & Russian companies have high margins, albeit with low growth. African and Middle Eastern companies have sky high margins, reflecting domestic companies that dominate local markets with little competition.

      Reinvestment Efficiency
      If revenue growth captures the scaling up factor, and margins the profitability of a business, the last part of the story has to be about the efficiency with which the growth is delivered. For manufacturing companies, this will be captured in how much they spend in adding production capacity, and how efficiently they use this added capacity to produce more units. For non-manufacturing companies, the investment may be in research and development, acquisitions and other "intangibles", but it too is reinvestment and its payoff in growth affects value. For retail firms, it may take the form of inventory, accounts receivable and other ingredients of working capital, and how well they can manage these as they grow.

      Reinvestment Efficiency:  Definitions & Usage
      Unlike revenue growth and margins, which has widely accepted proxies and measures, reinvestment efficiency remains more of a smorgasbord of different measures. Broadly speaking, these measures scale how much capital is invested either to the operating income that is created, in returns on capital measures, or to revenues, by relating capital invested to revenue growth.

      In sum, reinvestment in any period is defined broadly to include not just investments in plant and capacity, the accountant's traditional cap ex measure, but also working capital, acquisitions and investments in research and development and intangible assets.
      Reinvestment = (Cap Ex - Depreciation & Amortization) + Change in non-cash Working Capital + Acquisitions + (R&D expenses - Amortization of R&D)
      That reinvestment accumulated over time comprises the invested capital of the firm, and both numbers (reinvestment and invested capital) can be scaled to either after-tax operating income or to revenues. When margins are stable, the two approaches are equivalent, but when the margins are changing, the revenue-scaled measures become more useful.

      Reinvestment Measures: A Global Overview
       I noted at the start of this post that "ease of scaling up" has become a central theme of young growth companies reaching into new and often very large markets. While this has always been a selling point for conventional software and technology firms, it has expanded its reach into other businesses, from Uber in car service/logistics to Casper in mattress sales. In essence, the selling point for these models is that they can reinvest much more efficiently than their established competitors, though their growth pitch is still more focused on sales than on profits. In this section, I report on investment efficiency numbers, staying true to my premise that reinvestment has to include acquisitions and R&D. To get a sense of how investment efficiency varies across industries, I computed sales to invested capital and returns on capital, across industry groups, and in the table below, I report on the ten most and ten least efficient industries, at least when it comes to delivering revenues for every dollar of capital invested. 
      Looking at regional differences, again recognizing that the industry concentrations vary geographically, I find the following:
      Download spreadsheet
      Note that the concentration of natural resource companies in Australia, New Zealand and Canada, which lowered profitability, is also showing up as lower returns on capital. The more troubling number is the 4.55% median return on capital delivered by the median global company in 2019, not only well below the cost of capital globally, but also likely to see a major hit this year, as  the Corona Virus works through the global economy.

      Excess Returns
      I talked about risk and hurdle rates in my four earlier data posts, where I started with the price of risk in markets (equity risk premiums and default spreads) and then about relative risk measures. In this last section, I will bring together the return measures discussed in the last section with the hurdle rates estimated in prior posts to create composite measures of excess returns, as measures of value creation.

      Excess Returns Definitions and Usage
      While businesses that make money are viewed as successful, that is a low hurdle for success. After all, capital is invested in businesses and that capital invested elsewhere, in equivalent risk investments, could have earned a return. That return is what we were trying to estimate, with all of its complications, in my previous updates on risk free rates, equity risk premiums and relative risk measures.

      These comparisons, which are at first sight simple, are complicated by how well we can measure how much capital is invested in a project or existing assets and how closely the accounting earnings capture true earnings. Adding to the measurement issues is the fact that earnings are volatile and using a single year's number can skew our conclusions.

      Excess Returns: A Global Overview
      With the caveat in mind that the returns on capital that I compute for individual companies reflects operating income in 2019, a potential problem given that it is just one year and a number that clearly will change (and fairly dramatically so) because of the virus, I compared the return on capital to the cost of capital for each of the 39,000 non-financial service companies in my sample and used that comparison to create a global distribution of excess returns: 



      The story here is a depressing one, at least for this comparison, as 54% of global companies generated returns on capital that were lower than their costs of capital by 2% or more, and 32% of global companies earned returns that exceeded their costs of capital by 2% or more; 14% of companies earned returns that were within 2% of their costs of capital. The only part of the world where more companies earned more than their cost of capital than earned less was Japan, and even there, there are questions about whether this is an artifact of Japanese accounting practices rather than a sign of value creation. To complete the assessment, I looked at excess returns generated, by industry, and created a listing of the five industry groups with the most positive and the five with most negative median excess returns:
      Download spreadsheet
      You may be surprised to see biotechnology and healthcare IT at the top of the list of negative excess return businesses, but given that many of the companies in these industries are still  young, money-losing firms with promising products in the pipeline, this may be more a reflection of the limitations of using return on capital with young companies, than a true measure of excess returns. The presence of mining and oil/gas on the list is more troubling, since it suggests that even before the brutal shocks meted out in markets in the last few weeks, these sectors were struggling. It should be no surprise that the businesses that have the highest excess returns are mostly service companies, with low capital intensity, with the exception of tobacco, a high-margin business that also has the benefit of providing a non-discretionary product.

      Wrapping up
      Heading into a post-virus economy, where there will be wrenching changes in most sectors, you may wonder why I even bother looking at the profitability and excess returns from 2019. After all, every one of the numbers reported in this post will be dated, as companies update their financials to reflect the damage done. That said, I think it still makes sense to look at growth, profitability and reinvesting, pre-crisis, to get a sense of how much punishment companies can take. In businesses that already had anemic revenue growth, low margins and poor investment efficiency, the effects of the crisis will be far more devastating than in businesses with higher growth, margins and efficient investment. There is a reason why airlines, retail and oil are in the front lines of this war, suffering the most casualties, and why technology and heath care are doing better.

      YouTube Video


      Data
      1. Growth, Profit Margins, Reinvestment Efficiency and Excess Returns, by Region: 2020
      2. Growth, Profit Margins, Reinvestment Efficiency and Excess Returns, by Industry: 2020






      A Viral Market Update VII: Mayhem with Multiples

      I get a sense that I am approaching the end of this series of weekly posts, or perhaps I am just hoping that it is true, as the COVID crisis continued to play out in markets in the last two weeks, albeit on a more subdued scale and with a more positive twist. In this post, I will, as in the prior weeks, update the prior weeks’ market action (for two weeks, from April 4 to April 17) in different asset classes, and within equities, across regions, sectors and stock classifications. I will close this post by looking at how pricing tools, including a range of multiples (from PE ratios to price to book to EV to EBITDA multiples) will become shakier and less reliable in the aftermath of the crisis, and suggest ways in which we can compensate for the uncertainties.

      Asset Classes
      I started my crisis clock on February 14, reflecting the fact that I am US-based, and markets outside China did not wake up to the crisis until that week. In the weeks since, we have seen volatility rise and equity markets get whipsawed, with much of the pain being dispensed in February and the first three weeks in March. In the last month, equity indices around the world have seen positive returns, and in some cases, very good positive returns, as can be seen in the table below.
      Download data
      The week of April 10 to April 17 was a benign week, at least in sum, even though individual days still brought big movements, with most indices flat for the week. Moving on to the treasury market, we also saw steadiness, with both short and long term rates staying close to the lows that they hit just two weeks ago.
      Download data
      Looking at commodity prices, the divergence between oil and copper illustrated again the unique travails of oil, where a detente between Russia and China did little to stop oil prices from continuing to drop, while copper prices changed little.


      Download data
      In the two months since February 14, oil prices have dropped more than 65%, providing a contrast to copper, another commodity sensitive to the global economy, which has declined less than 10%. (To top of the craziness, the price of futures on Texas crude dropped below zero on April 20, but that is a story for another day/post.) 

      To complete the picture, I looked at gold and bitcoin, and while both have settled into holding patterns, the divergence since February 14 is stark.

      Download data
      In sum, gold has held its own, increasing 6.3% since February 14, though investors holding it were undoubtedly expecting a bigger pop, given the economic and market chaos, but bitcoin has disappointed those who believed it would play the role of a crisis asset, down 31% since the start of this crisis.

      Risk Update
      In my last post, I focused on how the price of risk has changed since February 14, 2020, starting with the corporate bond market, where default spreads have changed significantly over the last few weeks.
      Download data
      Note the surge in default spreads across bond ratings classes from February 14, 2020 to March 3, 2020, though there has been a drop off from highs in the last two weeks. The fear that  has played out in the bond market has also affected the price of risk in equity markets. In the graph below, I updated the equity risk premiums, by day, that I computed in my post two weeks ago, through April 17.
      Download spreadsheet
      The implied equity risk premium which I computed to be 6.01% on April 1, 2020, has declined to 6.27% if I compute the risk premium using the (now stale) earnings and cash flows, and 5.60%, if I assume a 30% drop in S&P 500 earnings this year and a substantial drop in buybacks. I have a feeling that this roller coaster ride is not quite done and I will continue to estimate the numbers daily.

      Equities Breakdown
      In keeping with my practice in my prior posts, I looked at market capitalizations of all publicly traded companies (36,481 companies with market caps exceeding $5 million on February 14, 2020) and started by computing changes in market capitalization, by region:
      Download data
      Looking at the aggregated returns since February 14, 2020, the worst performing regions in the world are Africa and Latin America, and China remains the standout as the best performing market. Australian and Canadian stocks have been punished, largely because of their natural resource focus, and globally, stocks have lost $15.2 trillion in value, a huge amount but about half as large as the loss was four weeks ago. In the next table, I break market cap changes down by sector:
      Download data
      There are few surprises in this table, with healthcare and consumer staples being the best performers, and energy and financial services the worst. Breaking down the sectors into finer detail, I look at companies classified into 95 industries, and list the ten best and worst performers over the crisis period (2/14 - 4/17):
      Download data
      I know that it fashionable to talk about how inefficient and volatile markets are but this crisis, in many ways, has been surprisingly orderly and markets have dispensed punishment judiciously, for the most part. 

      I also looked at other classifications, from pricing levels (PE and PBV) to momentum to dividends/buybacks and found no significant differences across companies. In fact, the evidence seems to more strongly support the notion that the market is punishing low PE, high dividend yield stocks that had little momentum coming into this crisis more than high PE , non-dividend paying stocks. That is disappointing news for value purists who have been waiting a long time to say "I told you so" to momentum and growth investors. In fact, the only variable that seems to offer support for financial moralists is financial leverage, as can be seen in the table below, where I break down global stocks based upon how much debt they had at the start of the crisis:
      The most highly levered companies, with leverage measured as debt scaled to EBITDA, have suffered more damage as this crisis has played out. 

      Pricing Update
      In my earlier posts, I argued that just because uncertainty has increased, there is no excuse for abandoning valuation first principles or process; you can still value companies, albeit with a much wider range of outcomes. One common counter that I got to this argument was that valuation is pointless when the uncertainty is so great and while most of those marking this argument did not bother presenting alternatives, my guess is that many will fall back on pricing metrics to decide what to buy or sell. Put simply, they will use a PE ratio or an enterprise value multiple of EBITDA or sales to decide what stocks to buy or sell, acting under the delusion that this will allow them to escape having to make assumptions in the future. In this section, I will start by breaking down pricing multiples and then use simple valuation algebra to argue that there are assumptions about cash flows, growth and risk embedded in every pricing multiple. I will close by noting how multiples behave in a crisis, and report on pricing multiples, broken down by region, sector and industry, pre and post crisis.

      Anatomy of a Multiple
      I think of multiples as standardized prices, allowing investors to get past the challenge of comparing per share values, which are determined by share count. That said, it is easy to be overwhelmed by the number of multiples you see in practice, with some in wide use (PE, Price to Book, EV to EBITDA) and some obscure (EV per subscriber, EV to Invested capital). To put these in perspective, I will start by breaking down the choices that you have in constructing a multiple and using it to make a pricing judgment:

      The numerator for any pricing multiple is a market value of equity, firm or operating assets, and the denominator is a scaling variable: revenues, earnings, cash flows or book value. There is no one "best" multiple or timing choice, since that will vary across time and across sectors, but here are two simple consistency rules to keep in mind, when constructing and using multiples:
      • Equity/Firm: If the numerator is an equity value, the denominator should be an equity value as well, while if the numerator is a firm or enterprise value, the denominator has to be an operating value. Thus, PE (market cap, an equity value, is divided by earnings per share, an equity value) and EV to EBITDA (EV is a market value of operating assets and EBITDA is a measure of operating cash flow) are consistent, but Price to EBITDA is an inconsistent abomination and Price to Sales is almost as badly constructed.
      • Timing: Multiples are constructed for comparisons across companies, not as stand alone measures. It follows therefore that you should be consistent in the timing you use for your scaling variable (revenues, book value, earnings) across companies. Thus, if you choose to use trailing earnings for your company to compute PE, you have to use trailing earnings for all your companies.
      Put simply, in pricing, you estimate a value for a business or its equity, based upon how "similar" companies (equities) are being priced in the market place.

      Determinants of Multiples
      Many analysts who use multiples to find under and over priced stocks do so because they do not want to confront the uncertainty associated with forecasting future growth, margins and cash flows in intrinsic valuation. That is an illusion, since embedded in every multiple are assumptions about growth, risk and investment efficiency. When you pay a hundred times earnings for a stock or ten times book value, you  are assuming high growth in earnings for the former and a monstrously high return on equity for the latter. In the picture below, I list out the fundamentals that are embedded in each multiple:

      This cheat sheet, designed to find the variables that are embedded in a multiple,  brings home a reality about pricing that should make anyone using it uncomfortable. The difference between intrinsic value, where you try (sometimes desperately) to forecast future growth and cash flows, and pricing, where you use a multiple, is that you are explicit about your assumptions in the future, making them both more transparent and easier to critique, and that you are implicit in your assumptions with the latter, making them easier to defend but also more dangerous.

      Pricing and Crisis - A Time Line
      In the aftermath of every crisis, investors abandon fealty to fundamentals, on the premise that they are in unique times and fall back on pricing. I am sure that will happen with this one as well, but if you decide to go this route, the nature of this crisis will make pricing much more difficult. To see why, take a look at how multiples will move as this crisis unfolds:
      • In phase one of this crisis,  the market reacts to the crisis by marking down stock prices almost immediately, but the scaling variable (revenues, earnings, book value) does not, partly because it takes time for the crisis to show up in operating numbers and even longer for accountants to record that in the financial statements. Consequently, as the crisis first unfolds, stocks will look cheaper on a trailing basis, as the market price drops and earnings/revenues/cashflows stay stagnant, and analysts/companies are too uncertain to offer guidance about future operating results. 
      • In phase two, analysts and companies start to provide forward guidance, and you can switch to forward values, if you trust them, but since the crisis can cause more companies to lose money, you will also see a greater dependence on revenue multiples in pricing. 
      • In phase three, as operating results more completely reflect crisis effects, trailing multiples will reflect the updated operating results, but you should not be surprised to see companies trade at much higher multiples of trailing earnings (if earnings are still positive), or have earnings multiples that are not meaningful. Again, a naive comparison of the trailing PE to historic norms will lead you to conclude that everything is over priced, even when that is not the case.
      No matter which phase you are in, you ultimately have to make judgments about whether the company will come out of the crisis, and if it does, what it will generate as earnings, to make sensible investment decisions. Just as there is no room for lazy and mechanistic valuation, in the midst of a crisis, there is no payoff to lazy and mechanistic pricing.

      Pricing Effects
      We are still in phase one of this crisis, though we are hopefully approaching its tail end. Not surprisingly, as market prices have dropped and trailing operating numbers reflect what companies did in 2019 (pre-crisis), there has been a drop in trailing pricing multiples across all regions of the world:
      Download data
      The same story unfolds across different sectors:
      Download data
      In some sectors, such as financial services, energy and airlines, where the punishment meted out by the market has been severe, you should not be surprised to see stocks trade at extraordinarily low multiples of trailing earnings. At the same time, companies have been reluctant to offer guidance for the coming year, making it difficult to shift to forward values. You could, of course, get ahead of the curve and try to forecast earnings in a post-virus world, say in 2022 or even 2025, and scale market capitalizations to those values.

      As companies start to report their first quarter earnings, you are starting to get a glimpse of the damage created by the crisis and my guess is that you will start to see more analysts and companies start to forecast forward numbers. For those companies where forward earnings are positive, you can switch to forward PE ratios, but expect these numbers to be much, much higher than historical norms. For those companies that expect losses in the next year, you will see revenue multiples or creative variations on future earnings, from earnings before COVID to earnings in 2025 used as the scalar. Later this year, as companies report numbers for the second and third quarters of 2020, the trailing operating numbers will finally catch up with the crisis, but they will come with caveats. Put simply, if you are abandoning or refusing to do intrinsic valuation, because you feel uncomfortable with having to make assumptions, the same uncertainty is going to pervade your pricing as well. 

      YouTube

      Data

      1. Market data (April 17, 2020)
      2. Regional breakdown - Market Changes and Pricing (April 17, 2020)
      3. Sector breakdown - Market Changes and Pricing (April 17, 2020)
      4. Industry breakdown - Market Changes and Pricing (April 17, 2020)
      5. Equity Risk Premium, by day (Updated through April 22, 2020)





      A Viral Market Meltdown VI: The Price of Risk

      It is a sign of how volatile the last few weeks have been,  that a week like the last one, where index levels move only 2-3% a day, high by historic standards, felt stable. As in prior weeks, I will start this one by looking at how the market action last week played out across asset classes, and within equity, across regions and industries first, but the bulk of this post will be an update on the price of risk, and how it has changed in both bond and stock markets over the last six weeks. In the process, I will compare this six-week periods to the 2008 crisis, which was also global, and shook the faith people had in markets, institutions and companies.

      The Markets last week
      The market action last week was more muted than it had been in prior weeks, but that is a relative statement, as we still saw big swings in almost every asset class. Using the same sequencing that I have used for the last few weeks, I will start with a  review of equity indices globally:
      Download raw data
      It was a quiet week for most markets, with the Nikkei and the Sensex being the exceptions, dropping 8,09% and 7.46% respectively. Over the last month, every market has seen double digit negative returns, with Shanghai being the only exception. Moving on to US treasuries, we saw more calm than in prior weeks, with rates staying close to where they were in the previous week:
      Download raw data
      The (relative) calm in equity and treasury markets also played out in the corporate bond market, with spreads decreasing slightly for higher rated bonds and increasing marginally for lower rated bonds.
      Download raw data
      The commodity markets continued on their wild ride, with oil again diverging significantly from copper:
      Download raw data
      Oil prices surged dramatically towards the end of the week, mostly on rumors that Saudi Arabia and Russia would come to an agreement on oil production, but copper prices stayed stable. Completing the analysis, I looked at gold and bitcoin last week:
      Both gold and bitcoin saw little price action during the week, not a bad development in a crisis market. In summary, looking at returns across asset classes last week, and comparing those returns to prior weeks, it is clear that last week saw a reduction in the volatility that has characterized previous weeks. It is unclear, though, whether the week is just the calm before another storm, or a true break in the crisis. The next few weeks will tell!

      Breaking down the weekly movements
      As in prior weeks, I start by looking at publicly traded companies around the world, and looking at how they did, in market capitalization terms, last week, and break down the information by region, sector/industry and classes (PE, momentum, debt etc.). I start with the regional breakdowns:
      As with the market indices, it was a  week of losses, albeit small ones, in much of the world, with the outliers being Eastern Europe & Russia, which saw a gain of 9.07%, and Japan, which lost 9.38% in market capitalization. Collectively, global stocks lost $1.6 trillion in the week of March 27-April 3, and have lost $22.7 trillion in market capitalization since February 14, 2020, a decline of 25.08%. Moving on to the sector breakdown:

      The rise in oil prices pushed up the market capitalization of the energy sector by 6.31%, but most of the other sectors saw losses during the week of 3/27-4/3/20. Incorporating the last week into the data, financial service firms have now taken the dubious lead among sectors, of biggest percentage drop in market capitalization since February 14, 2020, and consumer staples and health care still lead the list of least damaged sectors.  Honing down to the industry level and updating the list of ten most hurt and least hurt industries:
      Data on all industries
      The loser list has many of the same infrastructure industries that showed up in last week’s list, but the winner list has a healthy sprinkling of energy stocks, pushed up by the rise in oil prices during the week. I also did the breakdown, looking at companies in PE classes, momentum classes (based upon price change over the year leading into 2/14/20, net debt classes and dividend/buyback classes) and found that the only categorization where there is significant differentiation in market damage is net debt, where more highly levered companies continue to be punished more than less levered companies. You can find these categorizations and results by clicking on this link. I did extend the analysis to look at companies that have bond ratings, a subset of 2271 Firms out of the total sample of 36,789 firms, and the results reinforce the finding that leverage has the biggest explanatory power for damage from this crisis:
      As bond ratings drop, the decline in market value is more precipitous, with the ratings below investment grade (below BBB, in red) being particularly hit. 

      The Price of Risk
      In the last few weeks, as markets have tumbled, I have held back on reporting on a measure that I update every month, which is the equity risk premium. That said, the last six weeks reinforces a lesson that I learned the hard way in 2008, which is that dependence on a static, historical estimate makes no sense in a dynamic, shifting market. In this section, I want to focus on how the price of risk has changed over the last six weeks, and what lessons, if any, we can glean from those changes.

      Determinants
      In a post from earlier this year on the topic, I argued that every risky asset class market has a price of risk, though that price is more observable in some markets than others. The price of risk changes on a day-to-day basis, and is determined by a combination of variables that encompass almost everything going on in the world from uncertainty about future economic growth (more uncertainty -> higher price for risk) to political stability (more instability -> higher price for risk) to worries about catastrophes/disasters (more worries -> higher price for risk) to investor risk aversion (greater risk aversion -> higher price for risk) to information availability/reliability (less reliable and accessible information -> higher risk premiums). I know that I am giving short shrift to weighty topics, and if you are interested in a more in depth assessment of these variables, you can read my 2020 update on equity risk premiums here. (Be warned. It is long and boring, and may put you to sleep, but that may be a good thing..) The more general point though that emerges from identifying the determinants is that changes in these variables will change the prices for risk, and since investing and valuation has to be based upon updated prices for risk, you need measurement approaches that capture these changes.

      Bond Market Price of Risk
      In the bond market, the price of risk is observable, since as investors see more default risk in the future, and demand higher prices for risk, bond prices drop and interest rates on bonds increase. That is what I chronicled when I reported on the default spreads on bonds in different ratings classes in the last section, and looked at how these spreads changed over the last few weeks of this crisis. It is true that default spreads, for a given default risk class, don't change much in mature markets during periods of stability, and this can be seen in the graph below, where I look at the default spreads on Moody's Baa rated bonds (translating into an S&P BBB rating)  since 1960:
      Download raw data
      Even during this period, there have been sub-periods of tumult, as evidenced by the change in default spreads in the 2008 crisis. Looking more closely at the the period between September 12, 2008 to December 31, 2008 at the spreads on bonds, here is what you saw:

      In 2008, default spreads doubled between September 12, 2008 and December 31, 2008. In the last six weeks (February 14, 2020- April 3, 2020), the default spreads on bonds in every ratings class have widened, not surprising given both the economic damage done by the crisis and the higher likelihood of default and the fear factor:
      It is interesting that the default spreads did not show much effect during the first two weeks of this crisis (February 14- February 28), but woke up to the crisis in the third week. Over the six weeks, spreads have almost doubled for the highest risk classes, and have increased significantly even for higher rated bonds.

      Equity Market Price of Risk
      Unlike the bond market, it is more difficult to measure a forward-looking and dynamic measure of equity risk, though there are short cuts that people have employed. For instance, there are some investors who use the earnings yield (the inverse of the PE ratio) as a rough proxy, arguing that it should be higher, when equity investors are demanding a higher price for risk. There are others who focus on the VIX, a traded measure of volatility that is observable and is a gauge of fear and worry, rising during crisis and market downturns. In the last six weeks, the VIX has gone on a wild ride, as can be seen in the graph below, peaking at 85.47 on March 18, 2020.

      While the VIX is an instrument for measuring market fear, it is not a direct measure of the equity risk premium. My preference is an implied equity risk premium, computed by estimating the internal rate of return investors can expect to earn, given what they pay for stocks and expected cash flows in the future, and netting out the risk free rate:

      As some of you who have visited my website know, I update this equity risk premium (ERP) at the start of every year, and the graph below summarizes the implied equity risk premiums on the S&P 500 at the start of every year from 1960 to 2020.
      Download historical implied ERP
      Note that the equity risk premium stood at 5.20% at the end of 2019, but is has been more volatile since the 2008 crisis, than prior to it. It was during that crisis that I developed the practice of computing the premium on a day-to-day basis to capture the battle between fear and greed that characterize every crisis. In the figure below,I graph the implied ERP from September 12, 2008 (the Friday before Lehman’s collapse) until December 31, 2008:

      Note that on September 12, 2008, which was the triggering point for the 2008 crisis, the equity risk premium for the S&P 500 was 4.22% but during the next eight weeks, the ERP rose sharply to reach a high of 7.83% on November 20, 2008, before subsiding somewhat to end the year at 6.43%. One of the limitations that I faced during that period is that while I was able to update the index values and treasury bond rates every day, the earnings and cash flow numbers were being updated with a substantial lag, with the full changes not showing up until several months later.

      I decided to do the same day-to-day calculation for the implied equity risk premium, with an augmentation. Rather than allow earnings and cash flows to remain stagnant, in the face of a crisis that will almost certaintly decimate both, I computed a COVID-adjusted ERP as well, with estimated drops in earnings and cash flows. In making these judgments, I did change my estimates across time, starting with a 15% drop in earning in the first two weeks of this crisis, and ending with a 30% drop in earnings for the S&P in the most recent two. Those changes may reflect my slow learning, as the gravity of the crisis magnified each week:
      Download raw data
      I understand that this crisis is by no means over, and I intend to keep computing the implied equity risk premium daily for as long as I think necessary, but if your estimates are close to mine, the equity risk premium for the S&P 500 was 6.01% (with the adjusted numbers) on April 1, 2020

      Country Risk Premiums
      At the start of each year, I compute equity risk premiums, by country, with the intent of using these numbers when I value companies, and leave them unchanged for the first half of the year. This year, though, the crisis has caused the numbers to change, and in some cases, dramatically. First, the base premium that I use is the US implied equity risk premium which has jumped from 5.20% to 6.01% (see above). Second, the additional risk premiums for countries are based upon sovereign default spreads, which like corporate bond spreads, have widened significantly. My updated basis for computing the country equity risk premiums is below:

      My global picture of equity risk premiums at the start of April 2020 is provided below:
      Download spreadsheet
      Just to illustrate how much of a difference a few weeks can make to your estimates, I have also included the ERP from January 1, 2020, for comparison. Note that the premiums have not only climbed in every country, but they have increased more in the riskiest countries.

      Conclusion
      One of the lessons that I learned from the 2008 crisis was to move away from static approaches for computing equity risk premiums, dependent on looking at long periods of history. What I learned during the last three months of 2008 made me switch to using implied equity risk premiums in my valuation and corporate financial analysis, and to compute them on a monthly basis. This crisis has reinforced that practice. I have always found it difficult to grasp how companies can use hurdle rates that are not only set in stone, but set in stone a decade or two ago, even as the market environment shifts and the price of risk changes. The median cost of capital for a global company, which was 7.6% at the start of 2020, is now closer to 8%, with the increase in risk premiums more than compensating for the decline in risk free rates in much of the world and the rise in cost of capital, in US dollar terms, steeper in emerging markets than developed markets.

      YouTube Video


      Paper on Equity Risk Premiums
      1. Equity Risk Premiums: Determinants, Estimation  and Implications- The 2020 Edition
      Datasets
      1. Market Changes by Asset Class, 2/14 - 4/03
      2. Equity Market Changes by Industry, 2/14 - 4/03
      3. PE, Momentum & Dividend classes, 2/14-4/03
      4. Equity Risk Premium by day, 2/14 - 4/03
      5. Updated Equity Risk Premiums, by country (April 1, 2020)
      Spreadsheets



      A Viral Market Update VIII: A Crisis Test - Value vs Growth, Active vs Passive, Small Cap vs Large!

      In the weeks since my first update on the crisis on February 26, 2020, the markets have been on a roller coaster ride, as equity markets around the world collectively lost $30 trillion in market cap between February 14, 2020 and March 20, 2020, and then clawed back more than half of the loss in the following month. Having lived through market crises in the past, I know that this one is not quite done, but I believe we now have lived through enough of it to be able to start separating winners from losers, and use this winnowing process to address three big questions that have dominated investing for the last decade:
      • Has this crisis allowed active investors to shine, and use that performance to stop or even reverse the loss of market share to passive vehicles (ETFs and index funds) that has occurred over the last decade? 
      • Will this market correction lead to growth/momentum investing losing its mojo and allow value investors to reclaim what they believe is their rightful place on top of the investing food chain?  
      • Will the small cap premium, missing for so many decades, be rediscovered after this market shock?
      I know each of these is a hot button issue, and I welcome disagreement, but I will try to set my biases aside and let the data speak for itself.

      Market Action
      As with my prior updates, I will begin by surveying the market action, first over the two weeks (4/17-5/1), following my last update,  and then looking at the returns since February 14, the date that I started my crisis clock. First up, I look at returns on stock indices around the world, breaking them up into two periods, from February 14 to March 20, roughly the low point for markets during this crisis and from March 20 to May 1, as they mounted a comeback.
      Download data
      The divide in the two periods is clear. Consider the S&P 500, down 28.28% between 2/14 and 3/20, but up 22.82% from March 20 and May 1, resulting in an overall return of -11.92% over the period. While the magnitudes vary across the indices, the pattern repeats, with the Shanghai 50 close to breaking even over the entire period, and the Bovespa (Brazil) and the ASX 200 (Australia) delivering the worst cumulative returns between 2/14 and 5/1. As stock markets have swooned and partially recovered, the yields on US treasuries dropped sharply early in the crisis and have stayed low since.
      Download data
      The 3-month treasury bill rate, which was 1.58% on February 14,  has dropped close to zero on May 1, and the treasury bond rate has declined from 1.59% to 0.64% over the same period. The much talked about inverted yield curve late last year, that led to so many prognostications of gloom and doom, has become upward sloping, and staying consistent with my argument that too much was being made of the former as a predictor of recession, I will not read too much into its slope now. Moving to the corporate bond market, I focused on 10-year corporates in different ratings classes:

      Early in this crisis, the corporate bond markets did not reflect the worry and fear that equity investors were exhibiting, but they caught on with a vengeance a couple of weeks in, and the damage was clearly visible by April 3, 2020, with default spreads almost tripling across the board for all ratings classes. Since April 3, the spreads have declined, but remain well above pre-crisis levels. There should be no surprise that the price of risk in the bond market has risen, and as the crisis has taken hold, I have been updating equity risk premiums daily for the S&P 500 since February 14, 2020:
      Download data
      The equity risk premium surged early in the crisis, hitting a high of 7.75% on March 23, but that number has been dropping back over the last weeks, as the market recovers. By May 1, 2020, the premium was back down to 6.03%, with pre-crisis earnings and cash flows left intact, and building in a 30% drop in earnings and a 50% decline in buybacks yields an equity risk premium of 5.39%. For good reasons or bad, the price of risk in the equity market seems to be moving back to pre-crisis levels. I don’t track commodity prices on a regular basis, but I chose to track oil and copper prices since February 14:
      At the risk of repeating what I have said in prior weeks, the drop in copper prices is consistent with an expectation of a global economic showdown but the drop in oil prices reflects something more. In fact, a comparison of Brent and West Texas crude oil prices highlights one of the more jaw-dropping occurrences during this crisis, when the price of the latter dropped below zero on April 19.  The oil business deserves a deeper look and I plan to turn to that in the next few weeks. Finally, I look at gold and bitcoin prices during the crisis, with the intent of examining their performance as crisis assets:
      Download data
      Gold has held its own, but I think that the fact that it is up only 7.4% must be disappointing to true believers, and Bitcoin has behave more like equities than a crisis asset, and very risky equities at that, dropping more than 50% during the weeks when stocks were down, and rising in the next few weeks, as stocks rose, to end the period with a loss of 16.37% between February 14 and May 1.

      Equities: A Breakdown
      Starting with the market capitalizations of individual companies, I measured the change in market capitalization on a week to week basis, allowing me to slice and dice the data to chronicle where the damage has been greatest and where it has been the least. Breaking down companies by region, here is what the numbers updated through May 1 look like:
      Add caption
      Latin America has been the worst performing region in the world, with Africa, Australia and Russia right behind and China and the Middle East have been the best performing regions between February 14 and May 1. I continue the breakdown on a sector-basis in the table below:
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      Health care, consumer staples and technology have been the best performing sectors and financials are now the biggest losers. Extending the analysis to industries and looking at the updated list of worst and best performing industries:
      Add caption
      Repeating a refrain from my updates in earlier weeks, this has been, as crises go, about as orderly a retreat as any that I have seen. The selling has been more focused on sectors that have heavy capital investment and oil-focused, burdened with debt, and has been much more muted in sectors that have low capital intensity and less debt.

      Value versus Growth Investing
      In the tussle between value and growth investing, value investors have held the upper hand for a long time. In addition to laying claim to being the custodians of value, they also seemed to have all the numbers on their side of the argument, as they pointed to decades of outperformance by value stocks, at least in the United States. The last decades, though, have delivered numbers that are more favorable to growth investors, and this crisis is perhaps as good a time as any to reexamine the debate.

      The Difference
      For decades, we have accepted a lazy categorization of stocks on the value versus growth dimension. Stocks that trade at low PE or low price to book ratios are considered value stocks, and stocks that trade at high multiples of earnings and book value are growth stocks. In fact, the value factor in investing is built around price to book ratios. If you are a value investor, your reaction to this categorization is that this is no way to describe value and that true value investing incorporates many other dimensions including management quality, sustainable moats and low leverage. Conceding all those points, I would argue that the key difference between value and growth investing can be captured by looking at a financial balance sheet:

      Thus, the real difference between value and growth investors lies not in whether they care about value (sensible investors in both groups do), but where they believe the investing payoff is greater. Value investors believe that it is assets in place that markets get wrong, and that their best opportunities for finding "under valued" stocks is in mature companies with mispriced assets in place. Growth investors, on the other hand, assert that they are more likely to find mispricing in high growth companies, where the market is either missing or misestimating key elements of growth.

      The Lead In
      Until the last decade, it was conventional wisdom that value investing beat growth investing, especially over longer time horizon, and the backing for this statement took the form of either anecdotal evidence (with the list of illustrious value investors much longer than the list of legendary growth investors) or historical data showing that low price to book stocks have delivered higher returns than high price to book stocks:
      Source: Raw Data from Ken French
      Looking across the entire period (1927-2019), low price to book stocks have clearly won this battle, delivering 5.22% more than high price to book stocks, and this excess return is almost impervious to risk and transaction cost adjustments. Value investors entered the last decade, convinced of the superiority of their philosophy, and in the table below, I look at the difference in returns between low and high PE and PBV stocks, each decade going back to the 1920s.
      It is quite clear that 2010-2019 looks very different from prior decades, as high PE and high PBV stocks outperformed low PE and low PBV stocks by substantial margins. The under performance of value has played out not only in the mutual fund business, with value funds lagging growth funds, but  has also brought many legendary value investors down to earth. Pushed to explain why, the defense that value investors offered was that the 2008 crisis, Fed interventions and the rise of the FAANG stocks created a perfect storm that rewarded momentum and growth investing, at the expense of value. Implicit in this argument is the belief that this phase would pass and that value investing would regain its rightful place.

      The COVID Crisis 
      In the early days of the crisis, there were many value investors who viewed at least some of the market correction as punishment for investor overreach on growth and momentum stocks in the past decade.  As the weeks have progressed, that argument has been quelled by the cumulating evidence that the market punishment perversely has been far worse for value stocks, i.e., stocks with low PE ratios and high dividend yields than for momentum or growth stocks. To illustrate this, I first look at how the market effects have varied across stocks in different PE ratio classes:

      Note that it is the lowest PE stocks that have lost the most market capitalization (almost 25%) between February 14 and May 1, whereas the highest PE stocks have lost only 8.62%, and to add insult to injury, even money losing companies have done better than the lowest PE stocks. I follow up by looking at stocks broken down by price to book ratios:

      The results mirror what we saw with PE stocks, with low price to book stocks losing far more value than the highest price to book stocks.  I then break down stocks based upon dividend yields:
      Low dividend yield stocks and even non-dividend paying stocks have fared far better than high dividend yield stocks. Finally I look at companies, based upon net debt ratios:

      Put simply, here is what I see in the data. If I had followed old-time value investing rules and had bought stocks with low PE ratios and high dividends in pre-COVID times, I would have lost far more than if I bought high PE stocks or stocks that trade at high multiples of book value, paying little or no dividends. The only fundamental that has worked in favor of value investors is avoiding companies with high leverage.

      A Personal Viewpoint
      I believe that value investing has lost its way, a point of view I espoused to portfolio managers in Omaha a few years ago, in a talk, and in a paper on value investing, titled Value Investing: Investing for Grown Ups? In the talk and in the paper, I argued that much of value investing had become rigid (with meaningless rules and static metrics), ritualistic (worshiping at the altar of Buffett and Munger, and paying lip service to Ben Graham) and righteous (with finger wagging and worse reserved for anyone who invested in growth or tech companies). I also presented evidence that it was bringing less to the table than active growth investing, by noting that the average active value investor underperformed a value index fund by more than the average growth investor lagged growth index funds. I also think that fundamental shifts in the economy, and in corporate behavior, have rendered book value, still a key tool in the value investor's tool kit, almost worthless in sectors other than financial services, and accounting inconsistencies have made cross company comparisons much more difficult to make. On a hopeful note, I think that value investing can recover, but only if it is open to more flexible thinking about value, less hero worship and less of a sense of entitlement (to rewards). If you are a value investor, you will be better served accepting the reality that you can do everything right on the valuation front, and still make less money than your neighbor who picks stocks based upon astrological signs, and that luck trumps skill and hard work, even over long time periods.

      Active versus Passive Investing
      Some of the readers of this blog are in the active investing business and I apologize in advance for raising questions about your choice of profession. After all, any discussion of active versus passive investing that comes down on the side of the latter implicitly is a judgment of whether you are adding value by trying to pick stocks or time markets. Consequently, these discussions quickly turn rancid and personal, and I hope this one does not.

      The Difference
      In passive investing, as an investor, you allocate your wealth across asset classes (equities, bonds, real assets) based upon your risk aversion, liquidity needs and time horizon, and within each class, rather than pick individual stocks, bonds or real assets, you invest in index funds or exchange traded funds (ETFs)  to cover the spectrum of choices. In active investing, you try to time markets (by allocating more money to asset classes that you believe are under valued and less to those that you think are over valued) or pick individual assets that you believe offer the potential for higher returns. Active investing covers a whole range of different philosophies from day trading to buying entire companies and holding them for the long term.

      Put simply, active investing covers a range of philosophies with different time horizons, different and often contradictory views about how markets make mistakes and correct them,

      The Lead In
      Until the 1970s, active investing dominated passive investing for two simple reasons. The first was the presumption that institutional investors were smarter, and had access to more information than the rest of us, and should thus do better with our money. The second was that there were no passive investing vehicles available for average investors. Both delusions came crashing down in the late sixties and early seventies.
      • First, the pioneering studies of mutual fund performance, including this famous one that introduced Jensen's alpha, came to the surprising conclusion that rather than outperform markets, mutual funds under performed by non-trivial amounts. In the years since, there have been literally hundreds of studies that have asked the same question about mutual funds, hedge funds and private equity, using far richer data sets and more sophisticated risk adjustment models to arrive at the same result. You can see Morningstar's 10-year excess return distribution for all active large-blend mutual funds, from 2010-2019, below (with similar graphs for other classes of active mutual funds):
        If the counter is that it is hedge and private equity funds where the smart money resides today, the evidence with those funds, once you adjust for reporting and survivor bias, mirrors the mutual fund results. Put bluntly, "smart" money is not that smart, and the advantages that it possesses (bright people, more data, powerful models) don't translate into returns for its investors. Ironically, over the same period, there were hundreds of other studies that claimed to find market inefficiencies, at least on paper, suggesting that there is no internal inconsistency in believing that markets are inefficient and also believing that bearing these markets is really, really difficult to do.
      • Second, Jack Bogle upended investment management in 1976 with the Vanguard 500 Index fund, the most disruptive change in the history of the investment business. Over the next three decades, the index fund concept expanded to cover geographies and asset classes, allowing investors unhappy with their investment advisors and mutual funds to switch to low-cost alternatives that delivered higher returns. The entry of ETFs tilted the game even further in favor of passive investing, while also offering active investors new ways of playing sectors and markets.
      The shift of funds from active to passive has been occurring for a long time, but the shift was small early in the process. In 1995, less than 5% of money was passively invested (almost entirely in index funds) and that percentage rose to about 10% in 2002 and 20% in 2010. In the last decade, that shift has accelerated, as you can see in the graph below:
      Source: Morningstar
      The increase in passive investing's market share has come primarily from almost $4 trillion in funds flowing into passive vehicles, but active investing has also seen outflows in the last five years. While some have attributed this to failures of active investors in the last decade, I believe that active investing has been a loser's game, as Charley Ellis aptly described it, for decades, and that the shift can be more easily explained by investors having more choices, as trading moves online and becomes close to costless, and readier access to information on how their portfolios are performing. 

      The Crisis Performance
      Active investors have argued that their failures were due to an undisciplined bull market, where their stock pricing expertise was being discounted, and that their time would come when the next crisis hit. There were also dark warnings about how passive investing would lead to liquidity meltdowns and make the next crisis worse. If active investors wanted to have a chance to shine, they have got in their wish in the last few weeks, where their market timing and stock picking skills were in the spotlight. With their expertise, they should have managed to not only to avoid the worst of the damage in the first few weeks, but should have then gained on the upside, by redeploying assets to the sectors/stocks recovering the quickest. While there is anecdotal evidence that some investors were able to do this, with Bill Ackman's prescient hedge against the COVID collapse getting much attention, I am sure that there were plenty of other smart investors who not only did not see it coming, but made things worse by doubling down on losing bets or cashing out too early.

      As we look at the bigger picture, the results are, at best, mixed, and hopes that this crisis would vindicate active investors have not come to fruition, at least yet. I looked at Morningstar's assessment of returns on equity mutual funds in the first quarter of 2020, measured against returns on passive indices for each fund class:
      Source: Morningstar
      Note that the first quarter included the worst weeks of the crisis (February 14- March 20), and there is little evidence that mutual funds were able to get ahead of their passive counterparts, with only two groups showing outperformance (small and mid-cap value), but active funds collectively under performed by 1.37% during this period. Focusing on market timing skills, tactical asset allocation funds (whose selling pitch is that they can help investors avoid market crisis and bear markets) were down 13.87% during the quarter, at first sight beating the overall US equity market, which was down 20.57%. That comparison is skewed in favor of these funds, though, since tactical asset allocation funds typically tend to invest about 60% in equities, and when adjusted for that equity allocation, they too underperformed the market. Looking at hedge funds in the first quarter of 2020, the weighted hedge fund index was down 8.5% and saw $33 billion in fund outflows, though there were some bright spots, with macro hedge funds performing much better. Overall, though, there was little to celebrate on the active investing front during this crisis. On the market liquidity front, while much has been made of the swings up and down in the market during this crisis, the market has held up remarkably well. A comparison to the chaos in the last quarter of 2008 suggests that the market has dealt with and continues to deal with this crisis with far more equanimity than it did in 2008. In fact, I think that the financial markets have done far better than politicians, pandemic specialists and market gurus during the last weeks, in the face of uncertainty.

      A Personal Viewpoint
      I have been skeptical about both the reasons given for active investing's slide over the last decade and the dire consequences of passive investing, and this crisis has only reinforced that skepticism. For active investing to deal with its very real problems, it has to get past denial (that there is a problem), delusion (that active investing is actually working, based upon anecdotal evidence) and blame (that it is all someone else's fault). Coming out of this crisis, I think that more money will leave active investing and flow into passive investing, that active investing will continue to shrink as a business, but that there will be a subset of active investing that survives and prospers. I don't believe that  artificial intelligence and big data will rescue active investing, since any investment strategies built purely around numbers and mechanics will be quickly replicated and imitated. Instead, the future will belong to multidisciplinary money managers, who have well thought-out and deeply held investment philosophies, but are willing to learn and quickly adapt investment strategies to reflect market realities. 

      Small versus Large Cap 
      The small cap premium was among the earliest anomalies uncovered by researchers in the 1970s and it came from the recognition that small market capitalization stocks earned higher returns than the rest of the market, after adjusting for risk. That premium has become part of financial practice, driving some investors to allocate disproportionate portions of their portfolios to small cap funds and appraisers to add small cap premiums to discount rates, when valuing small companies.

      The Difference
      There are two things worth noting at the outset about the small cap premiums. The first is that market capitalization is the proxy for size in the small cap studio, not revenues or earnings. Thus, you can have a young company with little or no revenues and large losses with a large market capitalization and a mature company with large revenues and a small market capitalization. The second is that to define a small capitalization stock, you have to think in relative terms, by comparing market capitalizations across companies. In fact, much of the relevant research on small cap stocks has been based on breaking companies down by market capitalization into deciles and looking at returns  on each decile. One reason that the small cap premium resonates so strongly with investors is because it seems to make intuitive sense, since it seems reasonable that small companies, with less sustainable business models, less access to capital and greater key person risk, should be riskier than larger companies. 

      The Lead In
      As with value investing, the strongest arguments for the small cap premium come from looking at historical returns on US stocks, broken down by decile, into market cap classes.
      Going back to 1927, the smallest cap stocks have delivered about 3.47% more annually than than the rest of the market, on a value-weighted basis. That outperformance though obscures a troubling trend in the data, which is that the small cap premium has disappeared since 1980; small cap stocks have earned about 0.10% less than the average stock between 1980 and 2019. The table below breaks down the small cap premium, by decade:

      The data in this table is testimony to two phenomena. The first is the belief in mean reversion that lies at the heart of so many investment strategies, with the mean being computed over long time periods, and primarily with US stocks. The second is that once bad valuation practices, once embedded in the status quo, are very difficult to remove. In my view, the use of small cap premiums in valuation practice have no basis in the data, but that does not mean that people will stop using them.

      The Crisis Performance
      As with active and value investing, there are some who believe that the fading of the small cap premium is temporary and that it will return, when markets change. To the extent that this crisis may constitute a market shift, I examined the performance of stocks, broken down by market capitalization into deciles between February 14, 2020 and May 1, 2020.

      I know that it is still early in this crisis, but looking at the numbers so far, there is little good news for small cap investors, with stocks in the lowest two declines suffering more than the rest of the market. In fact, if there is a message in these returns, it is that the post-COVID economy will be tilted even more in favor of large companies, at the expense of small ones, as other businesses follow the tech model of concentrated market power. 

      A Personal Viewpoint
      It is still possible that the shifts in investor behavior and corporate performance could benefit small companies in the future, but I am hard pressed trying to think of reasons why. It is my belief that forces that allowed small cap stocks to earn a premium over large cap stocks have largely faded. I am not arguing that investing in small cap stocks is a bad strategy, but investing in small companies, just because they are small, and expecting to get rewarded for doing so, is asking to be rewarded for doing very little. Markets are unlikely to oblige. It is possible that you can build more discriminating strategies around small cap stocks that can make money, but that will require again bringing something else to the equation that is not being tracked or priced in by the market already.

      YouTube Video


      Data
      1. Market data (May 1, 2020)
      2. Regional breakdown - Market Changes and Pricing (May 1, 2020)
      3. Sector breakdown - Market Changes and Pricing (May 1, 2020)
      4. Industry breakdown - Market Changes and Pricing (May 1, 2020)
      5. Equity Risk Premium, by day (Updated through May 1, 2020)
      6. Small Cap versus Large Cap Stocks (1927-2019)
      7. Small Cap - Market Changes and Pricing (May 1, 2020)
      8. Value versus Growth ((1927-2019)
      9. PE breakdown - Market Changes and Pricing (May 1, 2020)
      10. PBV breakdown - Market Changes and Pricing (May 1, 2020)
      11. Dividend Yield  breakdown - Market Changes and Pricing (May 1, 2020)



      A Viral Market Update X: A Corporate Life Cycle Perspective

      Fear and greed are dueling forces in financial markers at all times, but especially so in periods of uncertainty, when they pull in opposite directions, causing wild market swings and momentum shifts. I think that no matter what your market views are right now, you would agree that we are in a period of intense uncertainty, with divergent views on how this pandemic will play out, not just in the coming months, but in the coming years. It is this divergence that have been at the heart of both the steep fall in equity markets in February and March, and the equally precipitous rise in April and May. As US equity markets climb back towards pre-crisis levels, the focus on market levels may be missing the underlying shift in value that has occurred across companies. In this post, I will focus on this shift, using the framework of a corporate life cycle, and record a redistribution of value from older, low growth, more capital intensive companies to younger, high growth companies. It is possible that this shift is the result of irrational exuberance on the part of young, inexperienced investors, but I think that a more plausible explanation is that it reflects not only the unique nature of this crisis, but also a changing business landscape.

      Updating the Market
      As with my previous updates, I will start with a chronicling of how markets have behaved in the two weeks since my last update, and overall, during the crisis. Let's start with equity indices, where we saw one week of relative stability (5/29-6/5) and a week of drama (6/5-6/12), after surges in April and May:
      Download data
      For those who thought that the worst of the crisis was behind them, June 11 delivered the message that this crisis is not quite done, as the S&P 500 dropped 7%, and markets around the world followed. I have computed the returns since February 14, broken down into two time periods, with the first stretching from February 14 to March 20, and the second from March 20 to June 12. Every equity index that I list in this table dropped in the first phase, with some indices losing more than 30%, as fear stalked markets around the world. In the second phase, every index posted positive returns, with some climbing back almost to pre-crisis levels. I will return to look at equities in more detail in the next section, but as stocks were going through contortions, US treasury yields were also on the move:


      Download data
      US treasury rates dropped in the first weeks of the crisis, and with 3-month yields dropping close to zero and 10-year rates declining below 1%. While it is convenient to attribute everything that happens to interest rates to the Fed, note that much of the drop in rates occurred before the Fed's two big moves, the first one on March 15, where the Fed Funds rate was cut by 0.5% (almost to zero) and a $700 billion quantitative easing plan was announced, and the second one on March 23, when the Fed lifted the cap on its easing plan and extended its role as a backstop in the corporate bond and lending markets. While treasury rates were not affected much by the Fed's actions, its entry into the corporate bond market played a key role in turning the tide, where default spreads across ratings classes had been on the rise since February 14:
      Download data

      Default spreads followed the path of equities, widening significantly between February 14 and March 20, and falling back by June 12, albeit to levels higher then on February 14. The fear about how the pandemic would slow economic growth also affected commodity prices, and I chart the path of copper and oil, two commodities sensitive to global economic growth below:

      Download data

      As with corporate bonds and equities, it is a tale of two periods, with commodity prices dropping between February 14 and March 20, before clawing their way back in the subsequent period. With copper, the market has retraced its entire decline, and it is now back to where it was trading at, on February 14. With oil, it is a different story, with a decline of more than 50% between February 14 and March 20 in both Brent and West Texas crude. and oil prices, notwithstanding a strong recovery between March 20 and June 12, are about 30% lower than they were on February 14. Finally, I look at gold and bitcoin, gold, because it has historically been a crisis asset and bitcoin, because it has been marketed by some as an alternative asset:

      Download data

      Gold has held its value and is up 9.28% during the crisis, though it saw less upside during the first few weeks of this crisis than in prior ones. Bitcoin has behaved more like equity, and very risky equity at that, during this crisis, dropping almost 40% between February 14 and March 20, before recovering to close down only 10.67% by June 12.

      Equities: A Breakdown
      In keeping with a practice I have adopted on my prior updates, I downloaded individual stock data on 37,050 publicly traded global companies, with market capitalizations exceeding $5 million, and computed changes in market cap, by region:
      Download data

      Looking at overall returns from February 14 to June 12, the worst performing regions in the world are mostly in emerging markets (India, Latin America and Africa), with the UK as the worst performing developing market, down about 20%.  Breaking down the companies by sector, I look at returns across the period, broken down into two sub periods:
      Download data
      The sectors with double digit negative returns over the entire period are energy, utilities, real estate, industrials and financials, with the first four being punished for their capital intensity and debt dependence, and financials reflecting the fear of debt defaults. Health care shows almost no change in value over the entire period, and tech is down only 3.2%. Breaking the sectors down into industries, and looking at returns over the crisis period, I list out the ten worst and best performing industries between February 14 and June 12, 2020:
      Download data

      There are no surprises here, given the earlier sector assessment, with a strong representation of infrastructure and financial service companies among the worst performing sectors, and health care and technology on the best performing list. 

      Crisis Effects across the Corporate Life Cycle
      In each update on the crisis, I have tried to look at a different facet of market performance, hoping to get some understanding of  what the market is pricing in, and whether it makes sense. This week, I will use the concept of a corporate life cycle, a structure that I have found useful in thinking about both corporate financial questions and in valuation, and look at how this crisis has played out across the life cycle. 

      The Corporate Life Cycle
      I believe that companies, like humans, go through a life cycle from newborn (start up) to toddler to teenager, peaking as successful growth companies, before becoming middle aged (mature) and then declining. 

      While there are companies that find pathways to reincarnation (IBM in 1992, Apple in 1999, Microsoft in 2013), they remain the exceptions to the rule that fighting corporate aging creates more costs than benefits. The life cycle is useful not just as a device for chronicling corporate age but also in identifying the challenges that companies face at each stage. It is also worth noting that the free cash flows, i.e., cash flows left over after taxes and reinvestment, vary as companies move through the life cycle:


      In general, negative cash flows (cash burn) are a feature of young companies, cash build ups occur as companies grow and mature, and declining companies return cash as they shrink. Finally, to understand how companies change as they move through the life cycle, I will draw on another general construct, the financial balance sheet:

      Note that young companies derive their value mostly or even entirely from growth assets, i.e., the value of investments that they are expected to make in the future, and that the portion that is attributable to assets in place increases as companies age, with mature and aging firms deriving most or all of their value from existing investments. Young companies, lacking the earnings and cash flows to service debt, are also more dependent on equity to fund their businesses than mature firms.

      The Crisis Effect across the Life Cycle
      A crisis tests all companies, but the dimensions on which they get tested will vary depending on where they fall in the life cycle. 
      1. Start up and very young companies: For young companies, the challenge is survival, since they mostly have small or no revenues, and are money losers. They need capital to make it to the next and more lucrative phases in the life cycle, and in a crisis, access to capital (from venture capitalists or public equity) can shut down or become prohibitively expensive, as investors become more fearful. These companies will either have to shut down or sell themselves at bargain basement prices to larger, deeper-pocketed competitors.
      2. Young growth companies: For young growth companies that have turned the corner on profitability, capital access still remains critical since it is needed for future growth. Without that capital, the values of these firms will shrink towards assets in place, and in a crisis, these firms have to hunker down and scale back their growth ambitions.
      3. Mature firms: For mature firms, the bigger damage from a crisis is the punishment it metes to assets in place, as the economy slows or goes into recession, and consumers cut back on spending. The effect will be greater on companies that sell discretionary products than on companies that sell staples.
      4. Declining firms: For declining firms, especially those with substantial debt, a crisis can tip them into distress and default, especially if access to risk capital declines, and risk premiums increase. 
      In summary, the answer to the question of which companies (young or old) get affected more in a crisis will depend  on how the crisis affects the real economy and capital access. In most crises, it is access to capital that takes the early hit, with the pain from economic effects showing up more gradually. As a result, in the first parts of the crisis, it is the firms at either end of the life cycle (young companies and declining ones) that are most dependent on new capital to survive that are hurt the most, with the pain spreading more slowly to mature firms, and least to firms that sell consumer staples.   How has this crisis played out in terms of damage to companies across the life cycle? Let me start with a very simplistic measure of life cycle, company age, as measured from the year of founding:
      Download data
      The table tells an interesting story. In the down phase (2/14-3/20), there was little distinction between younger and older firms, as firms in every age group lost about 30% of value. In the second phase from 3/20 to June 12, younger companies have seen a much more robust comeback than older firms, resulting in much lower negative returns over the entire period for younger firms (the bottom five deciles) than older ones (the top five deciles).  You could argue that company age is not a composite measure of where a company falls in the life cycle, since some companies move through the life cycle faster than others. To counter this critique, I break firms down by expected revenue growth, as estimated prior to the crisis, building on the assumption that expected revenue growth should be highest for young firms and lower for firms further along in the life cycle:
      Download data
      Note that expected revenue growth estimates are available for just over a third of all the firms in my sample, and across those firms, the differences are stark. Firms in the lowest revenue growth decile are down substantially over the crisis period (2/14 - 6/12) whereas the firms with the highest expected revenue growth, coming into the crisis, have seen their values increase over the same period.  

      In summary, this crisis seems to have had a much greater negative impact on older, more mature companies than on younger, high growth ones. perhaps because it started at a time, when capital markets were buoyant and investors were eagerly taking on risk, with risk premiums in both equity and bond markets at close to decade-level lows, with a global economic shut down, with a cessation of most business activity.  That shut down came with a time frame, though there was uncertainty not only about when economic activity would start up again, but how vigorously it would return. Young companies have also benefited from the fact, that after being on hold in the first few weeks of the crisis, risk capital came back in the middle of March, both in public and private markets. The big story, still unfolding, from this crisis is that access to risk capital has held up remarkably well, coming back into markets earlier and in larger magnitudes, than in prior crisis. The Fed has undoubtedly played a role in this comeback, especially with its  intervention in lending markets, but it has succeeded only because it tapped a willing investor base.That access to risk capital has also benefited distressed companies at the other end of the life cycle, explaining why you have seen surges in airline stock prices and in portions of the oil sector. To those who attribute the shift to amateur investors, subject to so much scorn from market watchers, there is collectively too little capital in the hands of these investors to have caused this much of a change in markets.

      The divergence in the market treatment between young and older companies during this crisis also explains why value has underperformed growth, since value investing strategies skew towards more mature companies and growth investing is more focused on younger companies. It may also explain why so many market "pros" have been left in the dust by amateurs, since many of the former have been using scripts developed in prior crisis to decide when and where to invest, and this one has followed a different path. While value investors and pros may still be vindicated, the lesson that I would take from this crisis is that while it is true that those who do not remember history are destined to repeat it, it is also true that those who let history alone drive their investment decisions are in just as much danger. 

      Conclusion
      The trajectory of markets in this crisis has followed the path of the virus, with markets rising and falling on news about viral breakouts in different parts of the world, and vaccines/medication to mitigate its effects.  It should therefore come as no surprise that just as the virus has had its most deadly effects on the elderly and the infirm, the market is meting out its biggest punishment to mature and aging companies. As we pass the four-month mark since this crisis started roiling financial markets in the US and Europe, it is still an evolving story and there will be more twists and turns before it is done. 

      YouTube Video
      <iframe width="560" height="315" src="https://www.youtube.com/embed/NR0BlxmQpv0" frameborder="0" allow="accelerometer; autoplay; encrypted-media; gyroscope; picture-in-picture" allowfullscreen></iframe>

      Data
      1. Market data (June 12, 2020)
      2. Regional breakdown - Market Changes and Pricing (June 12, 2020)
      3. Country breakdown - Market Changes and Pricing (June 12, 2020)
      4. Sector breakdown - Market Changes and Pricing (June 12, 2020)
      5. Industry breakdown - Market Changes and Pricing (June 12, 2020)
      6. Age breakdown - Market Changes and Pricing (June 12, 2020)
      7. Growth breakdown - Market Changes and Pricing (June 12, 2020)



      A Viral Market Update IX: A Do-it-Yourself S&P 500 Valuation

      It has been close to four weeks since my last viral market update, and I could come up with a whole host of excuses for the delay, but the truth is that I have not had much to say that is original, and I am naturally lazy. That said, markets have settled in, mostly with an upward bias in these last few weeks, and the big question, as US equities climb back towards pre-crisis levels is whether the market has lost its bearings. After all, the news, whether on macroeconomic indicators or company-level earnings, is not just bad, but historically so, and it seems incongruous that markets should be rising, when  consumer confidence and spending are plummeting, the ranks of the unemployed rising and professional economists are painting a picture of impending doom. There are some market gurus who are pointing to this disconnect as evidence that markets are just wrong and that a major correction is around the corner, but their credibility is undercut by the fact that many in this group have been forecasting this correction for the last decade,  and with metrics (PE, CAPE, Shiller PE) that have lost their potency. I have absolutely no shame in admitting that I am not a market timer, but I do believe that embedded in market action is always a link, though sometimes tenuous, to fundamentals. In this post, I will start with my usual updates of what has transpired in the last few weeks across markets, in general, and equities, in particular. I will then revisit my framework for valuing the S&P index, which I first presented in my first viral market post on February 27 and then expanded on in subsequent posts on March 9 and March 16. While I will update my valuation of the index, given what we have learned since, I will also follow a template that I developed when I valued Tesla earlier this year, and offer a Do-it-yourself (DIY) valuation of the index. 

      Market Update
      My crisis clock started on February 14, 2020, shortly after US equities hit all time highs, and in the weeks since, I have tracked the ups and downs of equity indices.
      Download data
      Between February 14 and March 20, it was a precipitous drop with almost equity index in the world down between 30-40%, with the Chinese markets being the exceptions, a bear market compressed into five weeks. Since March 20, though, it has been not just an up market, but one that has climbed steeply. For instance, the S&P 500 which dropped a little over 28% between February 14 and March 20, had recouped most of those losses by June 1, and is now down only 5.29% since February 14. Two emerging market indices, the Bovespa (Brazil) and the Sensex (India), and one developed market index, the CAC (France), have still lost more than 20% of their value over the period. Moving on to treasuries, the immediate effect of the crisis was a flight to US treasuries, where yields dropped across the board:
      Download data
      Note that almost all of the yield drop occurred before March 15, when the Fed announced its quantitative easing actions. The fear factor in the first few weeks that caused the flight to treasuries also pushed up default spreads on corporate bonds:
      Download data
      Note the dramatic surge in spreads between February 14 an April 3, with a tripling in the spread on BBB rated bonds. Like equities, corporate bonds seem to have entered a more sanguine period, with spreads on June 1, 2020, down significantly from their highs in early April. I have also been tracking two commodities, oil and copper, to measure how a global economic showdown is affecting prices:
      Download data
      Copper prices are down about 7% on June 1, from February 14 levels, but that is as improvement from the almost 14% drop in mid-March. The oil market has had volatility that cannot just be explained by the COVID crisis, as oil prices plunged in late April, with West Texas crude dropping below zero on April 19, but even oil prices have seen recovery in the last few weeks. Finally, I look at gold and bitcoin, the former a crisis asset of long standing and the latter a new entrant.

      Download data
      Gold has held up, and is up just over 9% in the weeks since February 14, but bitcoin has behaved more like a risky speculative investment than a crisis asset, dropping more than 50% by mid March before recouping most of its losses, as equities came back April and May.

      Equity Breakdown
      I have been downloading company-level data on publicly traded companies, at the end of each week for the last 15 weeks, and looking at changes in market capitalization across different classes of stocks. That allows me to see to not only get a more complete measure of market damage than just looking at indices, but to also use the data to double check assertions about causality. 

      Region
      The problem with indices, especially those that contain only handfuls of stock, is that it is easy to miss changes that are occurring at smaller and lower profile companies. I used the company-level data to break down the market changes since February 14 by region:
      Download data
      As with the equity indices, the divide is clear, both in terms of time, with the drop occurring between February 14 and March 20 and the rise from March 20 to June 1, but also in terms of geography, with emerging markets showing bigger declines in percentage terms over the entire period. If you prefer your data on a country level, you may find this picture more revealing:
      Download country-level data
      The full list of countries is available at this link. Note that all of the values in the data are in US dollar terms to allow for comparability, but that does mean that exchange rate effects will add to local stock market effects.

      Sector/ Industry
      While market behavior was characterized as chaotic in the first few weeks, this is clearly a market that has been orderly in how it doles out rewards and metes out punishment, as you can see in the breakdown of market cap changes by sector in the table below:
      Download data
      As you browse the table, note that health care, as a sector, is now in the plus column and that technology and consumer goods (both staple and discretionary) show much less damage than the rest of the market. In effect, the overall market may have recovered much of its losses, but along the way, value has been reallocated from financials, real estate and energy into health care and technology. Breaking down sectors into industries provides for more detail, and the ten best performing and ten worst performing industries between February 14 and June 1, 2020 are listed below:
      Download data
      The list of best and worst performing industries has stayed stable for most of the last seven to eight weeks, but the rise in the market in the last few weeks has led to some of the best performing industries now delivering positive returns, with software, precious metal, biotech and healthcare info/tech now posting returns exceeding 10%, since February 14, 2020. 

      The Mystery of Markets
      As markets have recovered from their mid-March lows, there are many who are puzzled by the rise.  For some, the skepticism comes from the disconnect with macroeconomic numbers that are abysmal, as unemployment claims climb into the tens of millions and consumer confidence hovers around historic lows.  I will spend the first part of this section arguing that this reflects a fundamental misunderstanding of what markets try to do, and a misreading of history. For others, the question is whether markets are adequately reflecting the potential for long term damage to earnings and cash flows, as well as the cost of defaults,  from this crisis. Since that answer to that question lies in the eyes of the beholder, I will provide a framework for converting your fears and hopes into numbers and a value for the market.

      Markets and the Economy
      The notion that stock markets and economies are closely tied together is deeply held, simply because it appeals to intuition. After all, how can stocks keep going up if the economy is doing badly? While I concede that the right answer is they cannot, there are three factors that may delink the two.
      • The first is that stocks are driven by earnings, not real growth in the economy or employment, and to the extent that companies can continue to generate income, even in stagnant or declining economies, you may see stock prices rise. 
      • The second is that the “economy” that stocks are tied to does not always have to be the domestic one, since globalization has made it possible for companies to continue to prosper in slow-growing economies. 
      • The third is time, since stock markets are prediction machines, albeit with a lot of noise and error, the link between markets and the economy, even if it exists, will be with a lag of months or longer. 
      To those who prefer a data-based argument, the graph below plots US stock market returns against real GDP growth in the United States, using quarterly data.
      Download data

      Note that there is almost no correlation between stock returns and real GDP growth contemporaneously, and while the correlation grows as you look at GDP is subsequent quarters, it is still modest even four quarters ahead. If the relationship between stock returns and measures of economic activity is weak, as both logic and the data suggest, it should be even weaker right now, where every measure of economic activity is ravaged by the crisis-driven shutdown. To those in the media and the investment community who profess to be shocked by the latest economic numbers, my question is whether you are just as shocked to see your speedometer at zero, when your car is parked in the driveway, or when your pie does not bake in an oven that is not turned on? In short, there is almost nothing of use to investors from poring over current macroeconomic data, which is one reason why markets have started ignoring them. That will change, as the economy opens up again, and markets start looking at the data for cues on how quickly it is coming back to life.

      Valuing the Market
      In my first viral market update, I sketched a picture of the drivers of value for the market, drawing on fundamentals. I revisited that picture and tweaked it to reflect the uncertainties that investors face about the future, broke down into near term (2020 & 2021) and the long term (in the years through 2024):

      While the picture looks daunting and your estimates are fraught with uncertainty, we are now in a better position to estimate the effects than even a few weeks ago:
      1. Earnings and Growth: In 2019, the companies in the S&P 500 reported 163 in earnings, and analysts were forecasting modest growth of about 4% over the next five years, prior to the crisis. It is beyond debate that the economic shut down will be devastating for earnings in 2020, with the damage spilling over in 2021. In my valuation in March 2020, there was almost no information on the extent of this damage, but as companies have reported first quarter earnings, we are getting preliminary estimates of future earnings. In the picture below, I look at three sets of predictions from analysts who trace the index:
        Sources: Yardeni, Thomson Reuters, Factset
        I follow up by also reporting on what market strategists at major banks are forecasting:
        As of right now, there seems to be only nascent attempts to forecast long term damage to earnings, but a consensus is forming that there will be some.
      2. Cash Return: In 2019, companies in the index returned 146.30 in cash to stockholders, 57.5 in dividends and 87.8 in buybacks, amounting to 89.75% of earnings in that year. This represented a continuation of a trend through the decade of increasing buybacks and cash return:
        As with earnings, this crisis will result in cash flow shocks, and dividends and buybacks will drop this year. Given that dividends tend to be stickier than buybacks, the drop will be lower fro the former than the latter. Analysts vary on how much, though, with a range of a drop of 30-70% in buybacks and 10-30% in dividends.
      3. Risk: Every crisis has consequences for risk premiums, as I noted in this post, and it is for that reason that I have been updating equity risk premiums, by day, since February 14.
        Add caption
        In the early weeks of this crisis, equity risk premiums soared, peaking at more than 7% in mid-March, and have steadily dropping since, though at 5.3-5.5% on June 1, they remain above pre-crisis levels.
      Using this information, I made my best judgments, assuming that earnings for the S&P 500 will be 120 in 2020 and 150 in 2021, at the more conservative end of the analyst estimates, and that dividends and buybacks would drop in 2020, the former by 20% and the latter by 50%.  I also assume that companies will return far less cash in future years, partly in response to the crisis:
      With these assumptions, I can value the index and I capture the valuation in the picture below. My estimated value for the index is about 2926, which would lead to a judgment that the index was over valued by about 6% (based upon the level on June 1, 2020).
      As with my March 2020 valuation, I am fully aware that my numbers are just a reflection of my story and that each of the inputs has a range around it, and I have brought in that uncertainty into a simulation below:
      Download simulation results (Oracle Crystal Ball used in simulation)
      Note that I have centered the simulations around the median estimates of earnings for 2020 and 2021 from analysts, while building in the range in the estimates into the distributions. The median value from the simulation is 2932. On June 1, the S&P 500 was trading at close to 3100, putting it near the 80th percentile of the distribution, bolstering the "market has gotten ahead of itself" camp, but there is something here for everyone. If you are more optimistic about earnings in 2020 and 2021 than the the median analyst, and about how quickly and completely the market will recover from the crisis shock, you will arrive at a higher value than mine. If you are more pessimistic about the future, perhaps because you think the market is under estimating the likelihood of a second wave of shutdowns or a surge in company defaults, your valuations will be much lower.

      In all of this discussion, you will note that I have not mentioned the Fed, and to those who are Fed-focused, it may seem like I am ignoring the elephant in the room. I have argued, for much of the last decade, that analysts and investors over estimate the effect that the Fed has on markets. To the counter that it is low interest rates that are keeping the index level high, my response is that low interest rates cut both ways, first by lowering the discount rate (and thus increasing value) but also by signaling much lower growth in the long term (which I capture by lowering growth in perpetuity to the risk free rate). In fact, in my valuation spreadsheet, I offer the option of raising interest rates to what you may believe are more normal levels over time, and you can check out the effect on value, and don't be surprised if it is not as large as you expect it to be, since I also adjust growth rates and equity risk premiums to reflect changed rates. In fact, use the spreadsheet to and make your disagreements with me explicit, come up with your value for the index, and let's get a crowd valuation of the S&P 500 going. (It is a google shared spreadsheet, where you can enter your estimated value for the index).

      Bottom Line
      Every investor has a narrative, sometimes explicit and sometimes implicit, about how the economy and markets will evolve over time. Markets reflect a collective narrative across investors, and there are times when your narrative will be at odds with that of the market. It is during those times that you will feel the urge to label markets as crazy or irrational, and to view yourself as the last sane investor left on the planet. While I understand that urge, it is my experience that projecting your personal fears and hopes on to the market, and then getting angry when the market responds differently is a recipe for frustration and dysfunctional investing.  That is not to say that markets cannot be wrong, but even if they are, a dose of humility is always in order, and there is always something that can be learned from market movements. Right now, it is true that markets are collectively more upbeat about the future than most economists/market experts, but given their relative track records over time, are you really more willing to trust the latter? I most certainly am not!

      YouTube Videos


      Data
      1. Market data (June 1, 2020)
      2. Regional breakdown - Market Changes and Pricing (June 1, 2020)
      3. Country breakdown - Market Changes and Pricing (June 1, 2020)
      4. Sector breakdown - Market Changes and Pricing (June 1, 2020)
      5. Industry breakdown - Market Changes and Pricing (June 1, 2020)
      6. Equity Risk Premium, by day (Updated through June 1, 2020)
      Spreadsheets
      1. Spreadsheet to value the index (June 1, 2020)
      2. Simulation results for S&P 500 valuation (June 1, 2020)
      Google Shared Spreadsheet (for your S&P 500 valuations)





      A Viral Market Update XII: The Resilience of Private Risk Capital

      In the midst of chaos and confusion, it is human nature to look for order and for a unifying theory that explains the world. As I have navigated my way through this crisis, I have used data from markets to try to come up with explanations for why markets have rebounded as quickly and as much as they have, and in the process, why they have added value to some companies, while reducing the value of others. It is in this pursuit that I noted that the crisis has enriched growth companies at the expense of value companies, flexible companies have gained at the expense of rigid ones, and young companies have gained on older, more mature businesses. But why have these shifts occurred? In this post, I look at a factor that lies behind all of them, and that is the resilience of private risk capital, taking the form of venture capital for start ups and private business, initial public offerings in public markets and debt (in the form bonds and bank loans) to the riskiest companies, as the crisis has unfolded. 

      Market Outlook
      Let me start, as I have in my prior posts on this crisis, start with a market overview. In the three weeks since my last update, equity indices have continued their recovery, albeit at a more modest pace, from the worst days of the crisis:

      Download data
      Note that I have broken returns down into two periods for every index, the first period (2/14-3/20) marking the worst days of this crisis, and the weeks since (3/20-7/17) representing the comeback. By July 17, the NASDAQ had not just recouped its losses but was up 9.61% since February 14, my starting date for the crisis. Within each region, there remain divergences, with the DAX outperforming the FTSE and CAC in Europe, and the Nikkei and Shanghai doing much better than the Sensex in Asia. As stocks have gone through a roller coaster ride, US treasuries seem to have gone into a coma, after an initial period of frenetic activity:

      The rates on US treasuries dropped significantly in the first four weeks of the crisis, but since the middle of March, have shown almost no movement, with short term treasuries staying close to zero, and 10-year treasuries at or around 0.7%. Tracking oil and copper, two economically sensitive commodities, here is what I see:

      Both commodities saw prices drop between February 14 and the end of March, but oil dropped significantly more than copper in that period. In the weeks since, both commodities have recovered, with copper now trading 12.5% higher than it was on February 14, but oil his still down more than 20%.  As the crisis has played out in the equity and bond markets, I also tracked gold and bitcoin price movements over the period:

      Download data
      Since February 14, gold prices are up more than 14%, reaffirming its role as a crisis asset, but bitcoin has been on a wild ride, dropping more than 50% between February 14 and March 20, as stock prices dropped, and rising almost 75% in the weeks since, as stocks have recovered. In short, it has behaved like very risky equity, not a crisis asset.

      Equity Breakdown
      While looking at indices, treasuries and commodities gives big picture perspective on this crisis, the real lessons are in the company-level data and to learn them, I examined market capitalization changes across all publicly traded companies, classified by region:

      Download data
      Emerging markets, at least collectively, have lost more value than developed markets, with Latin America, Eastern Europe and Africa showing the biggest losses. Asian stocks have done better, with China being the best performing region of the world and India being the laggard in that region. Updating the values globally, stocks have lost $3.6 trillion in market capitalization since the start of the crisis, but that is quite a turn around from the $26 trillion that had been lost through March 20. Breaking down the changes in value, by sector:

      Download data
      While every sector has seen improvement since the bottom on March 20, energy, financials and real estate still show substantial losses in market cap over the entire period, but six of the eleven sectors now show positive returns, with health care leading the way, up 9.5% since February 14. Breaking the sectors down further into industries, here is the list of the ten best and worst performing industries:
      There are two striking features in this table. The first is that the worst performing industries are a mix of  capital intensive businesses and financial services and the best performing industries are dominated by capital-light businesses and health care. The second is the divergence between the best and worst performing industries is striking, with the best performing industries (online retail and internet software) up more than 30% since February 14, while the worst performing industries (oil and airlines) are down more than 40% over the same period.

      Risk Capital
      There is little that I have said in this post, so far, that is new, since it is a continuation of trends that I have seen since March. That said, and now that we have information on winners and losers over the last five months, it is worth taking a closer look at the broader forces that are driving the market to reward some companies, and punish others, and what it is that is making market behavior so disconcerting to long-time market observers. Specifically, I will argue that the behavior of risk capital during this crisis has been very different from prior ones, and it is that difference that explains anomalous market behavior.

      Definition and Crisis Effects
      Risk capital is capital that is invested in the riskiest assets and markets, and it encompasses a wide range of investment activity. For young companies, private and in need of capital to be able to deliver on their potential, it takes the form of venture capital. In public markets, it manifests itself in the money that flows into initial public offerings and to the riskiest companies, often smaller and more money losing. It can also take the form of debt, lending to firms that are in or on the verge of distress, and investing in high yield bonds. In most market crises, risk capital becomes less accessible and available, as fear dominates greed, and investors look for safety. Thus, you will see venture capital, always a boom and bust business, become scarcer, and the young companies that are dependent on it have to either shut down or sell themselves to deep-pocketed and more established companies, often at bargain basement prices. In public markets, initial public offerings become rare or non-existent, and money flows out of the riskiest companies to safer companies (generally with stable earnings and large dividends). In corporate bond market, new issuance of corporate bonds drops off, across the board, but much more so for the riskiest companies (those below investment grade). As I will argue in the rest of this section, that has not been the case in this crisis. While the flight to safety was clearly a dominant theme in the first three or four weeks of this crisis, risk capital has not only stayed in the market through this crisis, but has become more accessible rather than less, at least in some segments. 

      Venture Capital
      Investing in young companies, especially start-ups and angel ventures, has always been a high-risk endeavors for two reasons. First, these businesses have to be priced or valued with much less information on business models or history than more mature companies, and many investors are uncomfortable making that leap. Second, the failure rate among these companies is high, since more than two-thirds of start ups do not make the transition to being viable businesses. Venture capital's role is to nurture these young companies through these early dangers, and in return, the hope is that the investment will earn outsize returns, when they exit.  This accentuated risk return trade off makes venture capital the canary in the coal mine, during a crisis, and you can see that play out in the following graph, tracking venture capital raised by year, both in the US and globally:

      Source: NVCA Yearbook

      In the last quarter of 2008 and in 2009, as the public markets plunged into crisis, note the drop of in venture capital invested, down more than 50% globally, and 60% in the United States. In fact, it took until 2014 for venture capital to return to levels seen before the crisis (in 2007), but once it did, it found new buoyancy leading into 2020. When the COVID crisis hit in February, the question was whether venture capital would retreat as it did in 2008, and the numbers so far don't seem to indicate that it will:
      Download data
      Venture capital infusions did drop off in the first quarter of 2020, but not precipitously, and staged a recovery int he second quarter. It is true that less money is being invested in angel seed companies, presumably the riskiest class, and more in later stage businesses, but it does not look like venture capital has shrunk back into its shell, at least so far. 

      Public Equity Risk Capital
      In public markets, risk capital plays out in more subtle ways than in private markets, flowing in and out of the riskiest segments of the market, as fears rise during a crisis. In most crises, as I noted earlier, the money flow favors the safer companies, pushing up their pricing and valuation, and works against the riskiest companies.

      1. Risk Groupings
      One measure of how risk capital has behaved in public markets is to look at market capitalization shifts from groupings of companies that are considered risky to groupings that can be considered safe. Since there can be disagreements about how best to create these groupings, I have considered multiple measures for the risk/safe continuum in the table below, and highlighted how market capitalizations have changed, in the aggregate, on each measure:

      To make sense of this table, pick a grouping, say PE ratios. The Risk On/Off columns highlight the conventional wisdom that low PE stocks are safe and high PE stocks are risky. The returns columns report on what companies in the top and bottom deciles of PE ratios have earned during this crisis period, in both percentage and dollar terms. Thus, the stocks with the highest PE ratios (top decile) have seen their market capitalization increase by 10.81% ($674 billion) while stocks in the lowest PE ratio decline have seen their market values drop by 8.31% ($246 billion).  On almost every measure that I use for risk in this table, this market has pushed up the valuations of the companies that would be considered riskiest and pushed down the values of the companies that would be considered safest.  The only risk categorization where punishment has been meted out to the riskiest companies is financial leverage, with the companies that have the most debt (in net debt to EBITDA terms) seeing market capitalization decrease by 15.49% ($1,082 billion), while companies that have the least debt have seen market value increase by 12.32% ($300 billion). It is still only five months into the crisis, and markets can surprise and shift quickly, but at least from today's vantage point, this crisis has played out in a most unusual way, with the riskiest companies increasing in value, at the expense of the safest, with debt-driven risk being the exception.

      2.  IPOs
      One of the most observable measures of market confidence in access to risk capital is initial public offerings, since companies going public are often younger, more risky companies. The best way to illustrate this is to look at initial public offerings over time, measuring both the number and dollar value raised in these offerings:

      Source: Jay Ritter IPO data
      In terms of number of initial public offerings, the 1990s clearly set a standard that we are unlikely to see in the near future, and while the dot com bust brought the IPO process back to earth, you can see the damage wrought by the 2008 crisis. In the last quarter of 2008, as the crisis unfolded, there was only one initial public offering made in the US and the drought continued through 2009. While the number of IPOs has remained well below dot com era levels, the value raised from IPOs bounced back in the last decade, reflecting the fact that companies were delaying going public until they were bigger in market cap terms, with 2019 representing a year with several high-profile IPOs that disappointed investors in the after-market. When the COVID crisis hit in February, the expectation was that just as in prior crisis, the IPO process would come to a grinding halt, as private companies waited for the return on risk capital. In the graph below, I look at initial public offerings (both in numbers and dollar proceeds), by quarter:

      Download data
      As with venture capital, there was a pause in the IPO process, in the first few weeks, and you can see that in the first quarter numbers. However, initial public offerings returned to the market in the second quarter, in both numbers and dollars, and the pipeline of IPOs is filling up again. In fact, I have not counted IPOs of SPACs (or blank check companies) in my statistics in my analysis, and there were quite a few of those in the second quarter of 2020, another indicator of investors willing to take risk. 

      3. The Price of  Risk (Equities)
      When risk capital is on the move, the number that best reflects its movement is the equity risk premium, rising as risk capital becomes scarcer and falling with access. During 2008, for instance, my estimates of the equity risk premium reflected this fear factor, rising from 4.4% on September 12 yo a high of 7.83% on November 20, before dropping back to 6.43% on December 31 (still well above pre-crisis levels):

      I have reported that process during this crisis, but my estimates of the equity risk premium for the S&P 500 are in the graph below:
      Download data

      The story embedded in this graph is the same one that you see in the VC and IPO pictures. In the first few weeks of the COVID crisis, the price of risk in the equity markets surged, just as it had in 2008, hitting a high of 7.75% on March 23. In the weeks since, equity risk premiums have almost dropped back to pre-crisis levels, as risk capital has come back into the market. Incidentally, this return of risk capital is not just a US-phenomenon, as can be seen in the picture below, where I report my estimates of the equity risk premiums, by country, through the crisis:
      Download the data

      With each country, I report three numbers, an equity risk premium from the start of 2020 (reflecting pre-crisis values), from April 1, 2020, at the height of the market meltdown, and from July 1, 2020, as capital has returned. Just to illustrate, Brazil saw its equity risk premium rise from 8.16% on January 1, 2020, to 11.51% on April 1, 2020, before dropping back to 9.64% on July 1, 2020. Put simply, risk capital has returned to the riskier emerging markets, though the return has not been as complete as it has been in the US.

      Risky Debt
      Much of the discussion about risk capital so far has been focused on equity markets, but there is risk capital in other markets as well. In the private lending market, risk capital is what supplies debt to the companies most in need of it, often distressed, and in the corporate bond market, it manifests itself as demand for the riskiest corporate bonds, usually below investment grade.

      The COVID Effect - Early Days
      In the first few weeks of the crisis, the key concern that investors had about the economic shut down was whether companies that carried significant debt loads would be able to survive the crisis. This fear manifested itself not only in concerns about bankruptcies, but also in government bailouts to save companies that were most exposed, such as airlines. There was also talk of how this crisis could spread to other sectors burdened with debt, and put the banking system at risk. It is these fears that led the Fed to announce on March 23, 2020, that it would be provide a backstop in the corporate lending market, proving loans to companies in distress and buying corporate bonds. There is debate about whether the Fed should be playing this role, but it cannot be denied that this action, more than any other by any entity (government or central bank) during this crisis, changed its trajectory.  It is not a coincidence that Boeing which had been having trouble raising debt, in early March, was able to borrow $25 billion in the corporate bond market a few weeks after the Fed's announcement. In fact, as you will see in the section below, the Fed's announced opened the flood gates for corporate bond issuances and caused a turnaround in corporate bond yields.

      The COVID Effect - Corporate Bond Issuances
      In the corporate bond market, risk capital is the lubricant that provides liquidity in the high yield bond market, and allows companies that are below investment grade to continue raising capital. Not surprisingly, during crises, it is this portion of the corporate bond market that is affected the most, with yields climbing and new bond issues becoming rarer. You can see this phenomenon play out in the graph below, where I look at corporate bond issuances by year:

      Download data

      During the 2008 crisis, bond issuances declined across the board in the last quarter of 2008 and the first quarter of 2009, but the drop was much more precipitous for high yield portion. During the COVID crisis, the numbers look very different:


      After a brief pause in issuances in the first few weeks (between February 14 and March 20), bond issuances returned stronger than ever, with high yield bond issuances hitting an all-time high (in dollar value) in June 2020. For the moment, at least, the Fed's backstop bet has paid off in the bond market.

      The Price of Risk (Bonds)
      As with the equity market, there is a market measure of access in risk capital in the bond market, and it takes the form of default spreads. During a crisis, as risk capital leaves, you see spreads increase, as was the case in the last quarter of 2008:


      Default spreads increased across the board for bonds in every ratings class, but much more so for the lowest rated bonds during the 2008 crisis. To provide a contrast, I looked at default spreads for bonds in seven ratings classes on February 14, March 20 and July 17:


      As in 2008, default spreads surged between February 14 and March 20, as the crisis first took hold, but unlike 2008, the spreads have rapidly scaled down and are now lower for the higher investment grade classes than they were pre-crisis and only marginally higher for the lowest rated bonds.

      Explaining the Resilience
      If you accept the evidence that risk capital has stayed in the market during this crisis, in contrast to its behavior in prior crises, the follow-up question is why. For some of you, I know the answer is obvious, and that is that this market recovery has been engineered and sustained by central banks. While there is some truth to the "Fed did it" argument, I think it is too facile and misses other ingredients that have contributed.
      1. Central Banks: Earlier in this post, I noted that the turnaround in this market can be traced to the Fed's announcement on March 23, that it would provide a backstop to the corporate bond/lending market. That said, the actual amount spent by the Fed on these programs has been modest, as can be seen in this graph:
        Source: Financial Times
        While there is a healthy debate to be had about whether central banks have become too activist, I believe that the Fed's corporate backstop announcement is the type of action you want central banks to take, since in its absence, bankruptcies and bailouts would have been the order of the day. In fact, the very fact that the Fed has actually not needed to use it is evidence that it worked, since private lenders stepped in to fill the gap. I concede that some risk taking investors will take the wrong cues from this action, expecting that the Fed will protect them from the downside, while they take advantage of the upside. 
      2. Investor Composition: The Fed's actions worked as well as they did because investors in both equity and bond markets responded quickly and substantively, and that response may reflect the changed composition of investors today. First, markets have become much more globalized, and investors are much more willing to invest across markets, with money moving from equity to debt markets, and across geographies, much more easily than it used to. Second, the investment world has flattened, as retail investors (the so called stupid money) catch up to institutional investors (smart money?) in terms of access to information, data and tools and are more willing to deviate from conventional wisdom. 
      3. Unique Crisis: As I have noted in prior posts, this has been an unusual crisis, in terms of sequencing. Unlike prior crises, where market meltdowns came first and the economic damage followed, in this one, the economic shutdown, precipitated by the virus, came when markets were at all-time highs and risk capital was widely accessible. It is possible that risk capital, for better or worse, believes that this is crisis comes with a timer, and that economies will revert back quickly once the virus passes, and shut downs end.
      4. Change in Corporate Structure: After two decades of disruption, it is quite clear that center of gravity has shifted for both economies and markets, with the bulk of the value in markets coming from companies that are very different from the companies that dominated the twentieth century. While much is made of the fact that the biggest companies of today's markets (in market capitalization terms) derive their value from intangible assets, I think the bigger difference is that these companies are also less capital intensive and more flexible. That flexibility, allowing them to take advantage of opportunities quickly, and scale down rapidly in the face of threats, limits downside and increases upside. At the risk of using a buzz word, there is more optionality in the biggest companies of today, making risk more an ally than an enemy for investors, and with options, risk can sometimes be more ally than enemy.
      Five months into this crisis, I am still learning, and there is much that we still do not know about both the virus and markets. 

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      A Viral Market Update XI: The Flexibility Premium

      I must confess that when I started these updates in February, I did not expect to be doing them in July, but a crisis is as good a time as any, to learn new lessons and relearn old ones. As the virus makes a comeback, particularly in the United States, it is not surprising that markets reflect the uncertainty that we all feel about how the rest of the year will play out in both our personal and business lives, with  mood rising and falling on positive and negative news stories. In this post, I will begin by updating the numbers for markets overall, and within the equity market, across regions, sectors and industries. I will then use the differences I see across companies to highlight flexibility in investing, operating, financing and cash return policies as the one quality that seems to be separating the winners from the losers in these last few months, and argue that this represents an acceleration of a longer term shift towards more nimble and adaptable business models.

      Market Update
      If you have been reading all of my viral market updates during this crisis, I admire your fortitude, and I know that you will get a sense of deja vu, as you read this section, since I follow the same road map on each of them. I start, as always, by looking at US dollar returns on selected equity indices around the world:

      Download data
      Looking at the entire time period (2/14-6/26), US equity indices have done better than European equity indices, with a strong rebound from the lows of March 20 allowing for a complete recoupment of losses in the NASDAQ and an almost complete retracing for the S&P 500. Asian equities have diverged, with Japan and China performing better than India. As equities have seesawed, US treasury bonds have stabilized, after a steep drop in yields in the first four weeks of the crisis:
      The treasury rates have settled in, at least for the moment, at close to zero at the short end of the maturity spectrum and at about 0.65-0.75% for the 10-year bonds and 1.2-1.4% for 30-year bonds. I know that there is a widely held view that it is the Fed that has engineered the rate drop, but note that much of the decline occurred before the Fed made its quantitative easing announcements in mid-march.  I think that the Fed’s real impact has been on private lending, with its March 23rd announcement that it would operate as a backstop in corporate bond and lending markets. You can see the effects of that announcement on default spreads for corporate bonds, across ratings classes:
      Note the climb in default spreads between February 14 and March 23, with investment grade (BBB) rated bonds almost tripling during that period, and the pull back in spreads since, to end at levels higher than on February 14, but well below the March 23rd levels. Mirroring the changes in the price of risk in the corporate bond markets, the price of risk in equity markets (measured with an implied equity risk premium) has been on a wild ride, rising dramatically between February 14 and March 23, before sliding down towards pre-crisis levels:
      Download data
      At one level, the fact that equity risk premiums are above 5% and well above historic norms (4.86% between 2000-2019 and 4.20% between 1960-2019) may seem comforting, but there is a disconcerting component to these expected values. The equity risk premium of 4.83% on February 14 was earned on top of a ten-year bond rate of 1.59%, yielding an expected return of 6.42% on equities, already low by historic standards. The equity risk premium of 5.23% on June 30 was earned over and above a ten-year bond rate of 0.66%, yielding an annual expected return of 5.89% on equities for the long term, a number well below the 7-8% that investors were pricing stocks to earn during much of the last decade. Paraphrasing Winston Churchill, equities don't look good as an investment class, until you compare them to the alternatives.

      Looking at oil and copper, the two economically-sensitive commodities that I have tracked through this crisis, the divergence between the two remains, with oil prices down almost 30% since February 14 and copper prices up 4.31% since that date:

      Download data


      Finally, I keep tabs on gold, a crisis investment of long standing, and bitcoin, a more recent entrant into the game. 

      Download data

      If this were a contest for a crisis asset, gold wins by a knock out, since bitcoin, at least during this crisis has moved with stocks, dropping more than 50% between February 14 and March 20 and rising more than 70% from its lows after March 20. It is possible that bitcoin can still live up to the promise of being a good currency, but it has not even come close to being one yet, snd if you are a Bitcoin advocate, you have your work cut out for you.

      Equities: An Overview
      I stick with my practice of downloading the market capitalizations of all publicly traded companies in the world, and then computing aggregated changes in value by groupings. In my first grouping, I look at how equities have performed across the regions of the world:

      Download data
      Looking at percentage change in aggregate market capitalization between February 14 and June 26, global equities have lost 9.30% of their value ($8.4 trillion), but that is quite a comeback from the 29% loss ($26.3 trillion) recorded on March 20. Emerging markets in Africa, Latin America and Eastern Europe show far more damage than developed markets over the entire period (February 14-June26), though the UK is an exception, down almost 20%. Breaking down the market action by sector:

      Download data

      If you were primarily invested in technology and health care, your reaction to the crisis might be "What crisis?", since those sectors are now ahead of where they were on February 14, and consumer product companies (both discretionary and staple) are not far behind. Energy and real estate have lagged the market, as have utilities, but financials remain the worst performing sector remains. If you look at the last four columns, you can see that even in sectors that have held their own during this period, the recovery has been uneven, with more stocks down than up in every sector. Finally, I break down sectors into industries, and list the ten worst and best performing, in terms of market cap change from February 14 to June 26:
      Download data
      As in my prior week updates, there is a preponderance of infrastructure and financial services in the worst performing industry list, and a dominance of health care and technology on the best perfuming list. Education is a new entrant into the best performing list, perhaps reflecting the promise and potential of online education.

      The Flexibility Story
      As the market makes its way back from its lows, it remains an uneven one, with wide divergences between winners and losers, and in my earlier posts, I have looked for clues in the data. In my fourth post from March 23, I noted that heavily indebted companies have under performed companies with lighter debt loads, and in my eighth post from May 13, I highlighted the fact that growth stocks are outperforming value stocks. In my last post from June 19, I used the concept of a corporate life cycle, and noted that younger companies seems to be doing much better than older companies. Others have noted that capital intensive businesses seem to have been worse affected during this crisis than capital-light businesses, and early in the crisis, buybacks were highlighted as a reason why some companies and sectors were doing worse than others. In fact, the new buzzword that business consultants are pushing is "resilience", arguing that the resilient companies have weathered this crisis better than the rest of the market. While there is some truth in all of these contentions, I would argue that if there is one quality that ties together all of these seemingly disparate factors, it is flexibility, and this crisis has reaffirmed the value of flexibility.

      Flexibility across the Business Model
      Simply put, the flexibility of an organization measures the speed and cost with which it responds to changed circumstances, with more flexible firms adjusting faster and at lower cost than less flexible firms. That definition, though, encompasses a range of actions that stretch across every aspect of business, covering everything from how investments are made, to how the business is operated, to how it is funded, and finally to how much cash is returned to owners (in the form of dividends and buybacks).

      a. Investment Flexibility
      To grow, businesses have to reinvest and investment flexibility measures how much they have to reinvest to deliver a given growth rate, and how long it will take for the investment to pay off


      While it is true that companies that are in businesses that require heavy infrastructure investment (toll roads, telecommunications, automobiles) have low investment flexibility, and service and software firms generally have high investment flexibility, the divide is not necessarily on whether the investments are in tangible or intangible assets. Pharmaceutical companies, for instance, have low investment flexibility because they have to spend large amounts in R&D, with significant leakage (as some R&D will not pay off) and have to wait long periods before commercial success. Over the last decade, disruption in many businesses with a history of low investment flexibility has come from new entrants with business models that allow them to scale up quickly, with relatively low investment. Uber and Airbnb are examples of sharing economy companies that have had a decisive advantage this dimension over their established competitors. To see how this crisis has played out on the financial flexibility dimension, I classified all non-financial service companies listed globally, based upon the ratio of sales to invested capital, on the (questionable) assumption that invested capital (computed from the accounting balance sheet values of debt, equity and cash) measures reinvestment, into ten deciles:

      Note that companies that can generate the most revenues per dollar of invested capital are signaling the highest investment flexibility and they have done far better during this crisis than firms that are in lowest decile of this measure. Some of this may be spurious correlation, but it is an interesting first take on how investment flexibility has been treated by the COVID market.

      b. Operating Flexibility
      During the course of operations, businesses will be hit by shock that cause their revenues to unexpectedly increase or drop, and operating flexibility measures how those revenue changes flow through into operating profitability. The key to decoding this effect is to break down the operating expenses of a company into fixed and variable, with the latter moving up and down with revenues, while the former stays fixed:

      Companies with high fixed costs, as a percent of revenues, will see much more dramatic swings in operating income, as revenues change, than companies that have more flexible cost structures. It is not surprising, therefore, that airlines have wild swings in profitability from good years to bad ones, whereas online retailers and service businesses have more muted effects. To see how operating flexibility has played out in this market, I would have liked to have broken costs down into fixed and variable for all companies, but lacking clean accounting measures of either, I settled for gross profit margins, on the assumption that companies with high gross margins have far more flexibility in dealing with revenue shocks than companies with low margins. Breaking down companies based upon gross margin into deciles, here is what I find:

      With a full admission that gross margin is a flawed measure of operating flexibility, companies with higher gross margins have done better than companies with lower gross margins, as this crisis has unfolded.

      c. Financing Flexibility
      As revenues go up and down, and operating income tracks those changes, financial flexibility measures how much net income (to equity investors) is altered, with firms with low financial flexibility showing much bigger swings in net income for a given change in operating income. The key drivers of financial flexibility are debt obligations and cash holdings, with the interest expenses on the former pushing up net income volatility, and the interest income from the latter dampening that volatility:

      If net debt, as a percent of cash flows or value, is the driver of financial flexibility, we can see how financial flexibility has played out in this crisis by breaking companies down into deciles based upon Net Debt as a multiple of EBITDA:

      Download data
      Companies with high net debt ratios have low financial flexibility and they have been damaged far more than companies with low net debt ratios. Note that the lowest decile of net debt ratios includes firms that have negative net debt, i.e., cash balances that exceed the debt, and they show an increase in market capitalizations between February 14 and June 26.

      d. Cash Return Flexibility
      The end game, when investing in publicly traded company stocks, is to collect cash flows from that investment, and companies have two choices when it comes to returning cash. The conventional approach has been to pay dividends, but over the last three decades, US companies in particular have turned to returning cash in the form of buybacks. Both dividends and buybacks have to be funded by cashflows to equity investors, and cash return flexibility measures how quickly companies can adjust their cash returns to reflect changes in cash flows to equity:

      Obviously, companies that return little or no cash, relative to their free cash flows to equity, are not only accumulating cash, but have far more cash return flexibility than companies that return a large proportion of their cash flows. Since dividends still remain the primary mechanism for returning cash across the world, I start by looking at dividend yield, classified into deciles, and looking at the market action in each decile for global companies:
      Download data

      Clearly non-dividend paying stocks and stocks with low dividend yields have done much better than companies with high dividend yields. Among companies that do return large portions of cash, those that return the bulk of their cash flows in the form of dividends have far less flexibility than those that buy back stock, mostly because dividends are sticky, since once they are initiated and set, companies are reluctant to change them. To examine whether the mode of cash return has been a factor in the market action, I break companies into four groups based upon whether they pay dividends and/or buy back stock:

      While companies that pay both dividends and buybacks have been worst affected and companies that use neither have performed the best over the period, isolating only companies that pay only dividends or buy back stock, companies that pay only dividends have under performed companies that buy back only stock. While the results are only indicative, they do suggest that making buybacks the bogeyman in this crisis is not backed up by the evidence.

      Implications and Conclusion
      During this crisis, markets have rewarded flexible companies, a continuation of a trend that predate the crisis to the last one. If the last decade has been a disruptive one, that disruption has been largely driven  by companies that have not only built flexible structures, but also used that flexibility to gain competitive advantages over their status quo competitors. As companies get pushed to increase flexibility, it is worth noting that this quest comes with costs, and these trade offs have to be acknowledged:
      1. Compressed Corporate Life Cycle: Earlier in this post, I argued that one of the benefits of having high investment flexibility is that companies can scale up faster; Uber and Airbnb have been able to go from start ups to large companies (at least in terms of operations and value) in very short time periods. However, the same forces that allow these companies to scale up faster also create business models which are more difficult to defend against new competitors, leading to shorter periods of maturity and more speedy decline, with important consequences.
      2. Losses on the upside: With operating and financial flexibility, the trade off is much simpler, since companies with greater operating and financial flexibility will be more protected on the downside, but at the expense of giving up some of the upside. Having large fixed costs and/or high net debt will result in bigger losses when times are bad, but it will also create larger profits on the upside.
      3. Social costs: As new business models are built to have motor flexibility, some of the actions that increase flexibility come with costs that are borne by society, rather than the company. For instance, Uber's business model of treating drivers as independent contractors rather than employees gives the company a more flexible cost structure, but it does pass on the costs of providing a safety net (health care and pensions) to society. As a society, we need to debate whether the benefits we gain by having a more nimble economy outweigh the social costs. 
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      From Class Rooms to Class Zooms: Teaching during COVID times!

      As some of you who have visited my website and read my bio know, I describe myself first and foremost as a teacher,  and every semester, for the last decade, I have invited anyone who is interested to join in my classes. In December 2019, when I posted my last invite, I fully expected to be teaching corporate finance and valuation, in person, at the Stern School of Business at NYU, in the spring of 2020, and I invited people to join in virtually, albeit for no credit. Needless to say, COVID upended my plans, as it has everyone else’s, and we had to move classes online in early March, and spent the last half of the semester, meeting on Zoom, and taking exams online. As the fall semester approaches, I have the luxury of sitting back and waiting, since I am not scheduled to teach until the spring again. I am thankful that I will not have to deal with the chaos that September will bring to classrooms around the world, in both schools and colleges, but that will not stop me from extending an invite to my classes in the fall.

      A Teacher's Lament
      I have been a long time advocate of using technology to deliver classes online, and my first attempts to do so date back to the 1990s, well before the appearance of Coursera, EdX and a host of other online platforms. When classes had to be moved online mid-semester in the spring of 2020, I was more prepared than most to deliver my classes online, having had some experience in the game. As this crisis has stretched from days to weeks, and from weeks to months, my office at home has become a home recording studio, but my updated camera still captures me in shades of dishevelment, and my new microphone cannot completely shut out the sounds of home, from my dog barking at the front door, to Alexa notifying me that a new package has arrived, to the microwave pinging.  

      That said, this semester was a reminder, in case I needed one, of how much of what I love about teaching comes from physically being a classroom. Don't get me wrong! I love what Zoom, Cisco WebEx, Microsoft Team and Google Classes have created as platforms,  to allow me to teach my classes online, but as I explain in this long-ago session I did on teaching as a craft, there is an element of magic that can show up only in a classroom, and even there only rarely. If you ask me where the magic comes from or how it is created, my answer would be that I do not know, and that if I did, I would bottle it and drink it myself. I am aware, though, when it happens, and it does so suddenly, and in settings and moments where you least expect it, and when it does, there is no experience quite like it.  It is the reason that I would not trade in what I do for a living for any other profession in the world, no matter how lucrative the payoffs. 

      I am sure many of you find yourself working in unfamiliar settings, as you struggle to get your job done from home, and juggle multiple roles (parents, teachers, handymen). I also know that some of you were expecting to be back in school soon and have been disappointed to find out that you will be taking your classes online again. The last thing that many of you may want to do is to add another online task to your to-do list, but just in case you do have the time and the inclination, I thought I would give you a look at the courses that I teach (or have taught) and the platforms that I offer them on, to find a course/platform combination that is to your liking. 

      Picking your Poison
      I have been lucky in my academic life that I have never been good enough at any one area of finance to become a specialist/expert, and have had to develop diverse interests in both teaching and research and different ways of delivering (timing, platform) what I know, to create something resembling a niche.

      Courses
      In 1985, in my very first year of teaching at the University of California at Berkeley, I taught five different classes from corporate finance to investments to central banking, knowing just enough of each to stay one step ahead of my students. In the years since, my primary teaching at the Stern School of Business has been focused on two courses, corporate finance to the first year MBAs, and valuation to the second year MBAs, with occasional forays into undergraduate teaching. Along the way, I also developed the material to teach a third course on investment philosophies that I have never delivered in a classroom at NYU but have taught in shorter programs elsewhere. In fact, over the last three decades, I have unpacked and repacked these three classes and delivered them on every continent, and in different durations, ranging from an hour (yes, really!) to a day to three days. I don’t require much in terms of pre-prep for any of these classes, but there are a few very basic financial building blocks and economic concepts that I draw on repeatedly that I have now packaged into a course that I unimaginatively call my foundations of finance class. 

      1. Foundations of Finance
      Coverage: I have always thought of finance as a hybrid discipline, with roots in economics, and substantial contributions from statistics, accounting and psychology. In this short class, more a collection of tools and topics than a real course, I look at how the time value of money, an incredibly simple construct built around cash flows and risk, underlies much of what we do in finance, and the mechanics of putting it into practice. I also do a brief introduction to three macroeconomic variables that show up repeatedly in finance, inflation, interest rates and exchange rates, more from the perspective of a practitioner who has to deal with them on a daily basis and less from that of an economist.
      Objective: To provide a basic understanding of the building blocks that I will use in my corporate finance and valuation classes. 
      Intended audience: If you have no background in finance or economics, the topics that I cover in this class will be useful. If you do, you may find the sessions going over familiar ground, and may find yourself skipping forward. 
      Structure: The class is built around 12 sessions, starting with an introduction to how finance views businesses, moving on to the time value of money and a basic introduction to how we value contractual, residual and contingent cash flows and closing with sessions on three macroeconomic variables (inflation, interest rates, exchange rates) that show up repeatedly in financial analysis.

      2. Corporate Finance
      Coverage: Corporate finance is the ultimate big-picture class laying out the first financial principles that govern how to run a business. Consequently, it covers every aspect of business, from whether and how much to invest back into the business to how to finance (borrowed money or your own) these investments to how much cash to take out of the business (dividends and cash return).
      Objectives: 
      (1) To provide perspective on the core principles that govern investing, financing and dividend decisions, and how choices on one of these dimensions can and often do affect choices on the other.
      (2) To get comfortable with the tools, models and theories that lead to the "right" corporate finance decisions.
      (3) To understand why managers and owners often choose to deviate from the script and make sub-optimal decisions.
      Intended audience: Everyone, from business owners to managers to consultants to investors, but I am biased... 
      Structure: This class starts with an assessment of corporate governance (and where power resides in a  company), moves on to how best assess investments, then to financing mix and type and ends with dividend policy. Since it is an applied class, I use corporate finance tools on a diverse group of companies to see how they work.

      3. Valuation
      Coverage: This class is about attaching a number to an asset, item or investment, and given that broad mission, it draws a contrast between valuing and pricing an investment and develops the tools of each  approach, with intrinsic and discounted cash flows determining value, and multiples/comparable assets driving pricing. 
      Objective: 
      (1) To value and price publicly traded companies, small and large, young and old, developed and emerging markets, as an investor.
      (2) To value and price privately owned and non-traded businesses
      (3) To value and price stand-alone assets
      (4) To price collectibles
      Intended audience: Investors of every stripe, from individuals to venture capitalists to fund managers, equity research analysts, value consultants and financial managers at public companies.
      Structure: The class begins with an examination of broad themes that animate valuation and pricing, and then spends a significant portion of time in the weeks of intrinsic value, talking about cash flows, growth and risk, before moving on to pricing and real option valuation. Along the way, we will look at valuation through different perspectives (investors, acquirers, managers).

      4. Investment Philosophies
      Coverage: This class is designed to provide you with a menu of investment philosophies, from old-time value investing to day trading, with descriptions of the market beliefs that underlie each one, the historical evidence on how well each philosophy as performed, as well as the skills and strengths you will need to make that philosophy work.
      Objective: To find the investment philosophy that is right for you, given your risk preferences, strengths and personal make up.
      Intended audience: Investors of all types, from individuals to professionals, novice to experienced and young to old.
      Structure: In keeping with the idea that there is no one best investment philosophy, the class will begin with the much maligned philosophy of technical analysis and charting, before moving on to value investing and growth investing in its different forms. We then look at trading strategies built around information and arbitrage-based strategy, before ending with a sobering assessment of how difficult it has proved for active investors to beat the market.

      Sequencing and Overlap
      If you an uninterested in any of these classes, there is clearly nothing more to say. If you are, I can offer my subjective road map through the classes. 
      • The course to start with is the Foundations class, since it is only twelve sessions and covers the basics. Feel free to jump ahead if you find the material too basic or just do the sessions that you are interested in.
      • Of the remaining three classes, the one that I think has the widest reach is corporate finance, since understanding how to run a business is something that I believe everyone can benefit from. Put simply, whether you are corporate lawyer, a marketing executive, a consultant or a strategist, understanding corporate finance can make you better at your job. In terms of sequencing, it also lays the foundations for getting more out of the valuations class and should precede it.
      • Valuation builds on corporate finance, but is most useful to those in the business of valuing companies (appraisers, equity research analysts, M&A analysts), but understanding what drives value can also help entrepreneurs and private equity investors. I think that understanding value can be useful even if you consider yourself more of a trader, but that may be my biases speaking.
      • The investment philosophies class is aimed at people interested in investing, whether they be individual investors or professional money managers. Thus, if you have little interest in actually valuing companies from scratch, and more interest in getting a broad perspective on how to invest money, you can skip both corporate finance and valuation and just take this class.
      Will there be some topics that get covered in more than one of these classes? Of course, but in my view (and remember again that I am biased), these are topics that are worth repeating and looking at through a different lens. Thus, I will cover the basics of estimating cost of capital in corporate finance, but with the perspective of estimating hurdle rates for companies that are evaluating projects, and again in valuation, but from the perspective of investors trying to value a company. 

      Delivery Platforms
      With each class that I teach, I have multiple versions that you can access, and you are welcome to pick the one that best fits the time you have available to spend on the class, and what you hope to get out of it. I have tried to make the content equally accessible in all of the platforms.

      1. Regular classes (Free): For the corporate finance and valuation classes, the classes that I teach at Stern are available in unvarnished, but complete, form (classroom recordings of lectures, slides, exams and even class emails). That detail, though, can be overwhelming, since no one was meant to watch a session that last 80 minutes (my regular class time) online, and you can drown in the weekly assignments, quizzes and other components that make for a regular class. That said, this is the closest you will get to a full time class experience in terms of content and if have patience and tolerance, you can make your way through these classes. You can find the entry pages to the classes below:
      With each class, you can stream the class from the NYU server, at least for the latest semesters. The spring 2020 class was distorted by the crisis, and if you prefer a more conventional class, I have the 2019 versions listed as well:
      As you will see on these pages, each recorded lecture comes with the slides that I used for that lecture and a post-class test and solution. Since the NYU server gets wiped clean every two or three years, I have YouTube playlists of the same classes at the links below:
      2. Online Classes (Free): If you don't have the time or the patience to sit through 26 sessions of 80 minutes apiece (and who can blame you?), I have created online versions of all four classes, where I have tried to compress what I would say in an 80-minute session into a 12-15 minute session, and honesty requires me to confess that it was not that difficult, a testimonial to how much padding we put into two-year MBA programs. The webcast pages for all four classes are available below:
      The videos are also available as YouTube playlists for each class:
      3. NYU Certificate Classes (definitely not free): The regular and online classes that I list above are free, but there are two catches. The first is that they come with no certification, since I have neither the inclination nor the resources to keep track of who is taking the class, how well they are doing and providing the certification. The second is that online classes require self-discipline, since there is no mechanism for me to prod or nag you to keep up with the class. For many of you, these are not deal breakers, and I know of many who have persevered to finish these classes. If you believe that you need both the structure of a real class (with deadlines and time schedules) and certification, there is a third option and that is to take these classes through New York University's Executive Education program. The links to the certificate versions of the classes are below:
      1. Foundations of Finance Online (Included in Corporate Finance and Valuation certificate classes)
      2. NYU Certificate in Corporate Finance
      3. NYU Certificate in Advanced Valuation 
      4. NYU Certificate in Investment Philosophies
      These classes have more polished versions of the videos that I recorded for my online class, come with exams and projects, and I do live Zoom sessions every two weeks, with each class, for the clearing up of doubts and questions. They also include quizzes, an exam and a final project, the last of which I will grade and return to you with feedback. Since these are offered through NYU, they come with a price tag, that some of you may find too high. Since the content on these courses is identical to the free online versions (even though NYU has chosen to add advanced to the valuation class and applied to the corporate finance class names), you will have to decide whether these add ons are worth the price that NYU charges for them. And for those of you find that price to be too high, there is always the free version!

      The University Model: Disruption Coming?
      You can accuse me of biting the hand that feeds me, but I have always though that the university model of education, especially as practiced by research universities, is dysfunctional and ripe for disruption.  If a university were treated as a business, and we were asked to objectively assess its performance, we would give it failing grades on multiple counts. The university governance system stinks, investments are driven by ego and me-tooism, the funding process is unsustainable, and universities seem to revel in mistreating their primary customers, the students, who deliver the tuition revenues that represent the bulk of their revenues. That said, this mistreatment is not a new phenomenon and the university model has endured for centuries, foiling and co-opting potential challengers over this period. As recently as a decade ago, there were some who proclaimed that MOOCs (massive open online courses) would upend universities, but that assault, like others before, failed and EdX and Coursera now operate as extensions of universities, rather than competitors. I argued a few years ago that technology-driven disruptors of education were failing because of a fundamental misunderstanding of what a university degree package offers students, viewing a university education as a collection of courses. At the same time, I offered a cautionary note to my university colleagues that change was already here, undermining the moats that universities have erected against competitors. If you are interested in that presentation, you can click here.

      In 2020, COVID may have accomplished what hundreds of years of competitors and critics have not, and exposed the underbelly of the university model. 
      • First, as classes moved online, there were many where students hardly noticed the difference, as classes taught without energy, enthusiasm and engagement in a physical classroom sound the same online, and are easier to mute. 
      • Second, of the many things that students misses after classes moved online, the classes themselves were low down the list, well below friends, college sports and parties. 
      • Third, the fact that most universities were unable or unwilling to cut tuition, even as classes move online, drew attention to the magnitude of the tuition and how little of it is directly connected to student education. 
      • Finally, it forced students and parents, who had been have been conditioned to believe that the only way to get an education is to spend four years at a university, out of their pre-conceptions and to experiment with alternative routes.
      My good friend, Scott Galloway, has been vocal in arguing that COVID is the tipping point that is going to upend the university model. He sees a world, where the strongest and most prestigious schools will survive and perhaps even thrive, while many small colleges and tuition-dependent universities will be decimated. While Scott and I agree on the trends and many of the problems with the university model,  I have more hope than Scott does for the model. I  think that COVID provides an opportunity for universities to remake themselves into institutions where real learning is delivered in classrooms, good teaching is valued, and the focus returns to educating students. This change will come with pain, felt disproportionately by the tenured faculty and administrators, who have benefited the most from the existing model, with the question of tenure itself being debated. As someone with tenure, I believe that no one is entitled to a job for life, and arguing that tenure is needed to allow researchers to express themselves freely sounds good, but is disingenuous. Much of academic research is so abstract and separated from reality that it is unlikely to be read, let alone be the basis for a firing. 

      The Bottom Line
      It has always been true that learning is not restricted to classrooms, and that your education may begin in a classroom, but it finds its grounding when you practice it in the real world, warts and all. There is almost nothing I teach in my classes that is timeless or profound, and I have learned that there is so much more that I do not know about the topics that I teach, than I do. I don't believe that I have either the knowledge or the intellect to answer every question that I am asked, but my job in teaching is to expose the process by which I try to get an answer, misguided and incorrect though it may be. As I have said repeatedly, and in many contexts, I would rather be transparently wrong than opaquely right, and I hope that if you take one or more of my classes, you will not only learn from my mistakes but also develop your own processes for answering the big questions in finance. Good luck and Godspeed!

      YouTube Video
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